When Is It Best to Tax the Wealthy? (Part 2 of 2)

When Is It Best to Tax theWealthy? (Part 2 of 2)This week I conclude a two-part series on taxingwealth and income from wealth. The presumption of theseries is that the wealthy will pay some tax; I alsoexamine various ways that distinctions can be and arebeing made among capital owners. Here we turn to smallbusiness versus large business, winners versus losers,and entrepreneurs versus inheritors.Small Business Versus Large BusinessOne of the most confusing of all distinctions in taxa-tion derives from taxing small business differently thanlarge business. The confusion comes in defining just whatis ‘‘small.’’ Generally speaking, tax preferences for smallbusiness are not really used by ‘‘new’’ business. The latteris usually disfavored by the way that investment incen-tives are applied so that only firms with well-establishedprofits can make use of them. Small business preferencesusually are not based on the income of the owner, either.A billionaire might own several small businesses and gettax breaks for each of them. A poor person, on the otherhand, might own shares of corporate stock through aretirement plan, yet pay capital tax on the returns. Quiteoften the business itself need not be small to make use ofsome tax incentive. Noncorporate businesses, no matterwhat their size or income or income of their owners, forinstance, can avoid corporate tax.A debate over tax subsidies for oil and gas industriesbenefiting from higher prices highlights some of thosedistinctions. Many of those subsidies are used by inde-pendent drillers, often partnerships, rather than the largecorporations that buy the oil and gas from the indepen-dent drillers. Are the partnerships small relative to othercorporations? Based on the size of the firm, often. Basedon the average income of their owners, often not.The best case that can be made for favoring smallbusinesses is that they face unjustified disadvantages thattend to reduce competition. The complexity of the legaland tax systems represents one disadvantage. In othercases, however, small businesses may be less, not more,efficient at some activities, as when there are substantialeconomies of scale that can only be exploited by largerbusinesseses. In those latter cases, public policy favoringsmall businesses could create, not reduce, distortions.When it comes to competition, attention to new busi-nesses often may be more appropriate than over smallbusinesses. Of course, a small business trying to newlytake on a larger business may raise some of the sameissues, so the distinction is not entirely pure. Still, existingbusinesses, small or large, can hardly be expected tolobby on behalf of potential new competitors. Finally,even if new or small business needed to be favored, it isnot clear why those preferences should be run throughthe tax code.Winners Versus Losers in the Capital MarketsUnder some very simplifying assumptions, taxingconsumption is equivalent to exempting capital incomefrom taxation. That has led some to suggest that one canproduce the same result in taxation either way. However,that is dead wrong. Among the misleading assumptionsis that everyone gets the same return from capital.Take two individuals, each of whom invests $10,000.One invests and achieves a real return of 7 percent(roughly the average return from stock investment) andthe other gets 2 percent real (roughly the average returnfrom bonds). Let’s call the household of the first investorthe ‘‘winner’’ (relatively speaking) in the capital marketsand the second the ‘‘loser.’’ Differences might be due toluck, planning, or differential risk preferences. Supposethe money is left to accumulate for 70 years. The winnerearns more than $1.1 million; the loser gets an extra$30,000 over his original $10,000 investment.With a pure consumption tax, the winner pays tax onmore than $1.1 million if it is consumed then; with a pureincome tax, the tax is collected over time and might beeven higher on a present value basis (with borrowing andcapital gains deferral, the result is less clear). Regardlessof whether a pure consumption tax or an income tax is inplace, the winner will pay much, much more tax than theloser. In a sense, the government shares in the gains andlosses of the investors.When the tax is forgiven on the capital income, as inthe case of Roth IRAs, the millionaire winner pays nomore tax than the loser. (There is an academic-styleexception that I won’t elaborate on much here, but itabstracts from the notion of winners and losers, assumesthat the winner can’t borrow, and, finally, that the winnerloses the opportunity to invest initially taxed dollars atthe same higher rate of return as implied by her win-nings. Obviously this academic-style argument doesn’twork when one taxpayer invests in General Motors andone in Microsoft in 1970 and they both cash out in 2005.)Entrepreneurs Versus InheritorsThe new versus old wealth debate applies not simplyacross individuals but across time for the same indi-vidual. In other wor