Economics is a beautiful discipline. Done right, it’s a science on par with physics. Unfortunately, too often, economists debase their discipline when they speak in the press. The public remains confused, and convinced that economists can get any result they want – a truly dismal science. Case in point is professor Trevor Tombe’s article in The Hub Why raising capital gains taxes makes sense—yes, really. Instead of helping the public understand the economic reasoning behind taxes on capital income, Tombe simply runs cover for the recent federal budget. Maybe everything in the budget is wonderful, including the new treatment of capital gains, but if economists want to explain the idea to the public, perhaps treating their discipline like a science instead of political punditry would be a good start.
What is efficiency?
Efficiency is a technical concept in economics and Tombe serves to confuse the public by using the word casually. Tombe says “An efficient tax system is one that is neutral and doesn’t bias such decisions.” Sure, but efficiency means far more. In economics efficiency hinges on the Pareto criterion: economic activity that makes everyone better off without making anyone worse off. For example, if you have more wheat than barley and your neighbour has more barley than wheat, and if you can find mutual agreeable terms, a trade would make you both better off while hurting no one. In economics, Pareto efficiency provides the foundation for understanding markets and policy intervention. In an idealized free market the entire economy becomes Pareto efficient through mutually improving trades, leaving the government or central planner with little if anything to do. In reality, markets are not perfect and just because an idealized society is Pareto efficient, for subjective reasons, we might not like the distribution of wealth, even if arrived at through voluntary means. Regardless of the government’s wisdom, it must generate revenue to fund programs. An optimal tax policy ensures that revenue collection minimizes additional distortions to decision making that further break the Pareto criterion. That’s what Tombe means by an efficient tax system, but keep in mind governments that redistribute wealth almost always sacrifice efficiency for equity. Maybe for political harmony it’s a good idea to give up some efficiency for equity, but economics as a science can’t offer too much about what is “fair” – that’s why we have philosophy (and a democracy).
Why tax capital gains differently?
Tombe provides a confused answer to this question. He starts with the argument that a dollar is a dollar, suggesting all sources of income should be taxed the same. He then compares the special capital gains treatment an investor receives when selling a second home to the need for partial capital gains inclusion on corporate profits because of existing corporate taxes. The implication is that second-home investors are still “not paying their fair share” but the corporations and shareholders at the new inclusion rate are. Tombe provides a graphic showing Canada’s “improved fairness” from the federal budget’s increase in the capital gains inclusion rate. Hurrah! The new capital gain inclusion rate is both more efficient and more equitable – the Holy Grail of economic policy!! Yeah, none of this is economics.
Remember: optimal tax policy requires that the government raises its revenue in a way that distorts decision making the least by keeping the Pareto criterion intact as much as possible. It is not clear – and it does not follow from anything in Tombe’s article – that equalizing tax rates across labour and capital accomplishes this goal. Optimal taxation economics shows that it actually does matter how a dollar is generated. There is an enormous body of research on this topic which Tombe completely ignores.
Optimal taxation theory has a core result, the Chamley–Judd theorem. This theorem states that over a long time horizon, the optimal tax rate on capital income goes to zero. More than that, the theorem shows that taxes on capital over the long run harm workers – capital taxes end up Pareto inefficient. The intuition is simple: when the capital stock shrinks, less is left for reinvestment which means lower productivity, less innovation, and therefore less consumption and leisure possibilities for workers (of course there are a lot of important details I’m skipping). The result is mathematically technical with lots of “ifs” that approximate the real world but none of which hold exactly. Chamley-Judd provides an important background result for thinking about optimal tax policies – optimal tax polices robustly separate capital income from other sources. Applying economics as a science in this instance is about identifying, through careful empirical and theoretical research, how the “ifs” of Chamley-Judd and the related literature are violated in a real economy at an actual point in time. One example of a violation is tax arbitrage created by shifting labour income to capital through various compensation schemes. Careful work can help determine the optimal tax rate on capital income in a real world situation. Where we land is complicated. Tombe offers no such insight and teaches us nothing about these difficult questions as they pertain to Canada. Instead he provides book-keeping accounting about “fairness”.
Economists, be scientists!
I don’t know what the optimal tax rate on capital income in Canada should be. Based on Tombe’s article, I don’t think he does either. Maybe capital gains inclusion rates should be increased because of the specifics around the failures of the assumptions behind Chamley-Judd, and those increases will lead us closer to an optimal tax policy. Or maybe taxes on capital income should be higher even though they will lead to inefficiencies and lower economic growth because the trade-off is politically savvy. Or maybe they should just be lower. I don’t know. Whatever the level, an evidence-based approach looks nothing like Tombe’s article.
For all economists out there: Please treat your discipline like a science. When given the opportunity teach the public, start from scientific principles like physicists do. Economics does not have to be the dismal science!