Monday, January 30, 2012

Why Mankiw is wrong, and so is Krugman…

After a long period of letting things slide, this fascinating discussion on taxes compels me to get involved. Not for lack of quality contribution to the discussion – the best of the best have spoken, but because the discussion seems to be focused on the wrong problem.

A lot of comment has focused on tax on investment income vis-à-vis tax on ‘normal’ income and the reasons why it differs to the extent that it does. Investment income or ‘capital gains’ are typically taxed at a rate lower than that on ‘normal’ income. As a result, those who derive any part of their income from investments pay a lower average rate of tax on their total income than those who don’t. When seen alongside the fact that those deriving investment income are typically wealthier than those who don’t, and the share of investment income typically increases with income, this is easily seen as a regime that favours rich over poor. Those who oppose it, like Paul Krugman, claim it contributes to increasing inequality by allowing the rich to retain more of their income. Those who oppose it, like Greg Mankiw and Donald Boudreaux, claim that since investment income represents post tax corporate income, the proportion of tax paid by those who derive it should be seen as the sum of the corporate tax rate and the justifiably lower ‘capital gains’ tax rate, which is higher than the tax rate for ‘normal’ income. On the face of it, both positions seem intuitively correct.

However, the issue is not about rich and poor, investment income & normal income, corporate taxes & individual taxes or even about progressive taxation. Its about the distinction between income and savings.

Apart from wages, every other source of income is taxed on the savings it generates. Individual entrepreneurs, businesses and corporations pay tax only on the portion of their income that is saved after all expenses required to earn that income have been deducted. These savings are called profits. Wage earners, on the other hand are taxed on total income, at roughly the same rate paid by all other entities on profits, with a few deductions thrown in to give a semblance of equity to the regime.

Seen from another perspective, except for expenses incurred by wage earners, deductible expenses for one entity are revenues for another. Whether its a professional speaker paying for airfare and accommodation while on a speaking assignment, or a business paying rent for the property it occupies, or a corporation paying telephone bills, the recipient entity accounts for the inflow as a revenue. As mentioned above, it then deducts all expenses incurred by it and pays tax on what remains, while wage earners pay tax on all they receive. But more importantly, when wage earners spend money on food, healthcare, clothing and housing, recipient entities have to account for the inflow as a receipt and pay tax on the profit it generates despite the fact that the wage earner is incurring this expenditure from after-tax income.

The issue at hand is not about favouring the rich, its about disfavouring wage earners regardless of their level of income. This discussion has emotional appeal for the US and other developed nations since a sizeable proportion their population consists of wage earners. However, their angst is not because others gets to keep more of their income. Its because they get to keep so little.