Once upon a time, a man went to work and earned a dollar. He used that dollar to buy a share of stock. The stock paid a dividend of 10 cents a year, 10 percent being the going rate of return in the land.
Thanks to wise corporate management, the dividend eventually doubled to 20 cents a year, causing the stock price to double as well. The man sold his share of stock for $2, which he put in the bank. Eventually, his children inherited the money and reinvested it in the same company. They used their 20-cent annual dividend to purchase goods and services, happily ever after.
That was a fairy tale. Here is the reality:
Once upon a time, a man went to work and earned a dollar. After paying state and federal income taxes, the man was left with 50 cents. He used the 50 cents to buy half a share of stock. When, after many years, the stock price doubled, he sold his half-share for a dollar, paid a 10-cent tax on the capital gain, and put the remaining 90 cents in the bank. Eventually, his children inherited the money, paid 50 cents in inheritance tax, and reinvested the remaining 40 cents in the original company.
The company continued to earn a 10 percent rate of return, of which half went to pay corporate income and excise taxes. The children therefore received an annual dividend of 5 percent, which came to two cents a year. After paying personal income tax on the two-cent dividend, they were left with a penny a year in income. They used part of that penny to purchase goods and services, and the rest went to paying sales taxes.
Okay, I agree — that's a worst-case scenario. There are many things the man could have done to reduce his family's tax burden. He could have chosen an investment that didn't pay any dividends. He could have chosen to hold his stock instead of selling it, accepting some extra risk in return for a lower tax rate. He could have chosen to spend everything he had before he died, leaving his children with nothing. For that matter, he could have chosen not to go to work in the first place. But the fact remains that after a series of perfectly reasonable economic choices, this man's family lost 95% of its income to taxes.
Ninety-five percent! From 20 cents a year down to a penny! How could such a thing happen? In America, no less. Simple — by taxing the same income five times.
Some aspects of multiple taxation are widely recognized, but others are not. Everyone knows about the "double taxation" of corporate income: first when it's earned by the corproation and again when it's paid out in the form of dividends.
But not everyone is aware that capital gains only exist when there are expectations of future income. That means that the capital-gains tax amounts to a third tax on income that's already slated to be taxed twice. Taxing both dividends and capital gains is like fining drivers for speeding and then fining them again for having a high speedometer reading.
And if you think this only applies to the super-rich, think again. Each of these taxes — along with the inheritance tax and any other tax on capital — is ultimately a disguised tax on labor. That's because in one sense, Marx was right — capital is the embodiment of past labor. Today's capital is a deferred reward for yesterday's hard work. Tax that reward and you're taxing the very work that made it possible.
A tax on capital — whether it comes in the form of a tax on dividends, or corporate income, or capital gains, or inheritance — is not just equivalent to a tax on labor, it is a highly discriminatory tax on labor. And who does it discriminate against the most? — the young.
Because the young have many years of saving ahead of them, taxes on capital hurt them far more than the old, who tend to spend their income as it arrives. So not only are people penalized for working, they're penalized doubly for working early in life. Now can you see why I'm in favor of eliminating the income tax on young people?
A tax on labor discourages work, and a tax on capital is nothing more than a stealth tax on labor. If we want the country to grow faster we need more capital, we need the fairy tale. Why do you think I'm for abolishing the capital-gains tax? Why do you think I'm for abolishing the inheritance tax and the double taxation of dividends? I'm not out to help the rich, I'm out to help the working man who wants to be rich. Everyone wants the fairy tale.
My thanks to Steven Landsburg for providing the fairy tale — and the reality. Mr. Landsburg is a professor of economics at the University of Rochester.