Steve Landsburg has a recent

post on capital gains taxation in which he makes one odd but arguably legitimate point while missing two other and, I think, more important ones. The result is that he gets the wrong answer to the question of how capital gains ought to be taxed.

His central claim is that the tax rate on capital gains ought to be zero—more precisely, that if it is zero, taxpayers with capital gains will end up paying as taxes the same proportion of their income as those with other forms of income. It's not as screwy a claim as it seems at first; here is the argument, in my words not his. It assumes a 50% income tax, no capital gains tax.

Taxpayer A earns $1000, pays $500 in taxes, has $500 left to spend on her own consumption—half as much as she would have in a world without taxes.

Taxpayer B earns $1000, pays $500 in taxes, uses the remaining $500 to buy an asset which then appreciates at 5%/year for the next twenty years; for simplicity we ignore compounding. B then sells the asset for $1000, which he can spend on himself.

In a world without taxes, B would have had $1000 to invest and so would have ended up with $2000. Hence A and B have both paid the same tax rate—50%. The only difference is that A chose to take her (taxed) income in the form of $500 of consumption in (say) 1990, B his (taxed) income in the form of $1000 of consumption in 2010. Each ended up with half the consumption he would have had in a world without taxes, so is really being taxed at 50% on all income. Hence, Steve argues, the fair capital gains tax rate, the rate that treats capital gains like other income, is zero.

What is being described here as capital gains looks an awful lot like interest. B could, after all, have deposited his $500 in a bank at 5% instead of buying an asset that appreciated at 5%. From an economic point of view, interest is what people are paid to postpone their consumption, making resources available for other people to use productively. It's not obvious why interest should not count as income and be taxable as such.

No doubt some of what shows up as capital gains is in fact implicit interest, but I don't think that is the natural way of looking at most of it. I think it is more accurately viewed as the return from a particular form of skilled labor. A speculator/investor spends time and effort figuring out what firms and what assets are going to increase in value and investing in them, improving the allocation of capital, nudging markets a little closer to efficiency, and being rewarded, assuming he does a good job, with income above and beyond the normal return on capital. I do not see why the income from that form of labor is a less suitable subject for taxation than income from digging ditches. And since the return is not a fixed proportion of the amount invested, as in Steve's case, but a function of the time and effort spent investing it, Steve's argument for implicit taxation does not apply.

There is, however, a serious problem with treating capital gains as ordinary income—much of it, perhaps most of it, is not income at all.

To see why, imagine that you buy a house for $100,000 and sell it, twenty years later, for $200,000. Over those twenty years, not only has the price of housing gone up, the price of practically everything has gone up, with the result that two dollars at the end of the period will buy about what one dollar bought at the beginning. Measured in nominal terms, by counting dollar bills, you have made a capital gain of $100,000 and will be taxed on it. Measured in real terms, by what those dollar bills will buy, you have made a capital gain of zero. Prices in our society trend up over time, so measured capital gains overstate—for long periods greatly overstate—actual capital gains.

Combine these two arguments and you have a simple conclusion. Capital gains ought to be indexed—measured in real rather than nominal terms, purchasing power not number of dollars. That done, they ought to be taxed as ordinary income.