CAMBRIDGE, Mass. (Project Syndicate)—The first months of President Joe Biden’s administration will be defined by the efforts to contain COVID-19 and deliver vaccinations on a mass scale. Over the medium term, however, the economy will determine the administration’s success.
Here, Biden has indicated that tax reform will be a high priority, and he has released plans to address long-running fiscal problems such as federal government revenue shortfalls and the tax system’s loss of progressivity. But these proposals do not yet go far enough to address a major fault line in the tax code: the excessively favorable treatment of capital income (profits and returns on financial assets and savings).
Tax breaks for capital
Capital has always been taxed more lightly than labor has in the United States. In my own research with MIT’s Andrea Manera and Pascual Restrepo of Boston University, we estimate that the effective tax on labor (accounting for payroll and federal-income taxes) in the 1980s and 1990s was about 25%, which meant that it cost $1.25 to pay an employee $1. By contrast, the effective tax on capital was only around 15%.
The situation has only worsened since then, as effective taxes on capital have declined. Following the Republicans’ 2017 tax cuts, capital such as equipment and software faced a tax rate of about 5%, while the effective tax on labor remained largely unchanged.
Today’s rock-bottom taxes on capital are the result of several developments. Marginal taxes on rich households—which tend to receive the greatest share of their income from capital—have declined, and many businesses have changed their tax status to become S-corporations, which are exempt from corporate income tax.
The biggest factor, however, is the U.S. tax code’s increasingly generous depreciation allowances, which have allowed corporations to deduct so much investment expenditure from their tax liability that some are actually receiving a net investment subsidy.
More inequality, more economic distortions
The asymmetry between capital and labor that began in the 1980s increased income inequality and distorted investment and employment decisions. Today, its consequences are graver still, because the range of technologies that firms can use to automate their operations has expanded. There are many more machines and algorithms capable of performing tasks done by human workers, and the tax code is actively encouraging companies to adopt them, even to the point of excess.
Consider the choice between employing 10 workers for the next 10 years, at a salary of $100,000 per year, and buying an $11 million machine that will perform exactly the same tasks. The cost of the first option is $12.5 million ($10 million for the workers, plus tax), whereas the cost of the second option is only $11.55 million (the price of the machine, plus the 5% effective tax on capital). The decision is easy. Even though the workers in this case are actually more efficient than the capital (receiving $10 million for work that would require an $11 million machine to do), the tax code nonetheless induces this hypothetical business to prefer job-eliminating automation.
To be sure, if more technologies, including digital technologies, were designed to complement rather than replace humans, additional capital investment need not eliminate jobs, and could even boost overall worker productivity. Unfortunately, this is not the case.
How did we end up with tax policies that are overtly fueling inequality and costing jobs?
For starters, large corporations have become more vocal and powerful politically over the last several decades—and not just because of the Supreme Court’s 2010 Citizens United ruling, which opened the floodgates for corporate spending in elections. Even more important has been the increase in industry lobbying, with corporations not only influencing lawmakers, but often even writing the legislation themselves.
The economics profession also hasn’t helped. Many economists have clung for too long to the view that capital should not be taxed, on the grounds that doing so discourages savings and reduces investment. But the evidence for these claims is hardly overwhelming. Recent estimates suggest that the supply of capital responds only modestly to tax rates. And given that labor taxes also distort a wide range of economic decisions, there is no compelling reason always to prefer one to the other.
This is not a call for the kind of wealth tax that became a hot-button issue in the Democratic presidential primaries. Rather, the point is to devise a tax code that does not inordinately disadvantage labor vis-à-vis machines.
Now that we are in the middle of the worst economic crisis in generations, it would be inadvisable to hike capital taxes suddenly. But as we emerge from the COVID-19 recession, the economy will need both jobs and more tax revenues, not just to service a larger national debt, but also to invest more in health care, infrastructure, and education.
Over the past 20 years, the capital share of national income in the U.S. has risen considerably, from about 35% in 2002 to around 45% as of the mid-2010s. Thus, simply restoring capital taxes to their level in the 1990s could increase federal revenues significantly—perhaps by as much as 4-5 % of gross domestic product.
Moreover, my research with Manera and Restrepo suggests that just rolling back overly generous depreciation allowances could reverse more than half of the decline in capital taxes since the 1990s. And if the various exemptions that have enabled corporations and capital-income earners to avoid taxes were removed, there might even be enough additional revenues to help workers directly, such as by reducing payroll taxes and redirecting more funding to Social Security and Medicare.
Ending the privileged tax treatment of capital would also go some way toward eliminating the incentives for excessive automation. But it probably would not be sufficient. Creating good, secure jobs with decent pay will also require other measures to encourage firms to invest in their workers and in labor-complementing rather than labor-replacing technologies.
All the same, removing the tax boondoggle for capital and automation is a critical first step.
Daron Acemoglu, Professor of Economics at MIT, is co-author (with James A. Robinson) of “Why Nations Fail: The Origins of Power, Prosperity and Poverty” and “The Narrow Corridor: States, Societies, and the Fate of Liberty. ”