I am often surprised by how many commenters say something to the effect, “I don’t get how taxing capital income is double taxing wage income.” Thus, here I’ll present a simple numerical example.

Imagine an island where residents produce 100 coconuts. They have the option of consuming the coconuts today, or planting them and having 200 coconuts in 10 years. In that case, the price of future consumption is 1/2 the price of current consumption.

Now assume this society introduces a 40% wage tax to fund public goods. You must pay a tax of 40%, or 40 coconuts, on your wage “income” of 100 coconuts. In that case you can consume 60 coconuts today, or plant the 60 and consume 120 coconuts in 10 years. The ratio is still 1 to 2, and the relative price of future coconuts is still 1/2 the price of current coconuts.

That sort of tax regime does not unfairly favor either current or future consumption.

Now someone suggests that in order to be “fair” we need to also have a 40% tax on capital gains, added on to the 40% wage tax. Now the person who choses to save the 60 coconuts (after paying the wage tax, faces another tax bill in 10 years. When the coconut trees mature, they pay a tax of 24 coconuts (40% on the capital gain of 60 coconuts.) They are left with 96 coconuts to consume (120 – 24).

In this case, the tax rate on current consumption is still 40%, but the tax rate of future consumption is 54% (200 – 96)/200. The choice is no longer between 100 coconuts today and 200 in ten years, or 60 today and 120 in 10 years. Now the choice is between 60 coconuts today and 96 in 10 years. People are being encouraged to eat their capital today, not save it and boost future consumption.

The best argument for a capital gains tax is that it prevents people from disguising wage income as capital gains. This is one reason that many countries set the capital gains tax rate at a level lower than the personal income tax rate. It is assumed that when someone sells their own business, some of the rise in the value of the business doesn’t just reflect saving, rather it derives from the owner’s labor in building up the business.

But if that’s the reason, then there is no justification for limiting how much non-business owners can put into their 401k plan, nor any justification for forcing them to withdraw funds at a specified age (currently 72). And yet I frequently see people claiming that the 401k program is some sort of “tax break”. It isn’t; all consumption (present and future) is taxed at the ordinary income tax rate. You pay the income tax on all of the funds pulled out of a 401k—including the capital gain—when you need the funds for consumption.  This is not double taxation, however, because the invested funds were not taxed when first earned.

PS.  I know the coconut example is kind of unrealistic; choose a different kind of nut if you prefer.  I assume it takes labor to find the first 100 coconuts, but after 10 years the new ones just fall from the sky.


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