Taxes, Subsidies, and Distortions

by Don Boudreaux on November 20, 2009

in Myths and Fallacies, Subsidies, Taxes

In the current New Yorker, James Surowiecki is properly critical of the economic distortions introduced by taxing debt-financed income much more lightly than taxing equity-financed income.

But his policy conclusion is a non sequitur:

Given the weak state of the economy and of housing prices, a wholesale rewriting of the tax code may be a bridge too far right now, but there are plenty of reforms—capping deductions, phasing them out over time, restricting their use by heavily leveraged companies—that would move in the right direction.

The clearest hurdle to these changes may be political, but the bigger hurdle is, in a way, psychological: because tax breaks on debt have been around so long, we can hardly imagine what it would be like if we changed them, and we tend to underestimate their influence in shaping our behavior. Subsidizing debt seems harmless simply because we’ve always done it. But the fact that you’ve had a bad habit for a long time doesn’t make it less dangerous.

It simply doesn’t follow – as a matter of logic, ethics, or economics – that, because debt-financed financial gains are taxed less heavily than are equity-financed financial gains, debt-financed gains are subsidized (as opposed to equity-financed gains bearing an undue tax burden).  Nor does it follow that taxes on debt-financed gains ought to be raised.  Eliminating these distortions can also be done by reducing taxes on equity-financed gains.

I wonder if Surowiecki believes that low-income Americans are being distortingly subsidized by high-income Americans.  After all, if failure to tax a financial gain as heavily as that gain might be taxed means that the untaxed portion of that gain is a subsidy, then it appears as if the current ‘progressive’ rates of income taxation in the U.S., in and of themselves, transfer subsidies from higher-income Americans to lower-income Americans.

If confronted with evidence of economic distortions created by ‘progressive’ income-tax rates, would Surowiecki advocate raising taxes on low-income workers as the only means of eliminting such distortions?

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