The French know that wine and cheese are healthy enough in moderation. If only President François Hollande understood that the same should go for taxes.
As Andrew Ross Sorkin wrote last week, Mr. Hollande has proposed a 75 percent marginal tax rate on all income over $1.3 million. Marginal tax rates on capital gains could rise to about 60 percent. French entrepreneurs, bankers and private equity professionals have responded by threatening to move their businesses to London.
Mr. Sorkin concluded, “The idea of soaking the rich is often a popular one. But if there is a lesson in the French experience, despite the economic models, it is that there are limits.â€
What are the limits? What would happen if we copied the French? In the United States, the populist case for redistribution of wealth is stronger now than it has been for generations. Income inequality is the highest it has been since the 1920s, in no small part because of income gains for corporate executives, investment bankers and fund managers. Tax policy and other factors have made the inequality trend more pronounced here than in, say, France.
The French proposal is half right. Broadening the tax base is a good idea. But the point is to allow for lower overall tax rates, not to confiscate wealth. We could do more to address inequality by making sure that all income is taxed, rather than increasing rates on the already burdened.
The way we know that tax rates are too high is to look at changes in behavior, like decisions whether to work longer or retire early, or to spend money or save it for later. All taxes cause economic distortions, but some distortions are worse than others. The two main behavioral responses to higher tax rates are the income effect and the substitution effect. The income effect occurs when a taxpayer works harder, earning more income to offset the tax and maintain a level rate of consumption. The substitution effect occurs when taxpayers work less to avoid the higher tax, substituting untaxed activity like leisure, household work or off-the-books work. Which effect dominates depends on the circumstances.
Consider how three different activities react to higher tax rates - investment income, labor income and entrepreneurial income.
The first category, investment income, is pretty sensitive to tax rates. Capital is highly mobile, and for this reason the United States generally taxes foreign investors at a low rate, or not at all. American investors also face a reduced rate on capital investments held for more than one year, although it is less clear that this preferential rate is necessary. American investors are taxed on their worldwide income, so mobility is not the issue. The main concern is lock-in - that investors could react to higher tax rates by holding on to assets to defer paying taxes on their gains.
The second category, labor income, is not as sensitive to tax rates. Lab or is not as mobile as financial capital, and the income effect helps offset the substitution effect. The optimal tax rate on labor income is probably higher than the optimal tax rate on capital income, although economists differ on this point.
But economists agree that there can be unwanted effects from high tax rates on labor income as well as capital income. Consider the situation of the second earner in a household. Because we do not tax the imputed income from providing household services to ourselves, it can be cheaper for a second earner to stay home and cook, clean and care for children rather than working outside the home, paying tax and then using after-tax income to pay someone else to assist with those household services. A decision to stay home to take care of children should be motivated by personal preference, not tax policy.
The third category is entrepreneurial income, like small-business income, founders' stock and carried interest for fund mana gers. The income here is mostly a return on labor, not capital, but it is often lightly taxed as investment income. And this is where the debate tends to get heated.
The case for a low tax rate on founders' stock is weaker than you might think. When Bill Gates, Steve Jobs and Mark Zuckerberg started their companies, the capital gains preference was hardly the motivating factor. Evidence suggests the rate of entrepreneurial entry is not very sensitive to tax rates. Taxing founders at a high rate may be impractical, however, because of the difficulty of distinguishing between investors and founders.
We should start by plucking the low-hanging fruit. Carried interest is labor income, not investment income, and it's not as mobile as financial capital. Few New York-based fund managers will give up United States citizenship and move permanently to Singapore just to avoid paying tax on carried interest.
The instinct of the French to tax all income at the same rat e is a good instinct. The mistake is in setting the rate at 75 percent.
For further reading on the tax treatment of founders' stock and carried interest, see Victor Fleischer, Taxing Founders' Stock, UCLA Law Review (2011), and Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, NYU Law Review (2008).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. Twitter: @vicfleischer
