For most of the past six decades, the U.S. government has taken a lenient approach toward taxing financial wealth. Dividends from stocks and gains on long-term investments are currently taxed at 15 percent, compared with rates on ordinary income as high as 35 percent. The differential treatment has resulted in such attention-grabbing distortions as Warren Buffett paying a smaller share of his income in taxes than his secretary, and Mitt Romney paying an effective federal rate of only 14.1 percent on $13.7 million in income last year.

In a certain kind of world, such a system makes sense. In the 1970s and 1980s, researchers built models of the economy showing that, if everyone started out with nothing, made money by working and didn’t pass anything on to their children, the optimal rate on investment income would be zero. The logic was that if you tax people once on their labor income, it’s not right to tax them again on the part that they set aside for the future. Doing so would inhibit saving, starving the economy of the investment it needs to grow. Fewer jobs would be created. Everyone would be worse off.

Now consider a different world. Here, some people are born well-off, with inheritances so large that they can live comfortably without working. Most, however, are born relatively poor, with little or no capital at all. In this world, taxing labor income alone would amplify the inequality by putting an outsized burden on people who work. Taxing capital, by contrast, would take some of the pressure off labor, increasing the incentive to work and providing a net benefit to the majority of the population.

The second world closely resembles the present-day U.S. As of 2010, the wealthiest 10 percent of families commanded about 75 percent of all households’ total net worth, while the poorest 50 percent held only 1 percent, according to Federal Reserve data. The distribution of inheritances is similar.

To get a sense of what tax rates should be in such a world, two researchers ― Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California, Berkeley ― built a model of the economy that took into account the vastly divergent financial endowments.

They found that the distribution of wealth makes a big difference: The more it’s concentrated in the hands of a few, the more the benefit of shifting the tax burden off labor income outweighs any potential negative impact on saving. They estimate that in the extremely concentrated case of the U.S., if the aim is to make humanity as a whole better off, the optimal tax rate on capital ― including bequests, corporate profits and investment income ― would be as much as 60 percent.

What does all this mean for the current U.S. tax system? It suggests that if you think the government needs more revenue to reduce its budget deficit, raising taxes on investment income is a good solution. What should the rate be? Anything above the current level would be an improvement. It would have the added advantage of reducing the incentive to game the system by, for example, classifying carried interest, the equity some investment managers receive as compensation for their work, as a capital gain instead of ordinary income.

Calculations by the Office of Management and Budget suggest that taxing capital gains and dividend income at the same rate as ordinary income could bring in roughly $1 trillion over the next 10 years if the top marginal rate stayed at 35 percent. Another $700 billion could be raised if capital gains weren’t zeroed out at death, requiring heirs to pay taxes on any gains that occurred before they inherited stocks, real estate or other assets. The total comes to more than 40 percent of the deficit reduction President Barack Obama and lawmakers are seeking in their efforts to avoid the fiscal cliff, the toxic combination of tax increases and spending cuts that will start to come into effect Jan. 1 unless Congress acts.

There’s scant evidence that raising rates on capital would have much effect on private saving or investment. In a recent report, the nonpartisan Congressional Research Service found no statistically significant relationship over the 65 years through 2010. It concluded in a separate report that higher taxes on capital gains would more likely increase public saving by allowing the government to reduce the budget deficit (running a deficit is the opposite of saving).

In an ideal world, we wouldn’t have to tax capital at all. In the U.S. as we know it, an increase in rates is long overdue.

(Bloomberg)