Piketty-Poketty-Poo: Some people are just itching to up tax to capital ...

Worstall @ the Weekend I'll cop to being a bear of little brain, for it can take me a long time to spot what should be obvious. And so it is with my taking so long to work out what's really going on with Capital in the Twenty-First Century author Thomas Piketty and all that wealth inequality stuff.

I believe his book is essentially a political project, one intent upon overturning the standard (and very widely agreed) convention in economics that we don't really want to be taxing capital or the returns to it. To some that's an affront to deeply held prejudices and thus that consensus must be overturned. And if blathering one about inequality is the way to do so, well, why not?

Please note that I'm not directly accusing anyone of deliberately doing this: I'm entirely undecided as to whether it's subconscious or not.

On to the basic point that pretty much all economists would sign up to: we don't want to be taxing capital nor the returns to capital. There's a lucid and elegant laying out of the case here.

It's also the main finding of optimal taxation theory – that's something that Britain's (he's a Brit when he's good, a Scot when he says something silly, like people would still work at 100 per cent tax rates) Sir John Mirrlees got his Nobel for.

The reason is that people investing in stuff – in factories, buildings, machinery, new products – is what makes next year and the following ones richer than this one. And we all know that if you tax something, then you get less of it (if you're not willing to sign up to that one then economics really isn't going to be your subject).

So, if we tax what people earn by investing, then we're going to get less investing and the future will be poorer than it would have been without that tax – for which our children will no doubt thank us, gratefully.

This is a sufficiently convincing argument that most economists would sign on to it. This isn't just the invention of some lapdog lackey of the plutocracy like myself: this is a widely held to be true result, axiomatic almost.

Yes, yes, you have to tax the bastards somehow

Everyone also agrees that it would be pretty difficult politically to insist that we don't tax the moneybags, ever. So, in reality our tax systems tend to tax returns to capital at lower rates than income from labour, albeit often lightly disguised lower rates.

Sure, we can all see that the Capital Gains Tax rate is lower than income tax. But dividends are also taxed (as are interest and rents) at a lower rate than labour income because they're not paying national insurance (or, in the US, Social Security).

This is not a mistake, this is a deliberately introduced feature of the tax system to take account of that general view that we shouldn't be taxing these returns to capital at all.

Another way of saying much the same thing is that we have the not unusual economic problem that efficiency and equity are pulling us in different directions. It's obviously efficient not to tax capital, but there's not all that many people who would think it equitable that we don't.

The current kludge to try to make sense of all of these things is what's known as a progressive consumption tax. Essentially we're trying to abolish that difference between income from investing and income from labour: instead saying that anything that you spend gets taxed and anything that you save doesn't. A tax return would look much like a current day one would.

You'd tot up your income at the end of the year, look at how much tax has been already withheld and so on. But any money that you'd put away into savings (broadly defined, cash in the bank, a holiday home, stocks, a pension) would then be deducted from that income. And then you pay income tax (or more accurately, a “consumption tax”) on the amount of money that you've spent that year.

The other side of this tax system is that any earnings you've had from previous investments are also tax-free: as long as you've reinvested them. But if you've taken those profits from previous investments, or you've taken capital out of your investment pot to spend on consumption, then all of that pays that income or consumption tax. And we can have progressively higher rates of that tax which gives us the whole name of a progressive consumption tax.

To give an example: say Tarquin owns Chelsea (the place, not the club). He's not taxed on his rents if they're put back into other investments – maybe extending the empire downmarket into Fulham or into a tractor factory in Banbury, whatever. But if he uses that income, or sells off a house to buy a fleet of Chelsea tractors for his mistresses then he gets hit with that consumption tax. And exactly the same will be true of someone saving a bit of their paltry wages for their old age. Tax-free to stick the money in, pay something like income tax when you take it out.

Or, as we could describe this, exactly as pensions are taxed these days. Or like having a giant ISA (or IRA for the colonial cousins) for all savings that one makes.

As I say, most economists consider this sort of system to be a highly desirable one on the grounds of efficiency.