Capital gains and income inequality

Capital gains, mainly from financial assets, is the biggest source of income growth for those at the top of the income ladder. Consider this from an Economix post by Laura Tyson,

According to the Congressional Budget Office, from 2002 to 2007 more than four-fifths of the increase in income inequality was the result of an increase in the share of household income from capital gains, with the remainder the result of an increase in other forms of capital income. Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income. The top 0.1 percent earns about half of all capital gains, and such gains account for about 60 percent of the income of the top 400 taxpayers.

Ironically, it is also that income stream which is taxed at the lowest rate. Capital gains tax was lowered from 28% to 20% by Clinton in 1997 and then to 15% by Bush in 2003. As "carried interest", President Bush extended this rate to fees earned by hedge fund and private equity managers. In other words, while wages are subject to both federal income tax and the payroll tax, capital gains and dividends are taxed at 15% and are not subject to the payroll tax.

These trends are not unique to the US and has become the norm across the world. In fact, in India, long-term capital gains, defined by investment of more than one year, in many assets are tax exempt. Apart from the dramatic concentration of wealth and the widening inequality, the incentives created by the lower capital gains taxes is responsible for the skewed growth of the financial sector itself. Raising this tax to the level of that for other labor income streams, would curtail outsize compensation in the financial sector. Besides, in these times of fiscal crisis, it would provide a much needed boost to government finances.