Tax reasons for investing

Economics of Investing

Taxation is an important, complex, and necessary issue. As they say: the only two certain things in life are death and taxes.

While the overall role and purpose of taxation (basically, providing public goods and redistribution) are important, one striking observation is that labour and capital income are in most countries taxed differently.

While personal labour income is taxed typically at a increasing marginal tax rate, capital income and gains are in most cases taxed at a fixed capital gains tax. Now assume you have your day job and earn the mean income in any OECD country, then your marginal tax rate (that is, the percentage of every additional dollar you earn in a given year) will be higher than the capital gains tax.

For instance, here we compare the top marginal tax rates on personal labour income (in blue) with the tax due for dividend payments (in red). As you can see, the income tax is almost everywhere (significantly) higher than the tax on capital income.

Source: author’s computation based on OECD Tax statistics

While there are several countries where capital gains are taxes by the same personal tax rate as labour income, these are the exception. Similarly, taxation between dividends and capital gains varies in some countries, but the general picture remains the same: income from capital is taxes at a lower rate than labour.

While one can argue whether this is fair form a economic efficiency or equity perspective (We do believe that savings and even some risk taking by a large share of the population should be encouraged, and would vote for a tax-free annual amount of income (say, 1,000 or even 10,000 USD) and a fixed tax rate for higher income), taking it as given, we can conclude that taxation favors capital income.

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