By Michael Kinsley

Let's not even talk about fairness. Almost no one disputes that most of the benefit of the proposed tax break for capital gains -- profits from the sale of investment assets such as stocks and real estate -- would go to people with incomes of more than $200,000 a year, or that the average person in that pleasant category would save $25,000 a year in taxes. The dispute is whether this break (which has passed the House and is currently stalled in the Senate) would be so good for the economy that we would all prosper from it, making resistance on fairness grounds foolish.

True? The answer to that is another question: Do you believe in free-market capitalism? Do you think the best recipe for prosperity is minimum Government interference in the economy? Devotees of the capital-gains break usually claim to be enthusiastic free-marketeers. Let us take them at their word. Does the capital-gains break make sense from a free-market point of view?

The ideal free-market tax system would be no taxes at all. Taxes discourage productive activity: working, saving, investing. Even President Bush, though, seems to recognize that we can't borrow the entire federal budget. So taxes are necessary. In real life, the ideal free-market tax system is one where taxes affect people's economic decisions as little as possible. That is, a tax system that leaves the world looking as much as possible like one with no taxes at all.

Such a tax system has two features. First, rates as low as possible. At this late date in the supply-side revolution, you don't need any more sermons about the evil effects of high tax rates. But there is a second, equally important feature. Tax rates should be the same on alternative forms of economic activity. If plumbers are taxed more than electricians, there will be fewer plumbers and more electricians than the free market would dictate. If a tax break goes to timber but not to steel, investment flows out of the steel industry and into the timber industry. In either case, the Government is overriding the free market and dictating the shape of the economy just as surely as if it did so directly. Except that doing so directly is called "socialism" (or at least "industrial policy"), whereas doing the same thing through tax breaks is called "a pro-business attitude."

There is nothing magical or unique about capital gains. A special break for this particular form of investment profit distorts the free market in two ways. First, it prejudices the economy in favor of certain kinds of investment. Those who say we need to encourage entrepreneurs or long-term investors with this break (which actually would reserve few of its benefits for those charmed circles) are saying the Government can outguess the market about which investments will pay off. If a risky or long-term investment makes more sense than keeping money in a savings account, the market will reward it without any special incentives. Or at least, you'd better believe it will, if you want to call yourself a free-marketeer.

Second, billions of dollars (not to mention vast reservoirs of human ingenuity) can be wasted turning disfavored forms of income into favored forms. The essential function of the tax-shelter industry was converting ordinary income into capital gains, before the gains break was eliminated in the 1986 tax reform.

Although they are now ostensibly taxed at the same rate as other income, capital gains already get favored treatment in two ways. First, they are only taxed when an investment is sold, unlike interest and dividends, which are taxed every year. An ideal free-market tax system would leave an investor indifferent between, say, a savings account paying 10% a year and a stock expected to rise 10% a year. But tax-free compounding means that, for a top- bracket taxpayer the after-tax profit on the stock will be 45% bigger after 20 years.

Second, most capital gains are never taxed at all! There is no tax when the owner dies before the asset is sold. The profit on inherited property is measured only from the moment it was inherited. This is a huge loophole, costing the Government more than $5 billion a year in lost revenue.

Our current tax system discriminates against capital gains in one way: it ignores inflation. If a stock has doubled during a time when the general price level has also doubled, the real profit is zero, but you'll pay a capital- gains tax anyway when you sell. Of course, the same is true of interest -- an 8% return on a money-market fund at a time of 5% inflation is really only 3% -- but no one is proposing to do anything about that. Furthermore, no one is proposing to limit the deduction for interest paid. In a world with no taxes, it would not make sense to borrow at 10% for an investment that will pay only 8%. If the tax system adjusts profits for inflation but not borrowing costs, such a topsy-turvy investment can suddenly become a brilliant tax shelter. If you believe in the free market, that makes no sense.

One other factor makes capital gains different from other forms of income: you can generally choose when to take them. In a world with no taxes, an investor would trade one investment for another whenever he or she thought the new one would be more profitable. In the real world, people hold on to investments they would otherwise trade in order to avoid paying the tax. That makes the economy less efficient. A tax break for capital gains would reduce this so-called lock-in effect. (Although, please note, this is exactly the opposite of one argument usually heard for a capital-gains break -- that we need to encourage long-term investment.) What would reduce the lock-in effect even more, however -- without adding to the favorable treatment capital gains already enjoy -- would be to tax capital gains at death. People would then know that their gains could not escape tax forever.

From a free-market perspective, then, there is no justification for a special tax break for capital gains. If advocates of a capital-gains break wish to concede that they are socialists engaged in large-scale Government intervention in the economy, we can start again from the top on that basis. Of course, if we're talking socialism, it will be a lot harder to avoid the fairness issue.