Capital gains—and how big a bite the government should take out of them—have become a major point of contention in the past couple of months.

In January, President Obama proposed tax changes designed to raise some $320 billion over 10 years, largely through higher levies on high-income Americans. The revenue would be used to cover $235 billion in tax breaks, mostly for moderate-income workers, along with other initiatives.

Among the changes he proposed: boosting the capital-gains rate to 28% for the top 1% of taxpayers, up from the current 23.8%, as well as a new capital-gains tax on many inheritances.

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The GOP fired back that taxing investment income would harm economic growth by discouraging business investment and thereby hurt workers’ incomes.

All of which points to a broader question that divides experts: Are capital gains so different from earned income that they should be taxed at a different rate?

Below, two experts tackle that question. Scott Sumner is professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University, where he is director of its program on monetary policy. Leonard E. Burman, director of the Urban-Brookings Tax Policy Center and the Paul Volcker chair in behavioral economics and professor of public administration and international affairs at Syracuse University’s Maxwell School, is author of “The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed.” They can be reached at reports@wsj.com.

YES: It Makes Sense for Individuals—and the Economy
By Scott Sumner

To many people, investment income should obviously be taxed at the same rate as labor income. After all, income is income, right?

But it’s not that simple. There are compelling reasons to treat capital gains differently than other earnings.

For one thing, taxes on investment earnings effectively double-tax that income. Labor income is taxed when it is earned, and investments are generally made out of after-tax earnings—so capital-gains levies represent another bite out of an investor’s money.

In effect, the system punishes those who put their money to work. Raising the capital-gains tax rate would just make the punishment that much more drastic.

This question doesn’t simply affect people who invest—it affects the entire economy. Investment capital is one of the most important drivers of economic growth, and the promise of big capital gains are an important inducement to get people to put money into critical but risky fields like biotechnology. If we want more inventions, or a faster cure for cancer, then we should have lower capital-gains taxes.

The Inflation Bite

Capital gains differ from regular income in another important way: They can be much harder hit by inflation, so they need a lower tax rate to reflect that fact.

Labor income is taxed as it is earned, so there’s no meaningful difference between your nominal and inflation-adjusted earnings. With a capital investment held over time, though, there can be a big difference between the nominal and real capital gain, with much of the nominal gain simply reflecting inflation.

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Consider investors who bought an apartment building for $1 million. Assume they held the building for 20 years, over which time its value rose at the rate of inflation, say 2% annually.

In that case, there wouldn’t be a change in the real value of the building. After 20 years it would be worth more in dollar terms, but those dollars would have no more purchasing power than the $1 million originally invested.

Some say we can sidestep the inflation problem—and thereby justify higher taxes on capital gains—by indexing investments to inflation.

But this would further complicate our already complex tax system. You would have to keep track of not just each investment and sale, but also the consumer-price index the day each transaction occurred. Having taught economics for 34 years, I can assure you that even most college graduates are incapable of doing the math required to index their capital income.

What Works Best

Critics raise a number of other arguments for raising capital-gains rates. They say lower rates provide perverse incentives, spurring people to go into certain jobs that are driven by capital gains instead of doing more productive work. And, they argue, lower rates lead people to spend great time and effort on unproductive things like setting up tax shelters.

Yet, as we’ve seen, capital gains are a way to reward investors in crucial industries. Do we want to risk cutting off that supply of funds to keep some people from becoming, say, hedge-fund managers? If we want to eliminate tax shelters, meanwhile, we should tighten the tax code, not raise taxes on capital gains.

Then there’s an argument about fairness. A low capital-gains rate, critics say, defeats the idea of progressive taxation, since mostly wealthy individuals take advantage of the lower rate.

The best way to handle the situation is to aim for progressivity with respect to consumption—what people take out of society. Ultimately, my preference is for a system where assets can be shifted around within a 401(k)-type structure. That means investors would be able to move their money from one investment to another, without facing a tax liability until they actually withdrew the money and spent it. There should be no limits to contributions to these plans, and no restrictions on the date of withdrawal.

Scott Sumner.
Scott Sumner.PHOTO: BENTLEY UNIVERSITY

Dr. Sumner is professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University, where he is director of its program on monetary policy. He can be reached at reports@wsj.com.