Consider Joe Worker: born to a humble family he works at after-school jobs during high school, saves his money, takes on debt only when necessary, and works his way through college to be the first in his family to get a degree. He gets a good job and diligently works his way up in the corporate hierarchy. At age 40, he makes $130,000 per year and, after deductions, has a taxable income of $100,000. Joe is the quintessential American success story - our accepted theme that anyone can make it through hard work and thrift. Unfortunately, Joe has worked so hard that he hasn't had time to get married, so filing "single" he pays $21,709 in Federal Income Taxes. In addition, he pays social security and medicare taxes of $8,170, for a total of $29,879 to the Federal Government.
Now consider Dylan Loafer, who never learned how to work despite the example of successful parents. Like Joe, Dylan's not married - but in Dylan's case it's not because of lack of time, it's because he's such an obvious loser. After a 20-year series of dead-end jobs where he's been paid minimum wage and paid almost nothing in taxes, at age 40 he inherits $2 million (after inheritance taxes) when his parents die of a combination of frustration and boredom in watching their child float through life. Dylan realizes that Mummy and Daddy aren't there to back him up, so he finally develops a work ethic. He studies hard and learns to manage his money. It takes a lot of attention to the markets and his investments, but he is able to make a consistent $130,000 per year in capital gains (about 6.5% return). He has the same adjustments to income as Joe, so his taxable income is $100,000. Dylan goes to pay his taxes, and finds that he owes the Federal government $15,000 - just about half of what Joe Worker has paid.
So here we have Joe Worker, a person who has spent his life building up skills, contributing to society through his work, and sacrificing to get into a position where he can send the government $30K per year. Joe pulls his own weight and takes handouts from no one. To work your way up to a job with an earned income of $130K is no small matter, and Joe is proud of his achievement and what he has contributed to our economy. But the "system" couldn't care less about what it takes to get to an earned income of $130K. No, the "system" rewards Dylan Loafer with a 50% tax reduction because he was lucky enough to be born to successful parents and figured out how to make a modest return on their capital. Dylan hasn't contributed to society in any significant way through his life, but the mere possession of capital makes him a favored person in the eyes of tax law. With his inheritance, his only future contribution to society is trying to figure out the best place to invest his money. Is it good when people pay attention to their investments? - of course it is. But is it worth a 50% tax subsidy? - I think not. We have set up a system that says the effort spent investing your own money is so important that it receives a lower tax rate than teaching children, curing disease, building bridges, roofing houses, fixing cars, or cleaning sewers.
So the next time someone tells you that the U.S. favors hard work - just say BULLSHIT. The U.S. system is skewed toward those who already have capital, giving them favorable tax treatment so that they can gain more capital. It doesn't take much math to figure out that the long term consequence is an ever-increasing divide between the rich, the middle class, and the poor. In this are the seeds of our own destruction. No society can long survive a "let them eat cake" attitude of those born lucky.
Capitalism and free-markets are not synonymous. Indeed, capitalists routinely try to undermine free markets - not just by outright monopolies but also by lobbying for special legal treatment and making decisions based on government bailouts (i.e. the wage-earner assumes the risk through taxpayer bailouts, but the profit goes to capital). Be wary of people who try to equate capitalism and free-markets - they are usually looking to shift taxes, risks, or clean-up costs to the wage-earning public.
I believe in regulated free markets and regulated capitalism. But capital shouldn't be more valuable than the sweat, creativity, or the the indispensable everyday efforts of those who are the heroic unrecognized gears making the wheels go around on the machine.
Solution: Capital gains should not be subsidized. They should be taxed at the rate of earned income plus the Social Security and Medicare contributions of both worker and employer. If capital does not receive favored treatment the overall tax rates can be reduced, which reduces the cost of hiring American workers. Will this raise the cost of capital? - of course. But the entire economic bubble we just experienced was only possible because capital costs were unrealistically low and did not reflect the actual costs of creating the capital. When hourly wage-earners and salaried professionals are subsidizing the cost of capital, they are getting screwed.