Why do we tax capital gains at a lower rate?

Mitt Romney paid about 14% of his income in taxes the last 2 years. This is for a number of reasons, but mainly it's because most of his income was classified as capital gains.

Why do we tax capital gains at a lower rate? There actually is a good economic rationale: Taxing returns on investment is effectively taxing income twice.

Suppose that you receive $80 pre-tax, and you can either choose to spend it now, or to save it for 10 years at the end of which it will earn a return of 50%.

If there were no taxes, this is a choice between $80 of consumption today, or $120 in 10 years.

If there were income taxes of (say) 50%, then after taxes you would have $40. This could be spent on $40 of consumption immediately, or saved to earn an additional $20 in interest. But since those interest payments are income, they would be taxed at 50% and so 10 years from now you could increase your consumption by $40 + $10 = $50.

Thus an income tax rate of 50% implies an effective tax rate of 1/2 on immediate consumption, or of 7/12 on delayed consumption. Since consumption is what people care about when making decisions, income taxes provide an incentive to consume immediately rather than to save.

Of course, the best solution would be a pure consumption tax system, but we get some improvement by having lower tax rates on income from interest payments on savings, which is why we tax capital gains at a lower rate.