Sunday, April 09, 2006
Defending the lower tax rate for capital gains
Even after the Bush tax cuts, some capital gains are actually taxed at a higher rate than ordinary income. This is because some of the nominal gain on the sale of an asset is reflected in the depreciation of the currency, a phenomenon popularly known as inflation. "Inflation" is itself a tax, caused by the government creating money faster than the growth of the underlying value of the economy (or faster than aggregate demand, if you are a Keynesian). Back when money was specie, governments inflated the currency by putting less precious metal into the coinage. Now they do this by creating more currency by fiat. Either way, inflation is a tax on cash that enures to the benefit of the treasury.
So, if the percentage increase of the selling price of an asset over its basis is less than the accumulated inflation since the establishment of the basis, the seller has actually lost money in real terms, even if he receives more nominal dollars than he paid. Theoretically, the government has taxed that asset in excess of the gain simply by depreciating the currency faster than the asset grew in value. Any capital gains tax, even 1%, under such circumstances means that the tax on that asset is substantially higher than the top rate for ordinary income.
Of course, in periods of low inflation, the odds of this happening are lower than in periods of high inflation, but the tax laws usually do not change as quickly as the inflation rate and investors cannot rely on them changing to their advantage in any event. The law needs to take into account, it seems to me, the possibility of higher inflation than we have seen in the last few years.
With that background, I think it is safe to say that most principled people agree in the abstract that capital gains and ordinary income should be taxed at the same rate. To do anything else creates a bias in favor of one type of income over the other, and I for one do not trust the government to decide which is "better" as between capital gains and other forms of income.1
One could tax capital gains and ordinary income at the same rate in an inflation-free world, because all the gains on sale would be investment gains -- none would be additional implicit tax because the government decided to print more money. We don't live in an inflation-free world, however, so we need a mechanism to compensate for the additional implicit inflation tax on capital gains (otherwise we create an unprincipled and unthinking bias against long-term investment).
The complex way to compensate for inflation would be to require everybody to calculate the "real" gain of each asset sold, and then tax only that. Even in an age of computers, though, that exercise would be so complicated for taxpayers that it would be wildly unpopular because of its complexity, rather than its perceived justice or injustice.
So instead we say that capital gains over the short-term will simply be taxed as ordinary income, but capital gains over the long term will be taxed at a much lower rate. This simple approach probably does away with a lot of the implicit tax, although it does result in over and under compensation, depending on holding periods.
During periods of low inflation, an investor who holds an asset for only a short period beyond the one year horizon pays a much lower tax on gains than he would under a complicated approach. On the other hand, an investor that holds an asset that does not appreciate much for a very long time -- property in North Dakota, maybe, or the shares of plenty of old industrial companies -- is probably grossly overtaxed on the gains for the reasons described above. If today I sell land for only three times what I paid for it in 1975, any capital gains tax is confiscatory, because I have no actual gains. The entire gain comes from inflation, which is itself a tax.
Now, one might reasonably argue that the current "simple" mechanism is too advantageous for capital gains, because lots of people hold assets for only short periods of time over the one year requirement and sell them for big gains. These people obviously pay much less tax (15% vs. 35% to the Feds) than they would on ordinary income earned over the same period. True, but they do pay a price for this advantage: they cannot deduct long-term capital losses against ordinary income. That means that excess losses are deferred, possibly for years, until the taxpayer has other off-setting capital gains. That deferrel is itself a hidden tax that becomes particularly onorous when asset prices are declining, or growing less quickly than ordinary income.
Therefore, any proposal that closes the gap between capital gains rates and ordinary income tax rates needs to allow for the deduction of realized capital losses against ordinary income. Even that, however, would generate perverse results. During periods of a declining stock market, lots of people in the investor class would pay little or no tax on their actual salaries. One can imagine the outraged headlines about "corporate chieftains" not paying taxes on their salaries, the reason being that they suffered huge capital losses that they were able to use to offset against their salary and bonus, something that the working rich cannot do today.
Having said all of that, I think that the current system creates a bias in favor of "short long-term" capital gains. I would support extending the holding period for long-term status (i.e., the 15% tax rate) to three years, and in return lowering the rate to 10% for assets held more than, say, 7 years (I'm open to negotiation!). Based purely on gut, rather than data, I suspect that that reform would more precisely compensate investors for the inflation embedded in their long-term capital gains, while retaining most of the "simplicity" of the current system.
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1. The Bush tax cuts reduced the extent of this bias by bringing down the tax rate for corporate dividends to the long-term capital gains rate. It did not do that for interest income, though, or (obviously) for salaries and bonuses, so the point still holds, even if it is less profound than it has generally been in the 90 years that we've had a federal income tax.
5 Comments:
By 
Dylan, at
Sun Apr 09, 01:02:00 PM:
The United States has considerably higher taxes on capital, and lower on labor, than European social paradises. I've always wondered if this is a practical necessity for a big welfare state - capital can flee a lot easier than labor, after all.
By Lanky_Bastard, at
Sun Apr 09, 09:07:00 PM:
Esteemed here? You're too gracious. However, if you grant me political capital, I'll spend it.
First: If inflation is a "hidden tax" (and "tax" is a silly term since it doesn't generate revenue) it also affects traditional income. There's no reason capital investments should be a sacred cow, exempt from inflation's effects. Try whining about inflation to someone making the same minimum wage that was legislated 9 years ago.
Second: Don't pretend that inflation even comes close to accounting for the difference between the 15% and 35% taxation rates. That's a 20% difference for simply holding an asset a single year. Inflation is about an order of magnitude lower.
Third: Even if you claim that many investments are long-term ones (say a decade) and that inflation becomes significant over those scales, it's also true that most investments continually compound over that same time scale. It's the same fundamental problem as any single year, but with lower fluctuations.
And since I've been tarnished by the "lefty" label already, I can claim this is an anti-progressive kickback to drop the effective tax rate of the most absolutely wealthy individuals in the US. The inevitable consequence will be an increased tax burden on the traditional incomes of those Americans who actually work. Ask yourself this: (try to table the traditional Republican/Democrat talking points for a minute and be honest), "Relative to where we were in the 90's, do you support that the tax burden has been specifically shifted off investors and onto working income?"
Take a big sip of Kool-aid and refute at will.
By Cardinalpark, at
Mon Apr 10, 11:43:00 AM:
Ah, taxes. Actually, there is a highly principled argument for no tax on capital gains viz. ordinary income, as opposed to equal rates. By definition, the income associated with capital gains (retained earnings), have already been taxed. So taxation of capital gains and dividends is punitive -- because the work required to generate them has already been taxed.
The rest is all about politics, not economics. And that is an old debate.
By honestpartisan, at
Mon Apr 10, 01:58:00 PM:
Your post undermines one of the arguments in favor of cutting capital gains taxes: the so-called "lock-in" effect. The argument is that capital gains taxes depress the incentive to realize the capital gains, so investors hold onto investments longer than the market would otherwise dictate, and capital will not be most efficiently allocated. The lower tax on long-term capital gains you advocate exacerbates this problem.
By Dawnfire82, at
Mon Apr 10, 09:39:00 PM:
God damn I hate economics... So many highly verbose arguments using very scientific terms to try and plan and predict something that cannot be planned and predicted. So many schools of thought exist and bicker because they all have some form of proof to hold onto. Reminds me of philosophy. At least with religion people eventually give up and fight to the death...
