The Capital Gains Tax

In my last commentary entitled, “The Graduated Income Tax," I pointed out that the reason the very rich pay a large percentage of our taxes is because they have most of the income and most of the wealth, and the gap between the haves and the have-nots gets ever greater. I showed that the graduated income tax only closes the gap a miniscule amount since after tax income shows only a slight closing of that gap.

I quoted Warren Buffett as pointing out that in the final analysis despite our theoretical graduated income tax, his marginal tax rate is 17.7 % on the $46 million he made last year, without trying to avoid paying higher taxes, while his secretary, who earned $60,000, was taxed at a marginal tax rate of 30%.

While many provisions of the tax code play a part in this, I have little doubt that a major reason is the favorable treatment given capital gains. It has often been said that America has a Protestant work ethic that places special value on work, and everyone in American society has an obligation to “work.” This, however, is not reflected in our tax system, for here we penalize work with a substantially higher tax rate than passive income, i.e. income earned without work. At the moment earned income is taxed at a marginal tax rate of 35% on incomes over $357,000, (This is extremely low by historical standards. Between 1941 and 1945 taxpayers with incomes over $1 million faced a top marginal rate of 94 percent.) but unearned income or capital gains (if held for more than a year) and dividends are taxed at 15%. I submit that there is no justifiable reason to tax unearned income at a rate below that for income, which is earned by actually working. While people at the lower end of the income scale often make a small percentage of their income from capital gains, those with high incomes, who often have never made a cent in their lives by the sweat of their brow, or even from intellectual effort, having often inherited their wealth, make the bulk of their income from unearned income. Furthermore, they have every opportunity to cheat even from this minimum burden, for while the wage earner has his income reported to the IRS by his employer, the investor is on his honor when reporting the cost of his asset, (stock or other) and can easily inflate his cost (“basis” in tax lingo) and even misrepresent the date of the acquisition to gain long term status (assets held less than a year don’t get this favorable treatment). Under present Internal Revenue law the broker must report the sale of stock to the IRS, but he is not required to report a purchase. Thus the IRS has no way of knowing whether tax evasion is occurring short of an audit, which is rare. I strongly urge, (and I am sorely disappointed that no major columnist or candidate has addressed this issue) that brokers and other sellers of assets, including real estate agents, be required to report the purchase and sale of all assets subject to tax.

I also believe that the present system which taxes capital gains only when the asset is sold (realized capital gain) distorts the capital markets. It is far better for the capital markets to function when the only consideration is to maximize ones gains or minimize ones losses, without tax consideration being a major factor in decision making. This becomes particularly egregious when one considers that the wealthy can postpone selling their assets indefinitely if they want to avoid paying taxes, while those in lesser financial positions must frequently sell to meet expenses, particularly after retirement. I believe that it would be far better if the value of the asset be assessed at the end of the taxable year (easily done with stocks and bonds) and that to the extent that the value of the asset has increased or decreased be used as the taxable gain or loss minus an allowance for inflation. It becomes an outright scandal when we consider that those who can afford to not sell their assets before they pass away, can avoid paying a capital gains tax altogether on their gains, since their heirs get the assets with a basis, not as of acquisition, but as of the death of the legator thus escaping ALL capital gains taxes.

Those who generally argue for reducing the tax burden on those who can best carry it maintain that dividends and capital gains are different from other income and not only deserve favored treatment but should be exempt from all taxation. Their arguments are so that numerous that it is difficult to set them all forth even without pointing out their fallacies, but let me attempt to cover at least the most prominent ones within the circumscribed length of this article. See here.

1.) “High effective capital gains rates reduce the capital stock and lower growth and productivity.” I discussed this in my previous article on the income tax. More capital will not be deployed unless there is consumer demand, which according to the Wall Street Journal accounts for 70% of GDP.

2.) “Capital gains taxes encourage a "lock-in" effect that discourages investors from selling their assets.” I think there is merit in this, which is why I advocate taxing all gains at the end of each fiscal year instead of at the time of sale.

3.) “Capital gains are not income -- as the Supreme Court held for many years, and even after the passage of the 16th Amendment.” This is more a reflection on the makeup of the Supreme Court than an argument and the Supreme Court has long since reversed this erroneous holding.

4.) “Capital gains are already taxed more than once through the corporate and personal income tax -- and taxing appreciating stocks or real estate can be a third layer of taxation.” This is the favored argument not only for not taxing capital gains and dividends, but for not taxing estates, but it is nonsensical, because ALL taxation is of a multiple nature. When a worker’s pay is taxed is it double taxation because that money was already taxed when the corporation earned it? Is it double taxation when a worker is taxed and then pays a portion to his grocer, who is taxed, who then pays his doctor, who is taxed, who pays his landlord who is taxed? The whole point of taxes, and the only way it can work, is that money, or any asset, is taxed every time it changes hands. What the corporation earns is taxed and when it passes those earnings to its stockholders it is taxed - it has changed hands. An even better illustration is the real estate tax where the same piece of property is taxed year after year. If it were otherwise the government would get a tax once and never again.

5.) “Lowering capital gains taxes substantially raises tax collections and increases tax payments by the rich” (Source) This is true in the short run but untrue in the long term, or as Professor Richard Serlin of the University of Arizona put it, “When there is a cut in the capital gains tax rate, there is an incentive to sell the stock then, and get the lower tax rate before a new administration raises it again. Thus, when the capital gains tax is cut, there is a rush of investors selling stocks to pay their capital gains taxes now, when the rate is law, rather than later when the rate may be raised back up. Capital gains tax revenue to the government thus may go up now, but it will go down later, and it will go down overall.”

But logic is not the strong point of the advocates of reverse taxation, i.e. placing the greatest tax burden on those who make the least, who are to be grateful for the opportunity to serve those who make the most.