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.

The Graduated Income Tax System

In my last commentary I discussed at length the history of the graduated income tax in the US and demonstrated that far from being a new socialist, or European idea, it had been with us for almost one and a half centuries and is as American as apple pie.

The radical opponents of this time honored idea (and I call them radicals rather than conservatives because it is hardly conservative to try to abolish a system that has been so time honored) argue that there is something wrong with a large portion of the population not paying any tax or even for a small portion of the populace to pay the bulk of the taxes. They chose to ignore the old axiom; “you can’t get blood from a stone.”

Beyond that they pretend that it is offensive to the principles of Capitalism, apparently being unaware that Adam Smith, the early apostle of capitalism, wrote in 1776 in his seminal treaty on capitalism, The Wealth of Nations, “The necessaries of life occasion the great expense of the poor. . . . The luxuries and vanities of life occasion the principal expense of the rich, and a magnificent house embellishes and sets off to the best advantage all the other luxuries and vanities which they possess. . . . It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.” It is rather interesting to note that Adam Smith espoused a graduated tax.

But none of this deters our modern radicals from proclaiming the unfairness of that which is both practical and just. Ari Fleisher, George W. Bush’s former press secretary for example wrote an article in the Wall Street Journal of April 16, 2007, “The income tax system is so bad, and increasingly reliant on a shrinking number of Americans to pay the nation's bills, that 40% of the country's households -- more than 44 million adults -- pay no income taxes at all. Not a penny.” I do not know whether this is accurate, but even if it is, it is not true that it is “INCREASINGLY reliant on a shrinking number of Americans to pay the nation's bills.” As I demonstrated in my previous article, according to the US Treasury department, our tax system as early as 1860 relied on a small number of the wealthy to pay the taxes and under the law of 1923 less than 1% of the population were expected to pay any tax at all. Fleisher goes on to complain that the richest (I assume he doesn’t mean the richest, but rather those with the largest taxable income since income taxes are based on income and not on wealth) 1% of Americans pay 37% of all our taxes. 10% of taxpayers pay 71% and 40% pay 99%. He goes on to complain that those who make under $43,200 carry only .09% of the income tax burden. Again I don’t know whether these figures are accurate, but assuming that they are, what does Mr. Fleisher propose, that we double the tax on people who often work two jobs and barely have enough to pay their rent, their medical bills, put food on the table and educate their children. But of course these people pay much more taxes than Mr. Fleisher gives them credit for, since they not only pay federal income taxes, but payroll taxes, sales taxes, real estate taxes, excise taxes and possibly local income taxes as well. Our tax system has over the years become not more progressive, but rather much more regressive and Mr. Fleisher and his cohorts, against all precedent, want to tax the have-nots more and more so that the billionaires, who are increasing their wealth as a percentage of the total wealth in the country, and whose after tax income is steadily increasing, can accumulate even more. But even this remains misleading, for the rich make most of their income from capital gains, which are not taxed to the same extent as income made from the sweat of one’s brow.

In order to see the extent of the gap in the income of Americans the following figures from the US Census bureau are instructive: The top 20% of Americans make 49.7% of total income. The next quintile made 23.3%. The middle quintile 14.8% or to put it another way the top 60% made 87.8 percent of total income in the US. The bottom 40% made 12.3% of income.

One can easily see that even if we had a flat tax, with everyone regardless of income paying the same percentage, the top 20% of earners would still be paying almost 50% of the federal income taxes. And while the graduated income tax is often described as redistributing income, it does so rather ineffectively, if at all, as can be seen from the figures below showing income distribution after taxes. As can be seen the difference for after tax income is miniscule. The top 20% have 46.2% of income, the next quintile have 22.3%, the middle 15.6%, the bottom 40% end up with 16%.

As for wealth as opposed to income, according to Forbes - September 17, 2008 edition - to become one of the 400 of the richest people in America one has to have a net income of $1.3 billion. Over the past year their combined wealth increased by $1.57 billion. The richest has a net value of $57 billion and would be worth $90 billion if he had not given away much of it to charity. The second richest is Warren Buffet with $50 billion, who had this to say about our tax system, when addressing a group of 400 wealthy individuals, “The 400 of us [here] pay a lower part of our income in taxes than our receptionists do, or our cleaning ladies, for that matter. If you’re in the luckiest 1 per cent of humanity, you owe it to the rest of humanity to think about the other 99 per cent.”

Mr. Buffett said that he was taxed at 17.7 per cent 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 30 per cent.

Not only are the rich not being overtaxed, it appears that the richer you are the smaller the percentage of your income goes to pay federal taxes. While we appear to have a graduated income tax, the lower capital gains tax more than makes up for this discrepancy, as do the innumerable tax deferrals and exemptions available only to the rich.

Even with some small restoration of fairness, as proposed by President elect Obama, we will be a long way from restoring our traditional graduated tax system, which has kept us from becoming a class structured society, and has kept us economically successful.