The main purpose of those columns was to explain why it would be economically harmful to impose punitive tax rates on productive behaviors such as work, saving, investment, and entrepreneurship.
Unsurprisingly, Biden still wants all these tax increases, even though Democrats lost control of the House of Representatives.
Eric Boehm’s article in Reason debunks Biden’s proposal (the president calls it a billionaire’s tax).
Say what you will about the Biden administration’s approach to tax-the-rich populism: It’s creative. …Taxpayers with net wealth above $100 million would have to pay a minimum effective tax rate of 20 percent on an expanded measure of income that adds unrealized capital gains to more conventional sources of income, like wages, business income, and investment income. …By raising the effective tax rate on capital gains, the proposal would reduce U.S. saving, discourage entrepreneurship, and decrease economic output. …An annual tax on paper gains would be conspicuously complex. The largest administrative problems relate to valuing non-tradable assets like privately held businesses and taxing illiquid taxpayers with large gains on paper but little cash on hand to pay a minimum tax bill. …Given these problems, it’s unsurprising the idea hasn’t caught on around the world.
And the Wall Street Journal has an editorial about this class-warfare scheme.
After the November midterm election, President Biden was asked what he would change in his last two years. “Nothing,” he said, and…he proved it by reproposing…enormous tax increases that he couldn’t get through even a Democratic Congress. Start with a reprise of his “billionaire minimum tax.” …For starters, it isn’t a billionaire tax and it isn’t an income tax. It would apply to households worth more than $100 million in accumulated assets, and its target is wealth. …if your assets rise in value during a year, you will pay taxes on that increase even if you realized no actual gains through a sale. …If your assets fell in value, you would not be able to deduct the full loss from your overall income. Heads the government wins, tails you lose.
The bottom line is that the capital gains tax is an awful levy.
Let’s consider how it discourages investment. People earn money, pay tax on that money, and then need to decide what to do with the remaining (after-tax) income.
If they save and invest, they can be hit with all sorts of additional taxes. Such as the capital gains tax.
If you want to be wonky, a capital gain occurs when an asset (like shares of stock) climbs in value between when it is purchased and when it is sold.
But stocks rise in value when the market expects a company will generate more income in the future.
Yet that income gets hit by both the corporate income tax and the personal income tax (the infamous double tax on dividends).
Now that I’ve whined about capital gains taxation, let’s see what happens when a country moves in the right direction.
Professor Terry Moon, from the University of British Columbia, authored a study on the impact of a partial cut in South Korea’s capital gains tax. His abstract succinctly summarizes the results.
This paper assesses the effects of capital gains taxes on investment in the Republic of Korea (hereafter, Korea), where capital gains tax rates vary at the firm level by firm size. Following a reform in 2014, firms with a tax cut increased investment by 34 log points and issued more equity by 9 cents per dollar of lagged revenue, relative to unaffected firms. Additionally, the effects were larger for firms that appeared more cash constrained or went public after the reform. Taken together, these findings are consistent with the “traditional view” predicting that lower payout taxes spur equity-financed investment by increasing marginal returns on investment.
There are several interesting charts and graphs in the study.
But this one is particularly enlightening since we can see big positive results for the firms that were eligible for lower tax rates compared to the ones that still faced higher tax rates.
Richard Rahn wrote about capital gains taxation late last year.
Here are some excerpts from his column in the Washington Times.
Would you vote for a tax that frequently taxes people at an effective rate of 100% or more, misallocates investment, reduces economic growth and job creation, often becomes almost impossible to calculate, and in many cases reduces, rather than increases, revenue for the government? …So-called “capital gains” are price changes most often caused by inflation, which, of course, is caused by incompetent or corrupt governments. …Some countries explicitly allow for the indexing of a capital gain for inflation. Other countries have no capital gains tax at all because they recognize what a destructive tax it is. …The current maximum federal capital gains tax is 23.8%. …“Build Back Better” (BBB) bill would push the top rate to 31.8%…and…citizens of states with high state income tax rates like California, New York, and New Jersey would find themselves paying destructive rates from 43 to 45%.
Needless to say, it is a bad idea to impose a 43 percent-45 percent tax on any type of productive behavior.
But it is downright crazy to impose that type of tax on economic activity (investment) that also gets hit by other forms of tax.
Let’s close with this map from the Tax Foundation. As you can see, some European nations have punitive rates, but countries such as Belgium, Slovakia, Luxembourg, the Czech Republic, and Switzerland wisely have chosen not to impose a capital gains tax..
P.S. For more information, I invite people to watch the video I narrated on the topic. And this editorial from the Wall Street Journal also is a good summary of the issue.
P.P.S. Biden wants America to have the world’s worst capital gains tax. To learn why that’s a bad idea, click here and here.
I think Joe Biden must be feeling envious that Trump got so much attention, so he has issued a tweet showing that he also suffers from economic illiteracy.
Or maybe Biden’s problem is dishonesty because his tweet is based on a make-believe number about the the average tax rate paid by billionaires.
For what it’s worth, this isn’t the first time that Biden has issued a tweet based on fake numbers.
In the previous instance, he deliberately confused the distinction between the financial concept of book income and and cash-flow concept of taxable income.
What accounts for his most recent error?
Reporting for the Wall Street Journal, Richard Rubin and Rachel Louise Ensign explain how the Biden Administration concocted this number.
What do the wealthy pay in federal taxes? On paper, the top marginal income-tax rate is 37% on ordinary income and 23.8% on capital gains. Government estimates put high-income filers’ average rates in the mid-20s. A new Biden administration analysis, however, pegs the average tax rate for the 400 wealthiest households at 8.2% from 2010 to 2018. …It’s far below traditional estimates from government number crunchers… Recent estimates of a broader group of rich people from the Congressional Budget Office, Treasury Department and the Joint Committee on Taxation fall between 23% and 26%.
So how does the Biden Administration get a number that is radically different than other sources?
By artificially inflating the income of rich people by asserting that changes in wealth should count as income.
White House…economists Greg Leiserson and Danny Yagan..include increases in unrealized capital gains. That is the change in the value of assets, including stocks, that haven’t been sold. …Conventional analyses and the current income-tax law don’t include unrealized gains.
At the risk of making a wonky point, “conventional analysis” and “income-tax law” don’t include unrealized capital gains as income because, well, changes in net worth are not income.
To understand why that would be wretched policy, let’s cite examples that apply to those of us who, sadly, are not billionaires.
Imagine filing your taxes next year and having to pay more money to the IRS simply because Zillow estimated that your house rose in value.
Imagine that you’re filling out your 1040 form next year and you have to pay more money to the IRS simply because your IRA or 401(k) rose in value.
Both of these examples sound absurd because they would be absurd. And if a policy is absurd and unfair for regular people, it’s also absurd and unfair for rich people.
Since I’m a fiscal wonk, I’ll close by making the point that the Biden Administration wants to take a bad tax (capital gains tax) and make it worse (by taxing paper gains in addition to actual gains).
The net result is that we would have a backdoor wealth tax – a approach that is so anti-growth that even most European governments have repealed those levies.
But since Joe Biden is motivated by class warfare (see here, here, here, and here), he apparently doesn’t care about the economic consequences.
P.S. Biden once claimed that it is “patriotic” to pay higher taxes, but he then played Benedict Arnold with his own tax return.
The common theme is “soak the rich.” Our friends on the left seem to think class-warfare taxation is politically popular, and it’s easy to understand their political calculus – win votes by pillaging a tiny group and distributing goodies to a much bigger group.
But if that’s the case, they may want to look at the results of a referendum that was decided earlier this week. It took place in the blue state of Washington, where voters had the chance to register their approval or disapproval of a capital gains tax imposed earlier in the year by the state’s politicians.
Here are the official results, which show a landslide rejection of the class-warfare levy. And it happened in a state that Biden won by nearly 20 percentage points.
Now for the bad news.
The referendum does not repeal the capital gains tax. It’s simply an “advisory vote.”
If you want to know more details, Jared Walczak wrote about the issue last month for the Tax Foundation.
On May 4th, Gov. Jay Inslee (D) signed legislation creating a 7 percent capital gains tax, to take effect next year. On November 2nd, Washington lawmakers will learn what voters think about it. Although the ballot measure asking voters to recommend on retaining or repealing the new tax is purely advisory, this gauge of voter sentiment could be particularly illuminating as Washington barrels forward on the implementation of a highly volatile, constitutionally suspect tax that breaches the state’s historic barrier against income taxation. …Legal challenges to the tax are already pending and may ultimately do more to stop it in its tracks than can a nonbinding advisory vote. Nevertheless, the fate of Advisory Question 37 is an important one, not only because the capital gains tax itself would be economically harmful, or because it shows an irreverence for the state constitution, a concern in its own right. It’s also important because if voters signal their opposition to taxing this specific class of income, that sends a strong message that they are decidedly uninterested in efforts to scrap the state’s ban on a broader income tax.
Well, the voters did send a “strong message” that they want to preserve the state’s zero-income-tax status.
Whether the courts listen (or, more important, whether they uphold the state’s constitution) is yet to be determined.
For purposes of today’s column, however, I’ll simply observe that the election results may have an impact on whether Biden’s awful fiscal proposals get enacted.
Most observers are focused on the upset victory for Republicans in Virginia and the huge vote gains for the GOP in New Jersey. And I won’t be upset if those remarkable election results lead my Democratic friends in DC to back away from Biden’s big-government agenda.
But I think what happened in the state of Washington also indicates that voters don’t want big government, even when politicians tell them “the rich” will pick up the tab. Maybe, just maybe, ordinary people realize that they’ll be collateral damage if we make the United States more like Europe.
But it turns out that higher taxes are not very popular, notwithstanding the delusions of Bernie Sanders, AOC, and the rest of the class-warfare crowd.
The bad news is that they’ve revived an awful idea to make capital gains taxes more onerous by taxing people on capital gains that only exist on paper.
In a column for the New York Times, Neil Irwin explains how the new scheme would work..
…congressional Democrats..are looking toward a change in the tax code that would reinvent how the government taxes investments… The Wyden plan would require the very wealthy — those with over $1 billion in assets or three straight years of income over $100 million — to pay taxes based on unrealized gains. …It could create some very large tax bills… If a family’s $10 billion net worth rose to $11 billion in a single year, a capital-gains rate of 20 percent would imply a $200 million tax bill.
In other words, families would be taxed on theoretical gains rather than real gains.
Some have said this scheme is similar to a wealth tax, though it’s more accurate to say it’s a tax on changes in wealth.
Mr. Irwin’s column also acknowledges some other problems with this proposed levy.
The proposal raises conceptual questions about what counts as income. When Americans buy assets — shares of stock, a piece of real estate, a business — that become more valuable over time, they owe tax only on the appreciation when they sell the asset. …The rationale is that just because something has increased in value doesn’t mean the owner has the cash on hand to pay taxes. Moreover, for those with complex holdings, like interests in multiple privately held companies, it could be onerous to calculate the change in valuations every year, with ambiguous results. …having a cutoff at which the new capital gains system applies could create perverse incentives… “If you have a threshold, you’re giving people a really strong incentive to rearrange their affairs to keep their income and wealth below the threshold,” said Leonard Burman, institute fellow at the Tax Policy Center.
In other words, this plan would be great news for accountants, lawyers, and other people involved with tax planning.
I support the right of people to minimize their taxes, of course, but I wish we had a simple and fair tax system so that there was no need for an entire industry of tax planners.
But I’m digressing. Let’s continue with our analysis of this latest threat to good tax policy.
Henry Olson opines in the Washington Post that it’s a big mistake to impose taxes on unrealized gains.
The Biden administration’s idea to tax billionaires’ unrealized capital gains…would be an unworkable and arguably unconstitutional mess that could harm everyone. …Tesla founder Elon Musk’s net worth rose by $126 billion last year as his company’s stock price soared, but he surely paid almost no tax on that because he never sold the stock. Biden’s plan would tax all of that rise, netting the federal government about $30 billion. Do the same for all the nation’s billionaires, and the feds could pull in loads of cash… If that sounds too good to be true, it’s because it is. …Privately held companies…are notoriously difficult to value. Rare but valuable items are even more difficult to fix an annual price. …Billionaires are precisely the people with the motive and the means to hire the best tax lawyers to fight the Internal Revenue Service at every step of the way, surely subjecting each tax return to excruciatingly long and expensive audits. …Expensive assets can go down in value, too, and billionaires would rightly insist that the IRS account for those reversals of fortune. …Would the IRS have to issue multi-billion dollar refund checks to return the billionaires’ quarterly estimated tax payments from earlier in the year?
These are all excellent points.
Henry also points out that the scheme may be unconstitutional.
The Constitution may not even permit taxation of unrealized gains. The 16th Amendment authorizes taxation of “income,”… Unrealized gains don’t fit under that rubric because the wealth is on paper, not in the hands of the owner to use as she wants.
And he closes with the all-important point that the current plan may target the richest of the rich, but sooner or later the rest of us would be in the crosshairs.
…it will only be a matter of time before lawmakers apply the tax to ordinary Americans. Anyone who owns a house or has a retirement account has unrealized capital gains. Billionaires get all the attention, but the real money is in the hands of the broader public, as the collective value of real estate and mutual funds dwarfs what the nation’s uber-wealthy hold. The government would love to get 25 percent of your 401(k)’s annual rise.
This means there should be no wealth tax, whether levied on annual wealth or imposed on changes in wealth.
P.S. Biden, et al, claim we need higher taxes on the rich because the current system is unfair, yet there’s never any recognition that the United States collects a greater share of revenue from the rich than any other developed nations (not because our tax rates on the rich are higher than average, but rather because our tax rates on lower-income and middle-class taxpayers are much lower than average).
P.P.S. The bottom line is that taxing unrealized capital gains is such a crazy idea that even nations such as France and Greece have never tried to impose such a levy.
By the way, I should have included “Less Common Sense” as a seventh reason. That’s because the capital gains tax will backfire on Biden and his class-warfare friends.
To be more specific, investors can choose not to sell assets if they think the tax rate is excessive, and this “lock-in effect” is a big reason why higher rates almost surely won’t produce higher revenues.
In a column earlier this year for the Wall Street Journal, former Federal Reserve Governor Lawrence Lindsey explained this “Laffer Curve” effect.
…43.4% is well above the rate that would generate the most revenue for the government. Congress’s Joint Committee on Taxation, which does the official scoring and is no den of supply siders, puts the revenue-maximizing rate at 28%. My work several decades ago puts it about 10 points lower than that. That means President Biden is willing to accept lower revenue as the price of higher tax rates. The implications for his administration’s economic thinking are mind-boggling. Even the revenue-maximizing rate is higher than would be optimal. As tax rates rise, the activity being taxed declines. The loss to the private side of society increases at a geometric rate (proportional to the square of the tax rate) as rates rise. … The Biden administration is blowing up one of the key concepts that has united the economics profession: maximizing social welfare. It now believes in taxation purely as a form of punishment and is even willing to sacrifice revenue to carry it out.
Democrats used to be far more sensible on this issue. For instance, Bill Clinton signed into a law a cut in the tax rate on capital gains.
And, as noted in this Wall Street Journaleditorial on the topic, another Democratic president also had very sensible views.
Even in the economically irrational 1970s the top capital-gains rate never broke 40%… A neutral revenue code would tax all income only once. But the U.S. also taxes business profits when they are earned, and President Biden wants to raise that tax rate by a third (to 28% from 21%). When a business distributes after-tax income in dividends, or an investor sells the shares that have risen in value due to higher earnings, the income is taxed a second time. …The most important reason to tax capital investment at low rates is to encourage saving and investment. …Tax something more and you get less of it. Tax capital income more, and you get less investment, which means less investment to improve worker productivity and thus smaller income gains over time. As a former U.S. President once put it: “The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth of the economy.” That wasn’t Ronald Reagan. It was John F. Kennedy.
Especially the current occupant of the White House. The bottom line is that Biden’s agenda is bad news for American prosperity and American competitiveness.
P.S. If you’re skeptical about my competitiveness assertion, check out this data.
Thanks to some new research from Professor John Diamond of Rice University, we can now quantify the likely damage if Biden’s proposals get enacted.
Here’s some of what he wrote in his new study.
We use a computable general equilibrium model of the U.S. economy to simulate the economic effects of these policy changes… The model is a dynamic, overlapping generations, computable general equilibrium model of the U.S. economy that focuses on the macroeconomic and transitional effects of tax reforms. …The simulation results in Table 1 show that GDP falls by roughly 0.1 percent 10 years after reform and 0.3 percent 50 years after reform, which implies per household income declines by roughly $310 after 10 years and $1,200 after 50 years. The long run decline in GDP is due to a decline in the capital stock of 1.0 percent and a decline in total hours worked of 0.1 percent. …this would be roughly equivalent to a loss of approximately 209,000 jobs in that year. Real wages decrease initially by 0.2 percent and by 0.6 percent in the long run.
Here is a summary of the probable economic consequences of Biden’s class-warfare scheme.
But the above analysis should probably be considered a best-case scenario.
So Prof. Diamond also analyzes the impact of inflation.
…capital gains are not adjusted for inflation and thus much of the taxable gains are not reflective of a real increase in wealth. Taxing nominal gains will reduce the after-tax rate of return and lead to less investment, especially in periods of higher inflation. …taxing the nominal value will reduce the real rate of return on investment, and may do so by enough to result in negative rates of return in periods of moderate to high inflation. Lower real rates of return reduce investment, the size of the capital stock, productivity, growth in wage rates, and labor supply. …Accounting for inflation in the model would exacerbate other existing distortions… An increase in the capital gains tax rate or repealing step up of basis will make investments in owner-occupied housing more attractive relative to other corporate and non-corporate investments.
Here’s what happens to the estimates of economic damage in a world with higher inflation?
Assuming the inflation rate is one percentage point higher on average (3.2 percent instead of 2.2 percent) implies that a rough estimate of the capital gains tax rate on nominal plus real returns would be 1.5 times higher than the real increase in the capital gains tax rate used in the standard model with no inflation. Table 2 shows the results of adjusting the capital gains tax rates by a factor of 1.5 to account for the effects of inflation. In this case, GDP falls by roughly 0.1 percent 10 years after reform and 0.4 percent 50 years after reform, which implies per household income declines by roughly $453 after 10 years and $1,700 after 50 years.
Here’s the table showing the additional economic damage. As you can see, the harm is much greater.
I’ll conclude with two comments.
First, inflation is obviously bad for citizens. But as I wrote more than 10 years ago, it’s profitable for governments.
Second, even seemingly small differences in economic growth produce big differences in long-run living standards.
P.S. If (already-taxed) corporate profits are distributed to shareholders, there’s a second layer of tax on those dividends. If the money is instead used to expand the business, it presumably will increase the value of shares (a capital gain) because of an expectation of higher future income (which will be double taxed when it occurs).
It’s presumably not controversial to point out that the Washington Post (like much of the media) leans to the left. Indeed, the paper’s bias has given me plenty of material over the years.
As you can see, what really irks me is when the bias translates into sloppy, inaccurate, or misleading statements.
In 2011,the Post asserted that a plan to trim the budget by less than 2/10ths of 1 percent would “slash” spending.
Later that year, the Post claimed that the German government was “fiscally conservative.”
Ms. Warren’s version of the wealth tax, which calls for 2 percent annual levies on net wealth above $50 million, and 3 percent above $1 billion, very rich people would face large tax bills even when they had little or negative net income, forcing them to sell assets to pay their taxes. …huge chunks of private wealth tied up in real estate, rare art and closely held businesses are more difficult — sometimes impossible — to assess consistently. …Such problems help explain why national wealth taxes yielded only modest revenue in the 11 European countries that levied them as of 1995, and why most of those countries subsequently repealed them.
I’m disappointed that the Post overlooked the biggest argument, which is that wealth taxation would reduce saving and investment and thus lead to lower wages.
But I suppose I should be happy with modest steps on the road to economic literacy.
The Post‘s editorial also echoed my argument by pointing out that ProPublica was very dishonest in the way it presented data illegally obtained from the IRS.
ProPublica muddied a basic distinction, which, properly understood, actually fortifies the case against a wealth tax. The story likened on-paper asset price appreciation with actual cash income, then lamented that the two aren’t taxed at the same rate. …ProPublica’s logic implies that, when the stock market goes down, Elon Musk, whose billions are tied up in shares of Tesla, should get a tax cut.
Amen (this argument also applies to the left’s argument for taxing unrealized capital gains).
Now that I’ve presented the sensible portions of the Post‘s editorial, let’s shift to the bad parts.
First and foremost, the entire purpose of the editorial was to support more class-warfare taxation.
Fortunately, legitimate goals of a wealth tax can be achieved through other means… This would require undoing not only some of the 2017 GOP tax cuts, but much previous tax policy as well… The higher capital gains rate should be applied to a broader base of investment income… President Biden’s American Families Plan calls for reform of this so-called “stepped-up basis” loophole that would yield an estimated $322.5 billion over 10 years.
The editorial also calls for an expanded death tax, one that would raise six times as much money as the current approach.
…simply reverting to estate tax rules in place as recently as 2004 could yield $98 billion per year, far more than the $16 billion the government raised in 2020.
Last but not least, it argues for these tax increases because it wants us to believe that politicians will wisely use any additional revenue in ways that will increase economic opportunity.
The public sector could use new revenue from stiffer capital gains and estate taxes to expand opportunity.
Proponents argue that if we give politicians more money, we’ll somehow get more prosperity.
At the risk of understatement, this theory isn’t based on empirical evidence.
Which is the message of a 2017 video from the Center for Freedom and Prosperity. And it’s also the reason I repeatedly ask the never-answered question.
P.S. To make the argument that capital gains taxes and death taxes are better than wealth taxation, the Post editorial cites research from the Paris-based Organization for Economic Cooperation and Development. Too bad the Post didn’t read the OECD study showing that class-warfare taxes reduce overall prosperity. Or the OECD study showing that more government spending reduces prosperity.
The economic argument against capital gains taxation is very simple. It is wrong to impose discriminatory taxes on income that is saved and invested.
It’s bad enough that government gets to tax our income one time, but it’s even worse when they get to impose multiple layers of tax on the same dollar.
Even worse, he wants to expand the capital gains tax so that it functions as an additional form of death tax.
And that tax would be imposed even if assets aren’t sold. In other words, it would a tax on capital gains that only exist on paper (a nutty idea associated with Sens. Ron Wyden and Elizabeth Warren).
I’m not joking. In an article for National Review, Ryan Ellis explains why Biden’s proposal is so misguided.
The Biden administration proposes that on top of the old death tax, which is assessed on estates, the federal government should add a new tax on the deceased’s last 1040 personal-income-tax return. This new, second tax would apply to tens of millions of Americans. …the year someone died, all of their unrealized capital gains (gains on unsold real estate, family farms and businesses, stocks and other investments, artwork, collectibles, etc.) would be subject to taxation as if the assets in question had been sold that year. …In short, what the Biden administration is proposing is to tax the capital gains on a person’s property when they die, even if the assets that account for those gains haven’t actually been sold. …to make matters worse, the administration also supports raising the top tax rate on long-term capital gains from 23.8 percent to 43.4 percent. When state capital-gains-tax rates are factored in, this would make the combined rate at or above 50 percent in many places — the highest capital-gains-tax rate in the world, and the highest in American history.
This sounds bad (and it is bad).
But there’s more bad news.
…that’s not all. After these unrealized, unsold, phantom gains are subject to the new 50 percent double death tax, there is still the matter of the old death tax to deal with. Imagine a 50 percent death tax followed by a 40 percent death tax on what is left, and you get the idea. Karl Marx called for the confiscation of wealth at death, but even he probably never dreamed this big. …Just like the old death tax, the double death tax would be a dream for the estate-planning industry, armies of actuaries and attorneys, and other tax professionals. But for the average American, it would be a nightmare. The death tax we have is bad enough. A second death tax would be a catastrophic mistake.
Hank Adler and Madison Spach also wrote about this topic last month for the Wall Street Journal.
Here’s some of what they wrote.
Mr. Biden’s American Families Plan would subject many estates worth far less than $11.7 million to a punishing new death tax. The plan would raise the total top rate on capital gains, currently 23.8% for most assets, to 40.8%—higher than the 40% maximum estate tax. It would apply the same tax to unrealized capital gains at death… The American Families Plan would result in negative value at death for many long-held leveraged real-estate assets. …Scenarios in which the new death tax would significantly reduce, nearly eliminate or even totally eliminate the net worth of decedents who invested and held real estate for decades wouldn’t be uncommon. …The American Families Plan would discourage long-term investment. That would be particularly true for those with existing wealth who would begin focusing on cash flow rather than long-term investment. The combination of the new death tax plus existing estate tax rates would change risk-reward ratios.
P.S. Keep in mind that there’s no “indexing,” which means investors often are being taxed on gains that merely reflect inflation.
P.P.S. Rather than increasing the tax burden on capital gains, we should copy Belgium, Chile, Costa Rica, Czech Republic, Hungary, Luxembourg, New Zealand, Singapore, Slovenia, Switzerland, and Turkey. What do they have in common? A capital gains tax rate of zero.
Which is why there should be no tax on capital gains, and a few nations sensibly take this approach.
But they’re outnumbered by countries that do impose this pernicious form of double taxation. For instance, the Tax Foundation has a new report about the level of capital gains taxation in Europe, which includes this very instructive map.
As you can see, some countries, such as Denmark (gee, what a surprise), have very punitive rates.
However, other nations (such as Switzerland, Belgium, Czech Republic, Slovakia, Luxembourg, and Slovenia) wisely don’t impose this form of double taxation.
If the United States was included, we would be in the middle of the pack. Actually, we would be a bit worse than average, especially when you include the Obamacare tax on capital gains.
But if Joe Biden succeeds, the United States soon will have the dubious honor of being the worst of the worst.
The Wall Street Journalopined this morning about the grim news.
Biden officials leaked that they will soon propose raising the federal tax on capital gains to 43.4% from a top rate of 23.8% today. …Mr. Biden will tax capital gains for taxpayers who earn more than $1 million at the personal income tax rate, which he also wants to raise to 39.6% from 37%. Add the 3.8% ObamaCare tax on investment, and you get to 43.4%. And that’s merely the federal rate. Add 13.3% in California and 11.85% in New York (plus 3.88% in New York City), which also tax capital gains as regular income, and you are heading toward the 60% rate range. Keep in mind this is on the sale of gains that are often inflated as assets are held for years without adjustment for inflation. Oh, and Mr. Biden also wants to eliminate the step-up in basis on capital gains that accrues at death.
Beating out Denmark for the highest capital gains tax rate is bad.
But it’s even worse when you realize that capital gains often occur because investors expect an asset to generate more future income. But that future income gets hit by the corporate income tax (as well as the tax on dividends) when it actually materializes.
And I also recommend these columns (here, here, and here) for additional information on why we should be eliminating the capital gains tax rather than increasing it.
P.S. Don’t forget that there’s no indexing to protect taxpayers from having to pay tax on gains that are due only to inflation.
A “capital gain” occurs when you buy something and later sell it for a higher price. A capital gains tax is when politicians decide they get to grab a slice of that additional wealth.
Simply stated, the capital gains tax is “double taxation,” which is what happens when there are additional layers of tax on income that is saved and invested.
I’m motivated to address this issue again because of a recent column in the Washington Post by Charles Lane.
He wants us to believe that singer-songwriter Bob Dylan has been rewarded by the capital gains tax.
Bob Dylan…just sold the rights to “Blowin’ in the Wind” and 600 other songs to Universal Music Publishing Group for a reported $300 million. …This is a tribute to his genius and, on the whole, to a political and economic system that rewards artists… Nevertheless, some socially conscious musician could write a song protesting the Dylan deal, because of what it reveals about that engine of irrationality and inequality known as the U.S. tax system. A cardinal defect of the system is highly favorable treatment of capital gains relative to ordinary income. The top rate on the former stands at 20 percent; on the latter, it is 37 percent. …the obscure 2006 law known as the Songwriters Capital Gains Tax Equity Act, which permits songwriters — but not painters, video game makers or novelists — to treat the proceeds from selling their copyrights as capital gains, too. …The capital gains break, for him and for others similarly situated, is basically a windfall. …President-elect Joe Biden supports equalizing capital gains and ordinary income rates, at least for households earning more than $1 million. If kept, Biden’s promise would restore a measure of equity and efficiency to the tax system.
At the risk of understatement, I disagree.
What Mr. Lane doesn’t appreciate or understand is that the Universal Music Publishing Group purchased the rights to Dylan’s music for $300 million because they expect his songs to generate more than $300 million of income in the future.
And that future income will be taxed when (and if) it actually materializes.
In other words, a capital gains tax is – for all intents and purposes – an added layer of tax on the expectation of future income. Double taxation in every possible sense.
Since we’re on the topic of capital gains taxation, I’ll also cite some relatively new research from the San Francisco Federal Reserve.
Here are the key findings in the working paper from Sungki Hong and Terry Moon.
This paper quantifies the aggregate effects of reducing capital gains taxes in the long run. We build a dynamic general equilibrium model with heterogeneous firms facing discrete capital gains tax rates based on firm size. We calibrate our model by targeting relevant micro moments and the difference-in-differences estimate of the capital elasticity based on the institutional setting in Korea. We find that the reform that reduced the capital gains tax rates from 24 percent to 10 percent for the firms affected by the new regulations increased aggregate investment by 2.6 percent and 1.7 percent in the short run and in the steady state, respectively. Moreover, a counterfactual analysis where we set a uniformly low tax rate of 10 percent shows that aggregate investment rose by 6.8 percent in the long run. …Our findings suggest that reducing capital gains tax rates would substantially increase investment in the short run, and accounting for dynamic and general equilibrium responses is important for understanding the aggregate effects of capital gains taxes.
And here are two of the key charts from the study.
And here’s the part of the study that explains the above charts.
Panel A in Figure 2…shows the parallel trend in investment between the affected and unaffected firms…positive and statistically significant coefficients after the year 2014 indicate that lower tax rates induced the affected firms to increase investment. Panel B in Figure 2…shows the parallel trend in investment between the affected and unaffected firms…positive and statistically significant coefficients after the year 2014 indicate that lower tax rates induced the affected firms to increase the size of tangible assets.
Candidates such as Elizabeth Warren and Bernie Sanders supposedly are competing for hard-left voters, while candidates such as Joe Biden and Pete Buttigieg are going after moderate voters. But a review of Buttigieg’s fiscal policy suggests he may belong in the first category.
In the interview, I focused on Buttigieg’s plan to subsidize colleges. Hopefully, I got across my main point is that students won’t be helped.
I’m not the only person to speculate that Buttigieg is simply a watered down version of Warren.
The Wall Street Journalopined today on Mayor Pete’s statist agenda.
Mr. Buttigieg has risen steadily in the Real Clear Politics polling average to a solid fourth place, with about 7% support. …on Friday he released what he called “An Economic Agenda for American Families.” For a candidate who wants to occupy the moderate lane, Mr. Buttigieg’s policy details veer notably left. …$700 billion—presumably over 10 years, but the plan doesn’t specifically say—for “universal, high-quality, and full-day early learning.” …$500 billion “to make college affordable.” That means free tuition at public universities… $430 billion for “affordable housing.” …$400 billion to top off the Earned Income Tax Credit… A $15 national minimum wage.
At the risk of understatement, that’s not a moderate platform.
This isn’t an economic agenda, and there isn’t a pro-growth item anywhere. It’s a social-welfare spending and union wish list. …Don’t forget the billions more he has allocated to green energy, as well as his $1.5 trillion health-care public option, “Medicare for All Who Want It.” So far Mayor Pete’s agenda totals $5.7 trillion… Mayor Pete’s policy wish list is shorter and cheaper than Elizabeth Warren’s, but it still includes gigantic tax increases to finance a huge expansion of the welfare and entitlement state. Call it Warren lite.
Methinks John Stossel needs to update this video. With $5.7 trillion of new outlays, Buttigieg is definitely trying to win the big-spender contest.
No wonder he’s now embracing class-warfare tax policy. One of his giant tax increases, which I should have mentioned in the interview, is a version of Elizabeth Warren’s “nutty idea” to force people to pay taxes on capital gains even if they haven’t sold assets and therefore don’t actually have capital gains!
By the way, Buttigieg is also a hypocrite. He’s joined with other Democratic candidates in embracing a carbon tax on lower-income and middle-class voters, yet the Chicago Tribunereports that he zips around the country on private jets.
Pete Buttigieg has spent roughly $300,000 on private jet travel this year, more than any other Democrat running for the White House, according to an analysis of campaign finance data. …his reliance on charter flights contrasts sharply with his image as a Rust Belt mayor who embodies frugality and Midwestern modesty. …Buttigieg’s campaign says the distance between its South Bend headquarters and major airports sometimes makes private jet travel necessary. “We are careful with how we spend our money, and we fly commercial as often as possible,” Buttigieg spokesman Chris Meagher said Wednesday. “We only fly noncommercial when the schedule dictates.”
Last month, I accused Elizabeth Warren of being a “fiscal fraud” for proposing a multi-trillion dollar government takeover of healthcare.
She then unveiled a plethora of class-warfare taxes. As I discussed yesterday on CNBC, she even wants to tax capital gains even if the gains are only on paper.
By the way, I’m disappointed that I forgot to mention in my final soundbite that school choice would be a very specific and very effective way of helping poor people climb the ladder of opportunity.
But let’s set that aside and focus on Senator Warren’s radical proposal.
Because the idea would be such a nightmare of complexity, I joked in the interview that the Senator must own shares in firms that do tax accounting.
That’s not a novel observation on my part. Earlier this year, the Wall Street Journalopined why this was a bad idea. Not just a bad idea, a ridiculously foolish idea.
Under current law, long-term capital gains are taxed at rates up to 20%—plus a 3.8% ObamaCare surcharge on investment income—only after the asset is sold. Mr. Wyden calls this a loophole. …Mr. Wyden…proposes an annual “mark to market” scheme… As an asset rises in value, its owners would pay tax each year on the incremental gain. This would create an enormous new accounting burden. Mr. Wyden may say that his mark-to-market rule will apply only to the top 1% or 0.1%, but it would still be a bonanza for tax attorneys. How will people in the top 2% know whether they’ve passed the threshold, and how far will they go to avoid it? …Mr. Wyden’s plan would tax gains that exist merely on paper. …And what about illiquid investments, such as private companies or real estate? As with Ms. Warren’s suggested wealth tax, no one knows how Mr. Wyden would go about valuing them. …Would the owner of an apartment building be asked to revalue it every year? Will an art investor be told to mark that Picasso to market? Good luck.
I’ve already written about Senator Wyden’s proposal.
It’s not just absurdly complex. It’s also bad tax policy, as the WSJ noted.
…there are good reasons to tax capital gains at preferential rates, which is why the U.S. has done it for decades under Democrats and Republicans. The lower rate…reduces the harm from double taxation after corporations already pay income taxes. …A lower tax rate is also a matter of fairness. If investors have capital losses, they aren’t allowed to deduct more than $3,000 a year. There’s no inflation adjustment either: If $100 of stock bought in 1999 is sold for $150 today, the difference is taxed even though much of it is an illusory gain caused by dollar erosion.
The final sentence should be emphasized.
Under the Wyden – now Warren – plan, you can have illusory gains that only reflect inflation, and then you can get taxed on those illusory gains even if you don’t actually get them because you haven’t sold the asset.
David Bahnsen, writing for National Review, says the idea is simply nutty.
Senator Ron Wyden of Oregon is the top-ranking member of the Senate’s tax committee... And his recent policy proposal to tax unrealized capital gains is just as extreme, silly, impractical, dangerous, and inane as any of the aforementioned policy whiffs floating around in the leftist hemisphere. …The problems here are almost as severe as the problems with getting a wind-powered ride across the Pacific Ocean in the Green New Deal. First and foremost, the compliance costs would be the biggest boondoggle our nation’s financial system has ever seen. How in the world is illiquid real estate that has not sold supposed to be “valued” each and every year, let alone illiquid businesses, private debt, venture capital, and the wide array of capital assets that make up our nation’s economy but do not fit in the cozy box of “mutual funds”? …Another problem exists for this delusional plan: How do smaller investors pay the tax on an investment that has not yet returned the cash to them? …Underlying all of the mess of this silly proposal from Senator Wyden is the Democrats’ continued lack of understanding about what is most needed in our economy — business investment. The war on capital is a war on jobs, on productivity, on growth, and on wages. Taking bold actions to disincentivize productivity, investment, risk-taking, and capital formation is akin to discouraging diet and exercise for someone trying to lose weight.
Which is why the right capital gains tax rate is zero.
In other words, instead of worsening the bias against capital, we should be copying nations such as Switzerland, Singapore, Luxembourg, and New Zealand by abolishing the capital gains tax.
I wrote yesterday about the generic desire among leftists to punish investors, entrepreneurs, and other high-income taxpayers.
Today, let’s focus on one of the specific tax hikes they want. There is near-unanimity among Democratic presidential candidates for higher tax rates on capital gains.
The Tax Foundation summarizes many of the key issues in capital gains taxation.
…viewed in the context of the entire tax system, there is a tax bias against income like capital gains. This is because taxes on saving and investment, like the capital gains tax, represent an additional layer of tax on capital income after the corporate income tax and the individual income tax. Under a neutral tax system, each dollar of income would only be taxed once. …Capital gains face multiple layers of tax, and in addition, gains are not adjusted for inflation. This means that investors can be taxed on capital gains that accrue due to price-level increases rather than real gains. …there are repercussions across the entire economy. Capital gains taxes can be especially harmful for entrepreneurs, and because they reduce the return to saving, they encourage immediate consumption over saving.
Here’s a chart depicting how this double taxation creates a bias against business investment.
Here are some excerpts from a column in the Wall Street Journal on the topic of capital gains taxation.
The authors focus on Laffer-Curve effects and argue that higher tax rates can backfire. I’m sympathetic to that argument, but I’m far more concerned about the negative impact of higher rates on economic performance and competitiveness.
…there is a relatively simple and painless way to maintain the federal coffers: Restore long-term capital-gains tax rates to the levels in place before President Obama took office. A reduction in this tax could generate significant additional revenue. …This particular levy is unique in that most of the time the taxpayer decides when to “realize” his capital gain and, consequently, when the government gets its revenue. If the capital-gains tax is too high, investors tend to hold on to assets to avoid being taxed. As a result, no revenue flows to the Treasury. If the tax is low enough, investors have an incentive to sell assets and realize capital gains. Both the investors and the government benefit. …The chance to test that theory came in May 2003, when Congress lowered the top rate on long-term capital gains to 15% from 20%. According to the Congressional Budget Office, by 2005-06 realizations of capital gains had more than doubled—up 151%—from the levels for 2002-03. Capital-gains tax receipts in 2005-06, at an average of $98 billion a year, were up 81% from 2002-03. Tax receipts reached a new peak of $127 billion in 2007 with the maximum rate still at 15%. By comparison, federal capital-gains tax receipts were a mere $7.9 billion in 1977 (the equivalent of about $31 billion in 2017 dollars), according to the Treasury Department. The effective maximum federal capital-gains tax was then 49%. …Using our post-2003 experience as a guide, we can predict a dramatic improvement in realizations and tax receipts if the top capital-gains tax rate is lowered to 15%. …but that’s not the only benefit. Such changes also increase the mobility of capital by inducing investors to realize gains. This allows investment money to flow more freely, particularly to new and young companies that are so important for growth and job creation.
Here’s another chart from the Tax Foundation showing that revenues are very sensitive to the tax rate.
Last but not least, Chris Edwards explains that the U.S. definitely over-taxes capital gains compared to other developed nations.
Democrats are proposing to raise capital gains taxes. …Almost every major Democratic presidential candidate supports taxing capital gains as ordinary income. …These are radical and misguided ideas. …capital gains taxes should be low or even zero. …the United States already has high tax rates compared to other countries. The U.S. federal-state rate on individual long-term gains of 28 percent compared at the time to an average across 34 OECD countries of just 16 percent. …the combined federal-state capital gains tax rates on investments in corporations…includes the corporate-level income tax and the tax on individual long-term gains. …Numerous countries in the OECD study do not tax individual long-term capital gains at all, including Belgium, Chile, Costa Rica, Czech Republic, Hungary, Luxembourg, New Zealand, Singapore, Slovenia, Switzerland, Turkey. The individual capital gains tax rate on long-term investments in those countries is zero. …Raising the federal corporate and individual capital gains tax rates would be a lose-lose-lose proposition of harming businesses and start-ups, undermining worker opportunities, and likely reducing government revenues.
Here’s his chart, showing the effective tax rate caused by double taxation.
I wrote two days ago about how the White House is contemplating ideas to boost the economy.
This is somewhat worrisome since “stimulus” plans oftentimes are based on Keynesian economics, which has a terrible track record. But there are policies that could help growth and I comment on some of them in this interview.
The discussion jumped from one idea to the next, so let’s makes sense of the various proposals by ranking them from best to worst.
And I’m including a few ideas that are part of the discussion in Washington, but weren’t mentioned in the interview.
Index Capital Gains – The moral argument for using regulatory authority to index capital gains for inflation is just as strong as the economic argument, as far as I’m concerned. Potential legal challenges could create uncertainly and thus mute the beneficial impact.
Lower Payroll Tax Rates – While it’s always a good idea to lower the marginal tax rate on work, politicians are only considering a temporary reduction, which would greatly reduce any potential benefits.
Do Nothing – As of today, based on Trump’s statements, this may be the most likely option. And since “doing something” in Washington often means more power for government, there’s a strong argument for “doing nothing.”
Easy Money from the Fed – Trump is browbeating the Federal Reserve in hopes that the central bank will use its powers to artificially reduce interest rates. The president apparently thinks Keynesian monetary policy will goose the economy. In reality, intervention by the Fed usually is the cause of economic instability.
In my ideal world, I would have included spending cuts. But I limited myself to ideas that with a greater-than-zero chance of getting implemented.
I’ll close with some observations on the state of the economy.
Economists have a terrible track record of predicting twists and turns in the economy. This is why I don’t make predictions and instead focus on analyzing how various policies will affect potential long-run growth.
That being said, it’s generally safe to assume that downturns are caused by bad economic policy, especially the Federal Reserve’s boom-bust monetary policy.
Ironically, some people then blame capitalism for the damage caused by government intervention (the Great Depression, the Financial Crisis, etc).
One of the worst features of the internal revenue code is the pervasive bias against income that is saved and invested.
People who immediately consume their after-tax income are largely untaxed (thankfully, we don’t have a value-added tax), but there are several additional layers of tax on people who set aside income to finance future economic growth.
But that’s not a realistic option, so what about interim steps?
Interestingly, some progress may be possible. According to a Bloomberg report, the Trump Administration may be on the verge of getting rid of the hidden inflation tax on capital gains.
The White House is developing a plan to cut taxes by indexing capital gains to inflation, according to people familiar with the matter, in a move that…may be done in a way that bypasses Congress. Consensus is growing among White House officials to advance the proposal soon, the people said, to ensure the benefit takes effect before President Donald Trump faces re-election in 2020. Revamping capital gains taxes through a rule or executive order likely would face legal challenges, a concern that reportedly prompted former President George H.W. Bush’s administration to drop a similar plan. …Indexing capital gains would slash tax bills for investors when selling assets such as stock or real estate by adjusting the original purchase price so no tax is paid on appreciation tied to inflation. …The inflation adjustment would amount to a several percentage point tax cut for investors, depending on the type of asset and how long it’s held, according to 2018 estimates from the non-partisan Congressional Research Service. Corporate stock with dividends held for 10 years would be currently be subject to an effective tax rate of 24.3%. That same holding indexed to inflation would be subject to a 21.4% tax rate, CRS said.
Kimberley Strassel of the Wall Street Journalopines that this would be a very desirable reform.
What if President Trump had the authority—on his own—to enact a second powerful tax reform? He does. The momentum is building for him to use it. …forces are aligning behind a plan: a White House order to index capital gains for inflation. It’s a long-overdue move—one that would further unleash the economy and boost GOP election prospects. …At President Reagan’s behest, Congress in the 1980s indexed much of the federal tax code for inflation. Oddly, capital gains weren’t similarly treated. The result is that businesses and individuals pay taxes on the full nominal amount they earn on investments, even though inflation eats up a good chunk of any gain. It’s not unheard of for taxes to exceed real gains after inflation. …the Internal Revenue Code does not require that the “cost” of an asset be measured only as its original price—meaning there is no reason Treasury could not construe it in today’s dollars. …The move would set off an explosion of buying and selling—of which the government would get its cut. The lower tax on capital would also help asset prices grow. All of this would be excellent news for the economy.
I especially like the examples showing how, even with modest levels of inflation, the actual capital gains tax rate can be much higher than official rate.
Remember, it’s the effective marginal tax rate that determines incentives for additional productive activity.
This is why any form of capital gains taxation is wrong. And it’s especially wrong to impose a hidden – and higher – tax simply because of inflation.
So what would happen if the rumors are true and Trump unilaterally eliminates the tax on inflationary gains?
The Tax Foundation estimated how such a change would affect the economy and the budget. The report includes a helpful example of how this reform would protect investors.
…if an individual purchased an asset for $100 in January 1, 2000 and sold that asset for $200 on July 1, 2018, the nominal capital gain would be $100. However, inflation over that period increased the price level by 49 percent. Under an indexing proposal, the individual would be able to gross up the basis of $100 by the total inflation during that period to $149. As a result, the individual would only be taxed on $51 instead of the full $100.
Here’s a table comparing the status quo with indexing.
Here’s the estimate of the economic benefits.
…indexing capital gains to inflation would increase the long-run size of the economy by 0.11 percent, which is equivalent to about $22 billion in 2018. This provision would primarily boost output by reducing the service price of capital, which would increase the incentive to invest in the United States. We estimate that the service price of capital would be 0.15 percent lower under this proposal. The capital stock would be 0.26 percent larger and the larger capital stock would boost labor productivity leading to 0.08 percent higher wages.
And here’s the accompanying table.
The Tax Foundation also prepared an estimate of the impact on tax revenue.
On a dynamic basis, the revenue loss would be…$148.3 billion over the next ten years. The increase in output due to the lower cost of capital would boost incomes, which would boost payroll revenue and slightly offset individual income tax revenue losses.
The bottom line is that this is not a self-financing reform (that only happens in rare instances), but it is a reform that would help the economy by encouraging more jobs and growth.
And, remember, even small improvements in growth have a meaningful impact over time.
Let’s close with a video from an unlikely supporter of inflation indexing.
Notwithstanding these remarks, I don’t think Schumer will applaud if Trump indexes the capital gains tax. Instead, I suspect he’s now more likely to support measures that would exacerbate this form of double taxation. Though I think he’s still on the right side (at least behind the scenes) on the issue of “carried interest,” so maybe he’s not a totally lost cause.
And there’s another arrow in the class-warfare quiver.
The Wall Street Journalreports on a misguided new idea from Ron Wyden, the ranking Democrat on the Senate Finance Committee.
The top Democrat on the Senate’s tax-writing committee proposed taxing unrealized gains in investment assets every year at the same rates as other income…an idea that would transform how the U.S. taxes the wealthiest people. …Under Mr. Wyden’s concept, capital gains would be taxed annually based on how much assets have gained in value. Now, by contrast, gains are taxed only when assets are sold and at a top rate of 23.8% instead of 37% for ordinary income.
There are two big reasons why this is a terrible idea.
Simply stated, there shouldn’t be an added layer of tax on people who earn money, pay tax on that money, and then buy assets with some of the remaining after-tax income.
Especially since the income generated by that additional investment already would be hit by the corporate income tax and the extra layer of tax on dividends.
Second, levying such a tax would be a logistical nightmare. Here’s another brief excerpt from the article.
Mr. Wyden’s concept would present logistical challenges. He would need to figure out how to value complex assets, handle declines in value, deal with people without enough cash to pay the tax and address illiquid investments such as closely held businesses and real estate.
So why would Sen. Wyden propose such a clunky class-warfare scheme?
Because it would generate (at least on paper) a lot of money that could be used to buy votes.
This mark-to-market tax concept…could raise substantial money. A similar proposal…would generate an estimated $125 billion in 2025 alone… Democrats, who are campaigning on wide-ranging and costly ideas for more spending on health care, infrastructure and education, can point to plans by Mr. Wyden and others to explain how they would pay for policy proposals.
Of course, no amount of tax increases would generate the revenue to finance the so-called Green New Deal.
In reality, a major reason for Wyden’s plan is that the left is motivated by class warfare rather than revenue collection.
Democrats have frequently found unfairness in the different ways that the U.S. tax system approaches wage and investment income. They have focused their response, in part, on the “Buffett Rule”, inspired by Warren Buffett’s claim that he pays a lower tax rate than his secretary.
I added this final excerpt simply so I can point out that Buffett’s claim is utter nonsense.
And so is the “Buffett rule” that some folks on the left have proposed.
My contribution was a chapter about the impact of taxation, especially the capital gains tax.
At a panel in Washington, I had a chance to discuss my findings.
If you don’t want to watch an 11-minute video, my presentation can be boiled down to four main points.
1. Demographics is destiny – Other authors actually had the responsibility of explaining in the book about the importance of demographic change. But it never hurts to remind people that this is a profound and baked-in-the-cake ticking time bomb.
So I shared this chart with the audience and emphasized that a modest-sized welfare state may have been feasible in the past, but will be far more burdensome in the future for the simple reason that the ratio of taxpayers to tax-consumers is dramatically changing.
And it goes without saying that big-sized welfare states are doomed to collapse. Think Greece and extend it to Italy, France, Japan, and other developed nations (including, I fear, the United States).
2. Entrepreneurship drives growth – Capital and labor are the two factors of production, but entrepreneurs are akin to the chefs who figure out news ways of mixing those ingredients.
For all intents and purposes, entrepreneurs produce the creative destruction that is a prerequisite for growth.
3. The tax code discourages entrepreneurship – The bulk of my presentation was dedicated to explaining that double taxation is both pervasive and harmful.
I shared my flowchart showing how the American tax code is biased against income that is saved and invest, which discourages entrepreneurial activity.
And then showed the capital gains tax burden in developed countries.
The U.S. is probably even worse than shown in the above chart since our capital gains tax is imposed on inflationary gains.
4. The United States need to be more competitive – Last but not least, I pointed out that America’s class-warfare tax policies are the fiscal equivalent of an “own goal” (soccer reference for World Cup fans).
And this chart from my chapter shows how the United States, as of mid-2016, had the highest combined tax rate on capital gains when including the effect of the capital gains tax.
That’s the bad news. The good news is that the Trump tax cuts did produce a lower corporate rate. So in the version below, I’ve added my back-of-the-envelope calculation of where the U.S. now ranks.
But the bottom line is still uncompetitive when looking at the tax burden on investment.
I’ve written over and over again that changing demographics are a very under-appreciated economic development. I’ve also written about why entrepreneurship is a critical determinant of growth.
There are chapters on theory and evidence. There are chapters on specific issues, such as taxes, regulation, migration, financial markets, and education.
It’s basically the literary equivalent of one-stop-shopping. You’ll learn why you should be concerned about demographic change. More important, since there’s not much policy makers can do to impact birthrates, you’ll learn everything you need to know about the potential policy changes that could help nations adapt to aging populations.
This short video is an introduction to the topic.
Let’s look at just a few of the highlights of the book.
In the opening chapter, Robert Murphy offers a primer on the importance of entrepreneurship.
…there is a crucial connection between entrepreneurship and economic prosperity. …There is a growing recognition that a society’s economic prosperity depends…specifically on entrepreneurship. …Two of the top names associated with the theory of entrepreneurship are Joseph Schumpeter and Israel Kirzner… Schumpeter famously invoked the term “creative destruction” to describe the volatile development occurring in a capitalist system… Kirzner has written extensively on entrepreneurship…and how…the alert entrepreneurial class who perceive these misallocations before their more complacent peers, and in the process earn pure profits… Schumpeter’s entrepreneur is a disruptor who creates new products first in his mind and then makes them a reality, whereas Kirzner’s entrepreneur is a coordinator who simply observes the profit opportunities waiting to be grasped. …If the goal is maximum economic efficiency in the long run, to provide the highest possible standard of living to citizens within the unavoidable constraints imposed by nature, then we need bold, innovative entrepreneurs who disrupt existing modes of production by introducing entirely new goods and services, but we also need vigilant, alert entrepreneurs who spot arbitrage opportunities in the existing price structure and quickly move to whittle them away.
Murphy describes in the chapter how there was a period of time when the economics profession didn’t properly appreciate the vital role of entrepreneurs.
But that fortunately has changed and academics are now paying closer attention. He cites some of the recent research.
An extensive literature documents the connection between entrepreneurship and economic growth. The studies vary in terms of the specific measure of entrepreneurship (e.g., small firms, self-employment rate, young firms, etc.) and the size of the economic unit being studied. …Carree et al. (2002) look at 23 OECD countries from 1976 to 1996. …They “find confirmation for the hypothesized economic growth penalty on deviations from the equilibrium rate of business ownership… An important policy implication of our exercises is that low barriers to entry and exit of businesses are necessary conditions for the equilibrium seeking mechanisms that are vital for a sound economic development” …Holtz-Eakin and Kao (2003) look at the birth and death rates of firms across US states, and find that this proxy for entrepreneurship contributes to growth. Similarly, Callejón and Segarra (1999) look at manufacturing firm birth and death rates in Spain from 1980 to 1992, and conclude that this measure of “turbulence” contributes to total factor productivity growth. …Wennekers and Thurik (1999) use business ownership rates as a proxy for “entrepreneurship.” Looking at a sample of 23 OECD countries from 1984 to 1994, they, too, find that entrepreneurship was associated with higher rates of employment growth at the national level.
In a chapter on taxation, Seth Giertz highlights the negative impact of taxes on entrepreneurship, particularly what happens with tax regimes have a bias against saving and investment.
High tax rates discourage both consumption and savings. But, for a given average tax rate, taxes on an income base penalize savings more heavily than taxes on consumption. …a consumption tax base is neutral between the decision to save versus consume. By contrast, an income tax base results in the double taxation of savings. …three major features of tax policy that are important for entrepreneurship. First, capital accumulation and access to capital is essential for innovation to have a big impact. Despite this, tax systems generally tax savings more heavily than consumption….Second, the tax treatment of risk affects incentives for entrepreneurship, since entrepreneurship tends to entail high risk. …progressivity can sometimes discourage entrepreneurship. This is because tax systems do not afford full offsets for losses, making progressivity effectively a tax increase. …Third, tax policy can lead entrepreneurial activity to shift from productive toward unproductive or destructive aims. Productive entrepreneurship tends to flourish when the route to great wealth is achieved primarily through private markets… High taxes reduce the rewards from productive entrepreneurship. All too often, smart, talented, and innovative people are drawn out of socially productive endeavours and into unproductive ones because the private returns from devising an innovative tax scheme—or lobbying government for special tax preferences—are greater than those for building the proverbial better mousetrap.
In a chapter I co-authored with Brian Garst, Charles Lammam, and Taylor Jackson, we look specifically at the negative impact of capital gains taxation on entrepreneurship.
We spend a bit of time reminding readers of what drives growth.
One of the more uncontroversial propositions in economics is that output is a function of labor (the workforce) and capital (machines, technology, land, etc.). Indeed, it is almost a tautology to say that growth exists when people provide more labor or more capital to the economy, or when—thanks to vital role of entrepreneurs—labor and capital are allocated more productively. In other words, labor and capital are the two “factors of production,” and the key for policymakers is to figure out the policy recipe that will increase the quantity and quality of those two resources. …In the absence of taxation, people provide labor to the economy so long as they value the income they earn more than they value the foregone leisure. And they provide capital to the economy (i.e., they save and invest) so long as they value future consumption (presumably augmented by earnings on capital) more than they value current consumption.
And we highlight how entrepreneurs generate the best type of growth.
this discussion also helps illustrate why entrepreneurship is so important. The preceding analysis basically focused on achieving growth by increasing the quantity of capital and labor. Such growth is real, but it has significant “opportunity costs” in that people must forego leisure and/or current consumption in order to have more disposable income. Entrepreneurs, by contrast, figure out how to increase the quality of capital and labor. More specifically, entrepreneurs earn profits by satisfying consumer desires with new and previously unknown or underused combinations of labor and capital. In their pursuit of profit, they come up with ways of generating more or better output from the same amount of labor and capital. This explains why we have much higher living standards today even though we work far fewer hours than our ancestors.
And here’s what we say about the counterproductive impact of capital gains taxation, particularly when combined with other forms of double taxation.
…the effective marginal tax rate on saving and investment is considerably higher than the effective marginal tax rate on consumption. This double taxation is understandably controversial since all economic theories—even Marxism and socialism—agree that capital is critical for long-run growth and higher living standards. …capital gains taxes harm economies in ways unique to the levy. …entrepreneurs play a vital role in the economy since they figure out more efficient ways to allocate labor and capital. …The potential for a capital gain is a big reason for the risk they incur and the effort they expend. Thus, the existence of capital gains taxes discourages some entrepreneurial activity from ever happening. …the capital gains tax is more easily avoidable than other forms of taxation. Entrepreneurs who generate wealth with good ideas can avoid the levy by simply choosing not to sell. This “lock-in effect” is not good for the overall economy… Most governments do not allow taxpayers to adjust the value of property for inflation when calculating capital gains. Even in a low-inflation environment, this can produce perverse results. …taxpayers can sometimes pay tax even when assets have lost value in real terms. …Capital gains taxes contribute to the problem of “debt bias,” which occurs when there is a tax advantage for corporate investments to be financed by debt instead of equity. …Excessive debt increases the probability of bankruptcy for the firm and contributes to systemic risk.
We then cite a lot of academic studies. I strongly encourage folks to peruse that section, but to keep this column manageable, let’s close by looking at two charts that reveal how some nation – including the United States – have uncompetitive tax systems.
Here are long-run capital gains tax rates in developed nations.
By the way, even though the data comes from a 2018 OECD report, it shows tax rates as of July 1, 2016. So not all the numbers will be current. For instance, I assume Macron’s reforms have mitigated France’s horrible score.
Speaking of horrible scores, here are the numbers showing the combined burden of the corporate income tax and capital gains tax. Sadly, the United States was at the top of this list as of July 1, 2016.
The good news is that the recent tax reform means that the United States no longer has the world’s most punitive tax system for new investment.
To add insult to injury (to be more accurate, to add injury to injury), the tax isn’t indexed for inflation. So investors get taxed on the full increase in the value of an asset even though a significant chunk of the increase often is due solely to inflation.
Steven Entin of the Tax Foundation has some new research on this issue.
Many elements of the income tax are adjusted for inflation, such as tax brackets, standard deductions, and income thresholds or dollar amounts of some tax credits. However, the purchase price of assets later sold for capital gains or losses is not adjusted for inflation. As a result, inflation can do a real number on savers by turning real losses into taxable nominal gains. To avoid such outcomes, it would make sense for the government to allow an inflation adjustment for the cost of assets.
During the late 1960s and 1970s, when inflation was high and the stock market was flat, it was not uncommon for people who sold assets to report inflated nominal capital gains that were negative in terms of purchasing power. In effect, the savers were taxed on a real loss. …Suppose one had bought $100 of stock in the XYZ Corporation in 1965, and sold it in 1981, for $110. This looks like a $10 gain. But…The stock would have had to rise to $286 just to keep pace with inflation. …the investor lost $176, in 1981 dollars ($286 – $110). Any tax collected on the nominal $10 gain was, in fact, a tax on a real loss.
But even if inflation remains low, this is still an important issue.
Taxing genuine capital gains is bad enough, so it’s not a surprise to learn that taxing inflationary gains is even worse. It exacerbates the anti-capital bias in the current tax code.
Taxation of fictitious gains or other capital income reduces saving and raises the cost of capital, thereby retarding investment, productivity growth, and wage growth. …In an ideal tax system, saving would not be treated worse than consumption. …When we earn income and pay tax, and use the after-tax income for consumption, the federal government generally leaves the consumption alone, except for a few excise taxes… The earnings are taxed, but not the enjoyment of the subsequent purchases. Saving is a purchase too. It lets us “buy” a stream of future income with after-tax money. But if we buy a bond, the stream of interest is taxed. If we buy a share of stock, the dividends are taxed, and any reinvested earnings that increase the value of the company are taxed as capital gains.
Here’s Steve’s conclusion.
Inflation raises the price of many assets acquired by savers. When they sell the assets, much of their capital gains may be due only to inflation. Inflation-related gains are not a real increase in wealth. Indexing the purchase price (tax basis) for inflation would provide savers some relief for this type of tax on fictitious income.
Well said, though I have one minor quibble. A capital gain, whether real or caused by inflation, is not income. It’s a change in nominal net worth.
Though I’m sure Steve would agree with me. He’s presumably using “income” because the tax code treats that change in net worth as income.
There is a chance we’ll see some progress on this issue. Ryan Ellis, writing for Forbes, is optimistic that the newly appointed head of Trump’s National Economic Council will try to fix this problem.
There’s one project that Kudlow needs to get to work on right away: indexing the basis of capital gains to inflation. …Just last August, Kudlow wrote an op-ed…urging President Trump to do this by executive order. …This finally may be the time that this issue is ready to cross the finish line.
Executive order?
Yes, because the law specifies the rates for capital gains taxation, but it’s up to the Treasury Department to specify what counts as a gain. And there’s a very strong argument that it’s not a genuine gain if an asset rises in value solely because of inflation.
Ryan explains the mechanics of how indexing would work..
How would indexing capital gains basis to inflation work? In the tax world, reporting a capital gain is a pretty simple exercise. When you sell an asset, like a stock, you report how much you sold it for. You can subtract what you bought it for (your “basis”) from what you sold it for to arrive at your gain. …If you’ve held the asset longer than a year, you generally pay tax at…20 percent, plus the 3.8 percent Obamacare investment surtax… A problem arises in that your basis purchase may have happened many years ago. The real value of the money you used to buy a stock has been eroded by inflation. For example, $100 in 1990 is only worth $51.41 today, a little more than half the supposed basis in real terms. …Someone whose $100 initial investment has grown to $500 would see a big difference in taxes.
Here’s the table showing that difference.
And here’s what it means.
Uncle Sam still gets to tax the gain–he just doesn’t get to take the phantom gains attributable to inflation. In fact, $22.50 of the current law tax–nearly one quarter of the tax bill–is entirely due to inflation, not any real increase in wealth. …This law change would help owners of real estate, including corporate owners of real estate. It would help small businesses who pay the capital gains tax when acquired by larger firms. It would help everyone in America with a prized collection of old baseball cards or stamps sitting in an album in their den. This is truly a tax cut for everyone.
For more information, here’s a video on the topic from the Center for Freedom and Prosperity.
As was pointed out in the video, Ronald Reagan indexed much of the tax code as part of his 1981 tax cut. Now it’s time to take the next step.
But let’s not forget that indexing should only be an interim step (assuming, of course, that the White House and Treasury are willing to do the right thing and protect investors from inflation).
The real goal should be total repeal of the capital gains tax.
In part, because there would be no distorting tax breaks that lure people into making decisions based on tax considerations rather than economic merit.
In the wonky jargon of public finance economists, this means we would have a “consumption-based” system, which is just another way of saying that income would be taxed only one time. No longer would the internal revenue code discourage capital formation by imposing a higher effective tax rate on income that is saved and invested (compared to the tax rate on income that is consumed).
Indeed, this is the feature of tax reform that probably generates the most growth. As I explain in this video on capital gains taxation, all economic theories – even Marxism and socialism – agree that capital formation is a key to long-run prosperity.
The good news is that reducing double taxation is a goal of most major tax plans in Washington. Trump’s campaign plan reduced double taxation, and the House Better Way Plan reduces double taxation.
But that doesn’t mean there’s an easy path for reform. The Hillreports on some of the conflicts that may sabotage legislation this year.
The fight over a border-adjustment tax isn’t the only challenge for Republicans in their push for tax reform. …Notably, some business groups have criticized the proposal to do away with the deduction for businesses’ net interest expenses. …the blueprint does not specifically discuss how the carried interest that fund managers receive would be taxed. Under current law, carried interest is taxed as capital gains, rather than at the higher rates for ordinary income. During the presidential race, Trump repeatedly said he wanted to eliminate the carried interest tax break, and Office of Management and Budget Director Mick Mulvaney told CNN on Sunday that Trump still plans to do this. Many Democrats also want carried interest to be taxed as ordinary income.
The border-adjustment tax is probably the biggest threat to tax reform, but the debate over “carried interest” also could be a problem since Trump endorsed a higher tax burden on this type of capital gain during the campaign.
Donald Trump vowed to stick up for Main Street over Wall Street — that line helped get him elected. But the new president has already hit a roadblock, with fellow Republicans who control Congress balking at Trump’s pledge to close a loophole that allows hedge fund and private equity managers to pay lower taxes on investment management fees. …The White House declined to comment on the status of negotiations between Trump and congressional Republicans over the carried-interest provision. …U.S. Rep. Jim Himes, D-Conn., a House Financial Services Committee member and former Goldman Sachs executive, said there is chaos on the tax reform front. “That’s on the list of dozens of things where there is disagreement between the president and the Republican majority in Congress,” Himes said.
Regarding the specific debate over carried interest, I’ve already explained why I prefer current law over Trump’s proposal.
Today I want to focus on the “story behind the story.” One of my main concerns is that the fight over the tax treatment of carried interest is merely a proxy for a larger campaign to increase the tax burden on all capital gains.
For instance, the ranking Democrat on the Senate Finance Committee openly uses the issue of carried interest as a wedge to advocate a huge increase in the overall tax rate on capital gains.
Of course, when you talk about the carried interest loophole, you’re talking about capital gains. And when you talk about capital gains, you’re talking about the biggest tax shelter of all – the one hiding in plain sight. Today the capital gains tax rate is 23.8 percent. …treat[ing] income from wages and wealth the same way. In my view, that’s a formula that ought to be repeated.
The statists at the Organization for Economic Cooperation and Development also advocate higher taxes on carried interest as part of a broader campaign for higher capital gains taxes.
Taxing as ordinary income all remuneration, including fringe benefits, carried interest arrangements, and stock options… Examining ways to tax capital income at the personal level at slightly progressive rates, and align top capital and labour income tax rates.
It would be an overstatement to say that everyone who wants higher taxes on carried interest wants higher taxes on all forms of capital gains. But it is accurate to assert that every advocate of higher taxes on capital gains wants higher taxes on carried interest.
For those wanting more information, here’s the Center for Freedom and Prosperity’s video on carried interest.
Last but not least, wonky readers may be interested in learning that carried interest partnerships can be traced all the way back to medieval Venice.
Start-up merchants needed investors, and investors needed some incentive to finance the merchants. For the investor, there was the risk of their investment literally sailing out of the harbor never to be seen again. The Venetian government solved this problem by creating one of the first examples of a joint stock company, the “colleganza.” The colleganza was a contract between the investor and the merchant willing to do the travel. The investor put up the money to buy the goods and hire the ship, and the merchant made the trip to sell the goods and then buy new foreign goods that could then be brought back and sold to Venetians. Profits were then split between the merchant and investor according to the agreements in the contract.
Fortunately for the merchants and investors of that era, neither income taxes nor capital gains taxes existed.
P.S. Italy didn’t have any sort of permanent income tax until 1864. Indeed, most modern nations didn’t impose these punitive levies until the late 1800s and early 1900s. The United States managed to hold out until that awful dreary day in 1913. It’s worth noting that the U.S. and other nations managed to become rich and prosperous prior to the adoption of those income taxes. And it’s also worth noting that the rapid growth of the 18th century occurred when the burden of government spending was very modest and there was almost no redistribution spending.
We’ll start with the uncontroversial proposition that saving and investment is a key driver of long-run growth. Simply stated, employees can produce more (and therefore earn more) when they work with better machines, equipment, and technology (i.e., the stock of capital).
But if we want to enjoy the higher incomes that are made possible by a larger and more productive capital stock, somebody has to save and invest. And that means they have to sacrifice current consumption. The good news is that some people are willing to forego current consumption if they think that saving and investment will enable them to have higher levels of future consumption. In other words, if they make wise investments, it’s a win-win situation since society is better off and they are better off.
And these investment decisions help drive financial markets.
Now let’s focus specifically on long-run investments. If you have some serious money to invest, one of your main goals is to find professionals who hopefully can identify profitable opportunities. You want these people, sometimes called “fund managers,” to wisely allocate your money so that it will grow in value. And in some cases, you try to encourage good long-run investments by telling fund managers that if your investments increase in value (i.e., earn a capital gain), they get to keep a share of that added wealth.
In the world of “private equity” and “venture capital,” that share of the added wealth that goes to fund managers is known as “carried interest.” And as a Bloombergarticle notes, it has played a big role in some of America’s great business success stories.
Venture capitalists…helped transform novel business ideas into some of the world’s most valuable companies, including Apple, Alphabet Inc., Amazon.com Inc., Facebook Inc., and Microsoft Corp. According to a 2015 study by Stanford University, 43 percent of public U.S. companies founded since 1979 had raised venture cash.
An article from the National Center for Policy Analysis has some additional data on the key role of investors who are willing to take long-run risks.
…up to 25 percent of pre-initial public offering (preIPO) startup funding comes from private equity or venture capital backers. Increasing the tax burden on these entities would damage a valuable access-to-capital pipeline for some startups — particularly in the energy, technology and biotech sectors where large up-front investments could be required.
The obvious conclusion is that we should be happy that there are people willing to put their money in long-run investments and that we should not be envious if they make good choices and therefore earn capital gains. And most people (other than the hard-core left) presumably will agree that people who take big risks should be able to earn big rewards.
That consensus breaks down, however, when you add taxes to the equation.
There’s the big-picture debate about whether there should be “double taxation” of income that is saved and invested. There are two schools of thought.
On one side, you have proponents of “consumption-base” taxation, and they favor reforms such as the flat tax that eliminate the tax code’s bias against saving and investment. These people want to eliminate double taxation because a bigger capital stock will mean a more prosperous economy. Advocates of this approach generally believe in equality of opportunity.
On the other side, you have advocates of the “Haig-Simons” or “comprehensive income tax” approach, which is based on the notion that extra layers of tax should be imposed on income that is saved an invested. These people want double taxation because it is consistent with their views of fairness. Advocates of this approach generally believe in equality of outcomes.
In the United States, we’ve historically dealt with that debate by cutting the baby in half. We have double taxation of capital gains and dividends, but usually at modest rates. We have double taxation of interest, but we allow some protection of savings if people put money in IRAs and 401(k)s.
But the debate never ends. And one manifestation of that ongoing fight is the battle over how to tax carried interest.
Folks on the left want to treat carried interest as “ordinary income,” which simply means that they want regular tax rates to apply so that there’s full double taxation rather than partial double taxation.
So who supports such an idea? To quote Claude Rains in Casablanca, it’s the usual suspects. Strident leftists in Congress and their ideological allies are pushing this version of a capital gains tax hike.
Rep. Sander Levin (D-Mich.), Sen. Tammy Baldwin (D-Wis.) and a group of millionaires made a push on Wednesday for consideration of legislation to close the carried-interest tax “loophole.” “We have to eliminate this loophole to make that sure everyone is paying their fair share and especially so that we can invest in an economy that creates jobs and lifts working American wages,” Baldwin said during a news conference on Capitol Hill. …The carried interest tax break is “the most egregious example of tax unfairness,” said Morris Pearl, chair of the Patriotic Millionaires — a group of 200 Americans with annual incomes of at least $1 million and/or assets of at least $5 million.
Folks on the right, by contrast, don’t think there should be any double taxation. And that means they obviously don’t favor an increase in the double taxation on certain types of capital gains. And that included carried interest, which they point out is not some sort of “loophole.” As Cliff Asness has explained, the treatment of carried interest is “consistent with the way employee-incentive stock options and professional partnerships are taxed.
But this isn’t just a left-right issue. Some so-called populists want higher capital gains taxes on carried interest, including the President-Elect of the United States. Kevin Williamson of National Review is not impressed.
Trump doesn’t understand how our economy works. …The big, ugly, stupid tax hike he’s planning is on Silicon Valley and its imitators around the country, the economic ecosystem of startup companies and the venture capitalists who put up the cash to turn their big ideas into viable products, dopey computer games, social-media annoyances, and companies that employ hundreds of thousands of people at very high wages. Which is to say, he wants to punish the part of the U.S. economy that works, for the crime of working. The so-called carried-interest loophole, which isn’t a loophole, drives progressives batty.
Kevin points out how carried interest works in the real world.
If you’re the cash-strapped startup, you go to venture capitalists; if you’re the established business, you go to a private-equity group. In both cases, the deal looks pretty similar: You get cash to do what you need to do, and the investor, rather than lending you money at a high interest rate, takes a piece of your company as recompense (for distressed companies being reorganized by private-equity firms, that’s usually 100 percent of the firm) on the theory that this will be worth more — preferably much more – than the money they put into your business. Eventually, the investor sells its stake in the company and pays the capital-gains tax on its capital gain.
And he doesn’t hold Trump in high regard.
Donald Trump does not understand this, because he isn’t a real businessman — he’s a Potemkin businessman, a New York City real-estate heir with his name on a lot of buildings he doesn’t own and didn’t build and whose real business is peddling celebrity and its by-products. He’s a lot more like Paris Hilton than he is like Henry Ford or Steve Jobs. Miss Hilton sells perfumes and the promise of glamour, Trump sells ugly neckties and the promise of glamour.
In her syndicated column, Veronique de Rugy explains why Republicans shouldn’t make common cause with the class-warfare crowd.
Trump…has seemingly swallowed a key assumption of the left. During the campaign, Trump and Hillary Clinton both pledged to raise taxes on carried interest. …sensing an opening, Senate Minority Leader Chuck Schumer recently indicated that he’d be willing to work with Trump on the issue. Of course he would. Democrats have been trying for years to raise taxes on capital. In fact, they see the reduced rate on all capital gains as a loophole. Their goal is to treat all capital gains as ordinary income because they want higher tax burdens overall. …Republicans need to remember that the left’s goal is not fairness but higher taxes. Treating carried interest as ordinary income for tax purposes would simply be the first step toward higher taxes on capital in general. That would be bad for economic growth and for our wallets.
Chuck Devore of the Texas Public Policy Foundation also has a sensible take on the economics of this issue.
…If the investment professional sees his marginal tax rate on capital gains from carried interest almost double, from 23.8 percent to 43.4 percent, he’ll change his behavior and charge more for his services. Pension funds and colleges will get less… Increasing taxes on investment success would mean less investment and consequently, fewer jobs, less innovation, and less prosperity. According to the Tax Foundation, the U.S. already levies the 6th-highest capital gains taxes among the 34 developed nations of the Organization for Economic Co-operation and Development… Generating capital gains means that money was used efficiently, benefiting not just the professional investment manager, but savers and the world. Losing money, on the other hand, is nothing to celebrate.
I agree.
The carried interest right is really a proxy for the bigger issue of whether there should be increased double taxation of capital gains. Which would be the exact opposite of what should happen if we want America to be more competitive and prosperous.
For more background on the issue of carried interest, this video from the Center for Freedom and Prosperity is very succinct and informative.
And if you want more info on the overall issue of capital gains taxation, I’m quite partial to my video on the topic.
Moreover, keep in mind that eliminating all favors from the internal revenue code also would be good for growth because people then will make decisions on the basis of what makes economic sense rather than because of peculiar quirks of the tax system.
Sounds great, right?
Well, it’s not quite as simple as it sounds because there’s a debate about how to measure loopholes. Sensible people want a tax code that’s neutral, which means the government doesn’t tilt the playing field. And one of the main implications of this benchmark is that the tax code shouldn’t create a bias against income that is saved and invested. In the world of public finance, this means they favor a neutral “consumption-base” tax system, but that’s simply another way of saying they want income taxed only one time.
Let’s look at three examples to see what this means in practice.
Example #1: Because they don’t want a bias that encourages people to spend their income today rather than in the future, advocates of a neutral tax code want to get rid of all double taxation of savings (Canada is moving in that direction). So that means they like IRAs and 401(k)s since those vehicles at least allow some savings to be protected from double taxation.
Proponents of Haig-Simons taxation, by contrast, think that IRAs and 401(k)s are loopholes.
Example #2: Another controversy revolves around the tax treatment of business investment. Advocates of neutral taxation believe in expensing, which is simply the common-sense view that investment expenditures should be recognized when they actually occur.
Proponents of Haig-Simons, however, think that investment expenditures should be “depreciated,” which means companies are forced to pretend that most of their investment costs which are incurred today actually take place in future years.
Example #3: Supporters of neutral taxation think capital gains taxes should be abolished because there already is tax on the income generated by assets such as stocks and bonds. So the “preferential rates” in the current system aren’t a loophole, but instead should be viewed as the partial mitigation of a penalty.
Proponents of Haig-Simons, not surprisingly, have the opposite view. Not only do they want to double tax capital gains, they also want them fully taxed, which would mean an economically jarring jump in the tax rate of more than 15 percentage points.
Now, having provided all this background information, let’s finally get to today’s topic.
If you’ve been following the presidential campaign, you’ll be aware that there’s a controversy over something called “carried interest.” It’s a wonky tax issue that seems very complicated, so I’m very happy that the Center for Freedom and Prosperity has produced a video that cuts through all the jargon and explains in a very clear and concise fashion that it’s really just an effort by some people to increase the capital gains tax.
There are four points from the video that deserve special emphasis.
Partnerships are voluntary agreements between consenting adults, and both parties concur that carried interest helps create a good incentive structure for productive investment.
A capital gain doesn’t magically become labor income just because an investor decides to share a portion of the gain with a fund manager.
An increase in the tax on carried interest would be the camel’s nose under the tent for more broad-based increases in the tax burden on capital gains.
By the way, I liked that the video also took a gentle swipe at some of the ignorant politicians who want to boost the tax burden on carried interest. They claim they’re going after hedge funds, when the tax actually is much more targeted at private equity partnerships.
But what really matters is not the ignorance of politicians. Instead, we should be focused on whether tax policy is being needlessly destructive because of high – and duplicative – taxes on saving and investment.
Such levies would reduce investment. And that means lower levels of productivity and concomitantly lower wages.
In other words, ordinary people will suffer a lot of collateral damage if this tax-the-rich scheme for carried interest is implemented.
The most compelling graph I’ve ever seen was put together by Andrew Coulson, one of my colleagues at the Cato Institute. It shows that there’s been a huge increase in the size and cost of the government education bureaucracy in recent decades, but that student performance has been stagnant.
The clear message is that workers earn more when there is more capital, which should be a common-sense observation. After all, workers with lots of machines, technology, and equipment obviously will be more productive (i.e., produce more per hour worked) than workers who don’t have access to capital.
And in the long run, worker compensation is tied to productivity.
This is why the President’s class-warfare proposals to increase capital gains tax rates, along with other proposals to increase the tax burden on saving and investment, are so pernicious.
The White House claims that the “rich” will bear the burden of the new taxes on capital, but the net effect will be to discourage capital investment, which means workers will be less productive and earn less income.
President Obama will propose raising top tax rates on capital gains and dividends to 28 percent, up from the current rate of 24 percent. Prior to 2013, the rate was 15 percent. Mr. Obama seeks to practically double capital gains and dividend taxes during the course of his presidency, a step that would have negative effects on investment and economic growth. …the middle class would be harmed by higher capital gains tax rates, because capital would be more likely to go offshore. …[a] higher rate would have negative effects on the economy by reducing U.S. investment or driving it overseas. If firms pay more in capital gains taxes in America, they would make fewer investments — especially in the businesses or projects that most need capital — and they would hire fewer workers, many of them middle-class. Higher capital gains taxes would reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground. Taxes on U.S. investment would be higher compared with taxes abroad, so some investment capital is likely to move offshore.
At this point, I want to emphasize that the point about higher taxes in America and foregone competitiveness isn’t just boilerplate.
The only compensating factor is that at least these destructive tax rates aren’t imposed on foreign investors. Yes, it’s irritating that our tax code treats U.S. citizens far worse than foreigners, but at least we benefit from all the overseas capital being invested in the American economy.
By the way, Diana also points out that higher capital gains tax rates may actually lose revenue for the simple reason that investors can decide to hold assets rather than sell them.
Here’s some of what she wrote, accompanied by a chart from the Tax Foundation.
…higher capital gains tax rates rarely result in more revenue, because capital gains realizations can be timed. When rates go up, people hold on to their assets rather than selling them, expecting that rates will go down at some point. …Capital gains tax revenues rose after 1997, when the rate was reduced from 28 percent to 20 percent, and again after 2003, when rates were reduced further to 15 percent… The decline in rates resulted in higher tax receipts from owners of capitals, as they sold assets, giving funds to Uncle Sam.
Not that Obama cares. If you pay close attention at the 4:20 mark of this video, you’ll see that he wants higher capital gains tax rates for reasons of spite.
But I don’t care about the revenue implications. I care about good tax policy. And in an ideal tax system, there wouldn’t be any tax on capital gains.
It’s a form of double taxation with pernicious effects, as the Wall Street Journalexplained back in 2012.
…the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. …If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax. Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.” …keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.
…why tax capital gains at all? …The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income. …Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income. ……why not avoid all these problems by reforming the entire tax system along the lines of a flat tax? The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.
And if you want to augment all this theory with some evidence, check out the details of this comprehensive study published by Canada’s Fraser Institute.
For more information, here’s the video I narrated for the Center for Freedom and Prosperity, which explains why the capital gains tax should be abolished.
P.S. These posters were designed by folks fighting higher capital gains taxes in the United Kingdom, but they apply equally well in the United States. And since we’re referencing our cousins on the other side of the Atlantic, you’ll be interested to know that Labor Party voters share Obama’s belief in jacking up tax rates even if the economic damage is so severe that the government doesn’t collect any revenue.
P.P.S. Don’t forget that the capital gains tax isn’t indexed for inflation, so the actual tax rate almost always is higher than the statutory rate. Indeed, for folks that have held assets for a long time, the effective tax rate can be more than 100 percent. Mon Dieu!
P.P.P.S. In the past 20-plus years, I’ve seen all sorts of arguments for class-warfare taxation. These include:
I suppose leftists deserve credit for being adaptable. Just about anything is an excuse for soak-the-rich tax hikes. The sun is shining, raise taxes! The sky is cloudy, increase tax rates!
P.P.P.P.S. You deserve a reward if you read this far.You can enjoy some amusing cartoons on class-warfare tax policy by clicking here,here,here,here,here,here, andhere.
But if you don’t trust the numbers from a big accounting firm, then you can peruse a study from the pro-tax Organization for Economic Cooperation and Development that reaches the same conclusion.
But does this really matter? Is the United States harmed by having a high tax rate?
The Wall Street Journal certainly makes a compelling case that high tax rates on capital gains are self-destructive.
And this remarkable chart shows that workers are victimized when there is less investment.
Let’s add to all this evidence.
Jason Clemens, Charles Lammam, and Matthew Lo have produced a thorough study for the Fraser Institute about the economic impact of capital gains taxation.
A capital gain (or loss) generally refers to the price of an asset when it is sold compared to its original purchase price. A capital gain occurs if the value of the asset at the time of sale is greater than the initial purchase price. …Capital gains taxes, of course, raise revenues for government but they do so with considerable economic costs. Capital gains taxes impose costs on the economy because they reduce returns on investment and thereby distort decision making by individuals and businesses. This can have a substantial impact on the reallocation of capital, the available stock of capital, and the level of entrepreneurship.
It turns out that there are many reasons why the capital gains tax harms economic performance. Clemens, Lammam, and Lo explain the “lock-in effect.”
Capital gains are taxed on a realization basis. This means that the tax is only imposed when an investor opts to withdraw his or her investment from the market and realize the capital gain. One of the most significant economic effects is the incentive this creates for owners of capital to retain their current investments even if more profitable and productive opportunities are available. Economists refer to this result as the “lock-in” effect. Capital that is locked into suboptimal investments and not reallocated to more profitable opportunities hinders economic output. …Peter Kugler and Carlos Lenz (2001)…examined the experience of regional governments (“cantons”) in Switzerland that eliminated their capital gains taxes. The authors’ statistical analysis showed that the elimination of capital gains taxes had a positive and economically significant effect on the long-term level of real income in seven of the eight cantons studied. Specifically, the increase in the long-term level of real income ranged between 1.1 percent and 3.0 percent, meaning that the size of the economy was 1 percent to 3 percent larger due to the elimination of capital gains taxes.
Then the authors analyze the impact of capital gains taxes on the “user cost” of capital investment.
Capital gains taxes make capital investments more expensive and therefore less investment occurs. …Several studies have investigated the link between the supply and cost of venture capital financing and capital gains taxation, and found theoretical and empirical evidence suggesting a direct causality between a lower tax rate and a greater supply of venture capital. …Kevin Milligan, Jack Mintz, and Thomas Wilson (1999) sought to estimate the sensitivity of investment to changes in the user cost of capital…and found that decreasing capital gains taxes by 4.0 percentage points leads to a 1.0 to 2.0 percent increase in investment.
Next, they investigate the impact on entrepreneurship.
Capital gains taxes reduce the return that entrepreneurs and investors receive from the sale of a business. This diminishes the reward for entrepreneurial risk-taking and reduces the number of entrepreneurs and the investors that support them. The result is lower levels of economic growth and job creation. …Analysing the stock of venture capital and tax rates on capital gains from 1972 to 1994, Gompers and Lerner found that a one percentage point increase in the rate of the capital gains tax was associated with a 3.8 percent reduction in venture capital funding.
Last but not least, the authors also discuss the impact of capital gains taxation on compliance costs, administrative costs, and tax avoidance. They also look at the marginal efficiency cost of capital gains taxation and report on some of the research in that area.
Dale Jorgensen and Kun-Young Yun (1991)…estimate the marginal efficiency costs of select US taxes and find that capital-based taxes (such as capital gains taxes) impose a marginal cost of $0.92 for one additional dollar of revenue compared to $0.26 for consumption taxes. …Baylor and Beausejour find that a $1 decrease in personal income taxes on capital (such as capital gains, dividends, and interest income) increases society’s well-being by $1.30; by comparison, a similar decrease in consumption taxes only produces a $0.10 benefit. …the Quebec government’s Ministry of Finance…found that a reduction in capital gains taxes yields more economic benefits than a reduction in other types of taxes such as sales taxes. Reducing the capital gains tax by $1 would yield a $1.21 increase in the GDP.
Here’s my video on the topic, which explains that the right capital gains tax rate is zero.
The bottom line is that the United States is shooting itself in the foot.
Or, to be more accurate, politicians are hobbling America’s productive sector and undermining U.S. competitiveness with senseless class-warfare taxation.
So while some countries are doing the right thing and abolishing their capital gains taxes, the United States is languishing in the international contest for more investment.
The only “good news” is that a few other nations also impose foolish policies as well.
P.S. It’s worth noting that all good tax reforms, such as the flat tax, completely abolish the capital gains tax.
P.P.S. This is yet another example of first-rate research from the Fraser Institute. They’re the publishers of Economic Freedom of the World, as well as some excellent research on the harmful impact of excessive government spending.
I was thinking that might be a good title for today’s post about some new research by Michelle Harding, a tax economist for the OECD. But then I realized that her study on “Taxation of Dividend, Interest, and Capital Gain Income” doesn’t contain any “good” news.
At least not if you want the United States to be more competitive and create more jobs. This is because the numbers show that the internal revenue code results in punitive double taxation of income that is saved and invested.
But it’s not newsworthy that there’s a lot of double taxation in America. What is shocking and discouraging, however, is finding out that our tax code is more punitive than just about every European welfare state.
This is the “bad” part of today’s discussion. Indeed, the tax burden on dividends, interest, and capital gains in America is far above the average for other industrialized nations.
Let’s look at some charts from the study, starting with the one comparing the tax burden on dividends.
As you can see, the United States has the dubious honor of having the sixth-highest overall tax rate (combined burden of corporate and personal taxes) among developed nations.
Though maybe we should feel lucky we’re not in France or Denmark.
The next chart looks at the tax burden on capital gains.
Once again, the United States has one of the most onerous tax systems among OECD countries, with only four other nations imposing a higher combined tax rate on capital gains.
By the way, if you want to know why this is a very bad idea, click here.
Last but not least, let’s look at the tax burden on interest.
I’m sure you’ve already detected the pattern, but I’ll state the obvious that this is another example of the United States being on the wrong side of the graph.
So the next time you hear somebody bloviating about Americans being too short-sighted and not saving enough, you may want to inform them that there’s not much incentive to save when the IRS gets a big share of any interest we earn.
Not that any of us are getting much interest since the Fed’s easy-money policy has created an atmosphere of artificially low interest rates, but that’s a topic for another day.
Let’s now move to the “ugly” part of the analysis.
Some of you may have noticed that the charts replicated above are based on tax laws on July 1, 2012.
Well, thanks to Obamacare and the fiscal cliff deal, the IRS began imposing higher tax rates on dividends, capital gains, and interest on January 1, 2013.
I don’t know if that means we’ll overtake France in the contest to have the most anti-competitive tax treatment of dividends and capital gains, but it’s definitely bad news.
Oh, and let’s add another bit of “ugly” news to the discussion.
Even worse than France, Greece, and Venezuela, which is nothing to brag about.
I don’t want to be the bearer of nothing but bad news, so let’s close with some “good” news. At least relatively speaking.
It’s not part of the study, but it’s worth pointing out that the overall burden of taxation – measured as a share of GDP – is higher in most other nations. The absence of a value-added tax is probably the most important reason why the United States retains an advantage in this category.
Needless to say, this is why we should fight to our last breath to make sure this European version of a national sales tax is never imposed in America.
P.S. One of the big accounting firms, Ernst and Young, published some research last year that is very similar to the OECD’s data.
Unfortunately, even though the United States already has a very anti-competitive system – as shown by these two charts, some folks think that the tax rate on capital gains should be even higher.
And it looks like they’re going to succeed, either because we go over the fiscal cliff or because Republicans acquiesce to Obama’s punitive proposal.
Nearly every country has reduced tax rates on individual long-term capital gains, with some countries imposing no tax at all. …If the U.S. capital gains tax rate rises next year as scheduled, it will be much higher than the average OECD rate. …Capital gains taxes raise less than five percent of federal revenues, yet they do substantial damage. Higher rates will harm investment, entrepreneurship, and growth, and will raise little, if any, added federal revenue. …Figure 1 shows that the U.S. capital gains tax rate of 19.1 percent in 2012 is higher than the OECD average rate of 16.4 percent. These figures include both federal and average state-level tax rates on long-term capital gains. Next year, the expiration of the Bush tax cuts will push up the U.S. rate by 5 percentage points, and the new investment tax imposed under the 2010 health care law will push up the rate another 3.8 percent. As a result, the top U.S. capital gains tax rate will be 27.9 percent, which will be far higher than the OECD average. The federal alternative minimum tax and other provisions can increase the U.S. capital gains tax rate even higher.
The worst country is Denmark, at 42 percent, followed by France (32.5 percent), Finland (32 percent), Sweden and Ireland (both 30 percent), and the United Kingdom and Norway (both 28 percent).
Every other developed nations will have a capital gains tax rate below the United States level. And even some of those above the U.S. level often have provisions that spare many taxpayers from this pernicious form of double taxation.
Some countries have exemptions for smaller investors. In Britain, for example, individuals can exempt from tax the first $17,000 of capital gains each year. Eleven OECD countries do not impose taxes on longterm capital gains, nor do some jurisdictions outside of the OECD, such as Hong Kong, Malaysia, and Thailand.
The nations on the list that don’t tax capital gains are Belgium, Czech Republic, Greece, Luxembourg, Mexico, Netherlands, New Zealand, Slovenia, South Korea, Switzerland, and Turkey.
In his paper, Chris also gives a good explanation of the underlying tax theory in the capital gains tax debate. Simply stated, the statists like the “Haig-Simons” approach because it justifies class-warfare tax policy.
To maximize growth, we should “tax the fruit of the tree, but not the tree itself.” That is, we should tax the flow of consumption produced by capital assets, not the capital that will provide for future consumption. A Haig-Simons tax base—which includes capital gains—taxes the tree itself. Why does a Haig-Simons tax base garner support if it is impractical and anti-growth? It appears to be because the liberal idea of “fairness” includes heavy taxation of high earners. Since high earners save more than others, they would be taxed heavily under a Haig-Simons tax base. …Today, many economists favor shifting from an income to a consumption tax base… Under a consumption tax base, savings would not be double-taxed, and capital gains would not face separate taxation because the cashflow from realized gains would be taxed when consumed. With regard to “fairness,” a Haig-Simons tax base penalizes frugal people and rewards the spendthrift. That’s because earnings are taxed a second time when saved, while immediate consumption does not face a further tax. That makes no sense because it is frugal people—savers—who are the benefactors of the economy since their funds get invested in the new businesses and new capital equipment that generates growth.
The right approach is to have a “consumption tax base,” which simply is another way of saying that income shouldn’t be taxed more than one time (as shown in this flowchart).
Writing about the death tax yesterday, I mentioned that it also is a perverse form of double taxation. And just as with the death tax, it’s worth noting that all the major pro-growth tax reform plans – such as the flat tax or national sales tax – also have no capital gains tax.
It’s bad enough when the IRS gets to tax our income one time. They shouldn’t be allowed more than one bite of the apple.
P.S. Chris makes a very important point about higher capital gains taxes collecting little, if any revenue. Simply stated, there’s a large Laffer Curve effect since investors can choose not to sell an asset if the tax penalty is too high.
One of the principles of good tax policy and fundamental tax reform is that there should be no double taxation of income that is saved and invested. Such a policy promotes current consumption at the expense of future consumption, which is simply an econo-geek way of saying that it penalizes capital formation.
The editors begin with an uncontroversial proposition.
The current Democratic obsession with raising the capital gains tax comes from a mistaken belief that the preferential rate applied to the sale of a family business, farm or financial asset is a “loophole” that mainly benefits the rich.
They offer three reasons why this view is wrong, starting with a basic inequity in the tax code.
Far from being a loophole, the low tax rate applied to capital gains is beneficial and fair for several reasons. First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses.
Next, the editors highlight the unfairness of not letting investors take inflation into account when calculating capital gains. As explained in this video, this can lead to tax rates of more than 100 percent on real gains.
Second, capital gains aren’t adjusted for inflation, so the gains from a dollar invested in an enterprise over a long period of time are partly real and partly inflationary. It’s therefore possible for investors to pay a tax on “gains” that are illusory, which is another reason for the lower tax rate.
This may not seem like an important issue today, but just wait ’til Bernanke gets to QE24 and assets are rising in value solely because of inflation.
Third, since the U.S. also taxes businesses on profits when they are earned, the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings. The main reason to tax capital investment at low rates is to encourage saving and investment. If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax.
There’s also good research to back up this theory – some produced by prominent leftists.
Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.”
Summers is talking about more than just the capital gains tax, so his estimate is best viewed as the type of growth that might be possible with a flat tax that eliminated all double taxation.
Nobel laureate Robert Lucas also thinks that such a reform would have large beneficial effects.
Almost all economists agree—or at least used to agree—that keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.
So why aren’t these reforms happening, either the medium-sized goal of getting rid of the capital gains tax, or the larger goal of junking the corrupt internal revenue code for a simple and fair flat tax?
A big obstacle is that too many politicians believe in class-warfare tax policy, even though lower-income people are among the biggest victims when the economy is weak.
P.S. Some of you may be wondering why I didn’t make a Laffer Curve argument for a lower capital gains tax. The main reason is because I have no interest in maximizing revenue for the government. I simply want good policy, which is why the rate should be zero.
P.P.S. I also didn’t bother to make a competitiveness argument, mostly because the WSJ’s editorial didn’t focus on that subtopic. But check out this post to see how Obama’s policy is putting America at a significant disadvantage.
That’s an amazingly powerful relationship. Wages for workers are very much tied to the amount of capital that’s invested. In other words, capitalists are the best friends of workers.
Politicians conveniently forget that dividends and capital gains get hit by the corporate income tax. And since America now has the developed world’s highest corporate income tax rate, it’s adding insult to injury to tax the income again. Actually, it’s adding injury to injury!
If you believe in fairness, the right capital gains tax rate is zero. John Goodman of the National Center for Policy Analysis, has a good explanation.
Income tax time is an appropriate moment to go to the heart of President Obama’s complaint about the taxes Warren Buffett and other rich people pay, or don’t pay. What the president is really complaining about is that the tax rate on capital gains is too low. But there is a more basic question to be asked: why tax capital gains at all?
That’s a very good question, because a capital gain isn’t income. It’s an asset that has increased in value. But the tax only applies on the gain if you sell the asset.
But why does an asset, such as shares of stock, rise in value? According to finance research, asset prices rise in value when there’s an expectation that there will be a greater after-tax stream of future income. But that income will be taxed (at least once!) when it materializes, so why tax it before it even happens? John hits the nail on the head.
The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income. Here is the bottom line: There is no need for the IRS to tax the bets that people make along the way — as stock prices gyrate up and down. Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income.
By the way, the capital gains tax isn’t indexed for inflation. So if you bought an asset 30 years ago and it’s doubled in value, you’ve actually lost money after adjusting for inflation. Yet the IRS will tax you. Sort of adding injury to injury to injury.
Finally, I like how John closes his column.
…why not avoid all these problems by reforming the entire tax system along the lines of a flat tax? The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.
highest capital gains tax rate.like wages, business income, and investment income. …By raising the effective tax rate on capital gains, the proposal would reduce U.S. saving, discourage entrepreneurship, and decrease economic output. …An annual tax on paper gains would be conspicuously complex. The largest administrative problems relate to valuing non-tradable assets like privately held businesses and taxing illiquid taxpayers with large gains on paper but little cash on hand to pay a minimum tax bill. …Given these problems, it’s unsurprising the idea hasn’t caught on around the world.
a reprise of his “billionaire minimum tax.” …For starters, it isn’t a billionaire tax and it isn’t an income tax. It would apply to households worth more than $100 million in accumulated assets, and its target is wealth. …if your assets rise in value during a year, you will pay taxes on that increase even if you realized no actual gains through a sale. …If your assets fell in value, you would not be able to deduct the full loss from your overall income. Heads the government wins, tails you lose.
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