The Case for Higher Capital Gains Taxes

Once upon the federal income tax was enacted as a tax surcharge for the rich. Today, passive income billionaires pay 20% federal taxes while employed professionals making $100K/year face a marginal tax rate of 38.4% [1] (both figures before applying deductions). Is it any wonder that we have had Wall St. Occupiers and Tea Party rallies over the past few years? We have the wealth gap of the Gilded Age [2] combined with the annoyances of Big Government at the same time. Why don’t we just go back to the feudal system while we are at it?

Or perhaps we should go back to taxing capital gains at the same rate as ordinary income [3].

What’s that? I hear screaming in the audience. “Tax capital gains? That’s unfair!” “You communist!” “Double taxation!” “What about my house?” Hmmm, I think I hear some mumbling in the audience as well. Let me get out the parabolic mike to filter out the screams. “We need more investments.” “High capital gains taxes don’t work.” “You collect more capital gains taxes with a lower rate.”

Very well, let us address the objections in detail.

Are Capital Gains Taxes Fair?

A roadside vegetable stand operator buys a case of bell peppers and sells the individual peppers at a markup. This counts as income. An investor buys a block of Apple stock and later sells some shares at a higher price. This too is income, isn’t it? If not, what’s the difference?

Here is one difference: the vegetable stand operator pays income taxes each year on his earnings. The Apple stock investor can defer paying taxes on accumulated gains by buying and holding for years or even decades. If anything, to be fair, taxes on long term capital gains should be higher than for ordinary income or short term capital gains: tax plus interest on taxes deferred. Think of the penalties our produce seller would have to pay if he deferred paying taxes on his income for 10 years. Why shouldn’t long term investors pay a similar penalty?

Well, long term investors do pay some penalties: corporate income tax and inflation. If either is too high then we do have a fairness case for taxing capital gains at a lower rate. If we had a loophole free corporate income tax and/or Carter era inflation rates, then capital gains taxed as ordinary income would indeed be unfair. But having some corporate income tax and/or inflation coupled with capital gains treated as ordinary income is not unfair. Wage earners pay a penalty for deferring their income too.

Consider, ye liberals in the audience: corporate income taxes and inflation hit the pensioner and passive income billionaire equally. If you want a progressive tax code, you need to make taxes on capital gains at least as progressive as the taxes on ordinary income. If that results in total capital gains taxes that are too high, then you should be doing something about corporate income taxes and or inflation. Let’s look at some numbers.

Double Taxation! Aaaaaaaaaaaaaaaaaaaaaaaaaaa!!!!

Let us visit a magical fairyland where inflation is zero and accounting is an exact science. In this wonderful land book value is equal to market value. Capital gains are equal to accumulated income minus dividends paid. Under these conditions capital gains taxes on sales of stock constitute a second income tax on top of the corporate rate. If the corporate rate is 35% and the top income tax rate is 35%, then the total effective rate is a whopping 58%. (To calculate this, calculate how much you get to keep after both taxes are applied and subtract from 100%. For the previous example, the corporation keeps 65% and then the individual keeps 65% of that. .65*.65 = .42 = 42%. 100% - 42% = 58% total tax.)

Here is the part which should make liberals cringe. Consider a widow pensioner who is in the 10% individual tax bracket. Her total tax rate is 100% - (1-.35)(1-.1) = 100% - 58.5% = 41.5%. Look at the average age of Tea Party marchers. Now you know why they march. And this is before we consider inflation.

And we come to a very unintuitive conclusion: liberals should be the ones calling for a lower corporate income tax rate. To tax billionaires at a higher rate than widows, you would need a progressive capital gains tax rate coupled with a lower tax rate on corporations – at least based on our back of the envelope fantasyland calculations. [That said, there are some compelling reasons for continuing to tax corporations, but that’s for another article.]

In the real world accounting is not an exact science. That’s why we have stock markets, venture capitalists, and high paid fund managers. Individual capital gains can be far greater – or less – than their share of the underlying corporation’s nominal profits during the time said individual held the stock. It is possible to make millions of dollars trading corporations which pay zero corporate income tax. It happens frequently for Silicon Valley startups, which often show negative profits in their early years. Therefore, either:

If the former, the taxes on capital gains on sales of corporate stock should be higher yet. Successful trading is rent-seeking worthy of punishment, and Warren Buffet should be subject to draconian fines – maybe even some jail time. If the latter, then the trade of stocks is just another form of income, and should be treated the same as trading green beans beside the highway. If progressive income taxes are fair, then so are progressive taxes on the long term trading of corporate stock.

But are income taxes the ideal type of tax?

Inflation, Capital Gains, and the Ideal Tax System

“From each according to his ability” is one possible criterion for an ideal tax system. The income tax fits this measure, somewhat, but it is imperfect. Consider two taxpayers of equal income:

  1. Bubba makes $80,000/year doing a task others find quite unpleasant: cleaning sewer lines and doing related services.
  2. Thurston makes $80,000/year selling shares of his long term growth stocks.

Both have equal income, but their situations are clearly not equal. Thurston has free time and great flexibility on where to live. These translate to greater ability to pay taxes. Going to work is expensive.

On a deeper philosophical level, the inequality between Bubba and Thurston is even greater. Not only does Bubba have to spend time going to work, he has to take care of other people’s crap to take home the same amount as Thurston. The income tax is far less egalitarian than advertised. A cosmically egalitarian tax would tax passive income at a higher rate than wages. (However, it would also factor in age, since the human body depreciates over time, so old people would be allowed more passive income at a lower rate than young people.)

Now let’s look at the income tax from a more conservative/libertarian perspective. Think of government as a giant monopoly utility corporation performing services ill-served by a competitive marketplace. A fair tax system would be one based on how much government service an individual consumes just as a fair electric bill is based on how much electricity an individual uses.

Who consumes more government service: Thurston or Bubba? At a conservative 4% withdrawal rate, Thurston needs $2 million in assets in order to safely have $80,000/year to spend. Bubba needs his beat up panel truck and trusty PoopBlaster 9000 to ply his trade. All but the die-hard anarchist would agree that protection of property is a core service of government, and Thurston has more property to protect.

Not only does Thurston have more property to protect, it is property which more heavily relies on government. Corporate shares are only meaningful in a civilized realm where abstract contracts are enforced by wide-ranging governments. We have the contracts between Thurston and his brokers, the contracts that hold corporate management accountable to shareholders, and possibility patents and copyrights held by said corporations. Bubba, on the other hand, works next to his working capital, and who wants to steal a used PoopBlaster 9000? Ew! Bubba doesn’t need much help from the government enforcing contracts. His business is transactional. He can demand cash up front. But he really doesn’t have to. He knows where his customers live, and are you going to stiff a guy who knows where you live and is armed with a PoopBlaster 9000?

By both liberal and libertarian metrics, wealth taxes are better than income taxes. Capital gains taxes coupled with inflation are wealth taxes. Let’s do some numbers.

Suppose we have 3% inflation and a 35% top capital gains tax rate. Just to break even on your investments you need to make 3% “profit” each year. 35% of this is effectively a 1.05% property tax. This is in line with local property taxes charged for real estate and business property.

Anarchists who find even this amount to be unacceptable should ask themselves how much they would have to pay local warlords or private protection companies to protect their property were there no government to provide military, police and courthouse services. I suspect the number would be more than 1% for any visible property. (This is a fundamental moral justification of government. Government is force, and taxation is theft, but it can be less force and theft than you would have in a typical state of nature. Unbelievers are hereby invited to see how much they save on taxes by moving to Somalia.)

Even non anarchists in the audience may find the idea of paying taxes on unprofitable property to be somehow wrong. Think it through. Even non-performing assets require protection. Even unprofitable corporations are using the protection and contract enforcement services of government. Property taxes are fair – if the amount is reasonable.

With Carter-era inflation levels, high capital gains rates do become an unfair property tax. It made sense to have a lower tax rate for capital gains rate during that time. There should have been a lower rate for dividends and interest for the same reason. With inflation, money in a savings account is depreciating, but you don’t get to deduct that depreciation on your 1040 form.

Income taxes on investments multiplied by inflation equals property tax. At reasonable rates, this is an improvement over pure incomes taxes. But this is not the optimal arrangement. Inflation distorts the economy in many ways. I would rather make the property taxes explicit and get rid of both income taxes and inflation. But this is a big project, and the government needs more revenue yesterday. Raise the capital gains rate.

A Problem with Progressive Capital Gains Taxes

Fred makes $100,000/year on average. George makes $30,000/year most years but this year sold his house for $70,000 profit. Should George pay the same tax rate as Fred?

This is the big problem with making the capital gains rate progressive: moderate income people can look well off or even rich for income tax purposes on the years that they sell expensive assets for a profit. This defeats the original purpose of the income tax. It also leads millions of people of moderate means to call for keeping tax cuts for the rich. They know that at times they too will look rich to the IRS.

We could get around some of the problem by keeping the homeowner’s exemption. But this is not sufficient. Middle class taxpayers can run up other momentary windfalls: A small business owner sells her business. A small farmer harvests a swath of lumber.

One way around the problem would be to allow people to spread their gains over several years under such windfall situations. This is ugly, and we need to ensure that savvy taxpayers don’t abuse the privilege.

Another possibility would be to treat the higher rates for higher tax brackets as a separate tax. Then allow people a larger exemption. Unused exemption amounts could be carried over from year to year.

Finally, we could keep things simple as I propose with the Simple Tax: merge Social Security and Medicare taxes into the income tax and make the rate flat for the first half million dollars or so. Then we can simply treat long term capital gains as ordinary income and have a system both simpler and more progressive than what we have today.

Is a Higher Capital Gains Tax Practical?

I’ve run over 2000 words and still haven’t addressed the mumblers in the audience. Won’t people just defer their capital gains indefinitely? Will the government actually lose tax revenues by raising the capital gains rate to ordinary income rates? And what would happen to the economy if we taxed Warren Buffet as much as we tax his secretary?

These are important questions, and I will address them in a future article. Stay tuned.

[1] Total income is nominal income plus employer contributions FICA and Medicare (6.2% and 1.45%) Thus, total income is $107,500 for a nominal $100K income. Income tax rate of 28% is applied to just nominal income, as is employee payroll taxes of 4.2% (FICA) and 1.45% (Medicare). Marginal tax rate is thus (6.2% + 1.45% + 28% + 4.2% + 1.45%)/1.0765 = 41.3%/1.0765 = 38.4%. These are pre Trump tax reform numbers.

[2] I may be exaggerating a bit here. Note that even if we did achieve Gilded Age inequality in terms of dollar ratios, it wouldn’t feel as unequal because we are richer overall. “Work harder or ride the bus instead of having a car” is not as dire a threat as “Work harder or starve to death.”

[3] This happened under Reagan. Don’t call me a communist for calling for treating capital gains as ordinary income unless you want to call Reagan a communist as well.