The Case Against the Capital Gains Tax Break
One of the most controversial features of the U.S. tax system is the preferential treatment given to capital gains. While income from wages and salaries faces a maximum rate of 37 percent, capital gains on assets held for more than a year, in most cases, are taxed at a maximum rate of just 20 percent.
Is there any economic justification for the low rate on capital gains or is it just a give-away for the rich?
The issue came to the surface yet again in an interesting exchange between Elizabeth Warren and John Delaney during CNN’s July debate for Democratic presidential candidates. Warren defended her plan to place a wealth tax on the personal fortunes of $50 million or more. Delaney criticized the wealth tax as impractical and possibly unconstitutional, but he agreed that the rich (including himself) should pay more taxes — but he offered a better way to do it:
The real solution is to raise the capital gains rates. There is no reason why people who invest for a living should pay less than people who work for a living. That’s ridiculous. It’s the biggest loophole in our tax code.
Delaney is right about that. Capital gains should be taxed as ordinary income. The arguments used by people who benefit from the capital gains preference sound superficially plausible, but they a wrong. Here is why:
Are capital gains really income?
One argument for lenient treatment is that capital gains are not income, but only an accounting entry that reflects a transfer of ownership of an existing asset. If we want assets to come under the control of those who can put them to best use, say defenders of the preference, we should not erect barriers to their purchase and sale. Tax income if you will — wages, interest, rents, profits — but not ownership transfers.
That might make sense if it were possible to distinguish cleanly between income and capital gains, but it is not. Consider a hypothetical example: I make a contract with my wife to supply 2,000 hours of labor over the coming year for a payment of $2,000. She can, if she wants, call on me to use those hours mowing the lawn and making lasagna for dinner. Instead, she can treat the contract as an asset (which it clearly is) and sell it to the local university. The university pays her, say, $100,000 for the right to command 2,000 hours of my time as a lecturer. Come April 15, she reports a basis of $2,000 on sale of the contract and a capital gain of $98,000. I report labor income of $2,000. If capital gains are preferentially taxed, it’s a pretty neat way to reduce the total taxes on our joint return, no? At the same time, it moves my labor to a higher-valued use than cooking or lawn mowing.
Although this example seems absurd, the real world is full of situations where businesses can do just that kind of thing: Structure a transaction to make it look like a capital gain instead of ordinary income. A corporation can pay dividends to its shareholders or retain earnings and allow the market price of its shares to appreciate. It can pay executives high salaries or give them stock options structured to produce equivalent capital gains. The examples are endless.
One of the most controversial ploys is the carried interest rule, which allows hedge fund and private equity managers to structure the income they receive for their services in a form that qualifies for taxation as capital gains. Even some commentators who are otherwise enthusiastic about lenient taxation of capital gains draw the line at carried interest. For example, David Frum, who is a lot happier than I am about the general principle of a lower tax rate for capital gains, agrees that the carried interest rule is “utterly unjustifiable.” “If you’re investing with other people’s money,” he says, “What you are earning is income — and it should be taxed as such.”
Furthermore, tax avoidance strategies that convert ordinary income to capital gains are not costless. Often they require more than just waving an accountant’s wand over something a firm would do anyway. Structuring transactions to take advantage of specific tax rules often requires changing actual business practices — the choice of financing methods, the timing of investments, even entry into whole lines of business that would be unattractive except for their tax advantages.
Do we need a capital gains preference to correct for inflation?
A second justification is that we need low tax rates on capital gains to avoid taxing “phantom” gains produced by inflation. The argument seems plausible. When there is inflation, asset owners may be taxed on nominal gains even when real asset values do not increase.
For example, suppose you buy some shares of stock at $100 and sell them for $120 a couple years later, after inflation has pushed up the prices of goods and services in general by 10 percent, leaving you with a real gain of just $10. If you pay 37 percent tax as ordinary income on the $20 nominal gain, your tax rate on the $10 real gain is 74 percent. Cutting the rate on nominal capital gains to 20 percent still leaves the real rate at 40 percent — enough (almost) to level the playing field, right?
Not really. There are two flaws in this argument.
First, any arbitrary rule like a fixed lower tax rate or an exclusion of a portion of capital gains can only crudely approximate the necessary adjustment for inflation. The 20 percent rate that is close to right in the example we just gave becomes too low a rate if inflation slows (as it has in recent years), or too high, if it were to accelerate again. Furthermore, at any given rate of inflation, the rate that just levels the playing field for a person whose ordinary income falls in one tax bracket will be too high or too low for others in different brackets.
A more nuanced approach would be to index the basis on which capital gains are calculated to reflect inflation between the date of purchase and the date of sale. That would avoid the taxation of phantom capital gains, but it would not solve a second, equally serious problem.
That problem is that other forms of investment income, too, are subject to phantom taxation when there is inflation. Suppose you are subject to a 30 percent tax rate on interest income that you earn from a bond with a 5 percent coupon that you own during a period of zero inflation. If inflation later rises to 5 percent, and the same borrower then offers a 10 percent coupon rate on a similar bond, your real income before tax would be unchanged. The trouble is, you would have to pay 30 percent tax on the full 10 percent nominal interest, which would come to 60 percent on the 5 percent real interest that remains after you subtract the effect of inflation.
The situation is similar for income from the common stock of a firm that has constant real profit, from which it pays a constant share as dividends. Faster inflation increases the real effective rate of taxation on the dividends.
A helpful paper from the Congressional Budget Office explores the problem in detail. The paper confirms that faster inflation raises the effective tax rate on investment income, but it points out that the effect is inherently smaller for capital gains than for dividend or interest income. Attacking the problem of phantom capital gains in isolation by whatever means — a preferential capital gains rate, an exclusion, or indexation — only widens the gap between the way inflation affects capital gains and the way it affects dividends and interest. Doing so increases the attractiveness of tax avoidance strategies that involve inefficient business practices.
The ideal solution to distortions caused by inflation would be to index the entire tax system. Indexation would have to cover not only all forms of investment income, but also taxation of ordinary income, real estate, inheritance, and everything else. But trying to remove the effect of inflation on capital gains taxes separately is likely to make things worse, not better.
Do we need low capital gains taxes to avoid double taxation?
Avoidance of double taxation of corporate profits is a third common argument in defense of lenient tax treatment of capital gains. The idea is that corporate profits are taxed at the business level and then again at the individual level when they are paid out as management bonuses, dividends and capital gains.
It is true that a preferential rate on capital gains is one way to attack the distortion — one way, but a bad one. A much better way would be to fix the flaws in corporate taxes that are the source of the problem rather than apply a Band-Aid to capital gains.
One part of that job was done in the 2017 Tax Cuts and Jobs Act, which lowered corporate tax rates across the board. But the 2017 corporate tax cut left a key part of job unfinished. If we want to enjoy the potential efficiency benefits of reforms to corporate taxes, those taxes should not simply be reduced, but reduced and shifted to the individual incomes of the managers and shareholders who are the ultimate recipients of corporate profits. That would require eliminating the capital gains preference.
A regime with no corporate taxes and full taxation of profits when paid out would eliminate double taxation once and for all without an unfair redistribution of the overall burden of taxation.
The bottom line
The bottom line is that we do need to recognize that capital gains taxes, just like taxes on ordinary income, payroll taxes, sales taxes, property taxes and most other taxes, do affect business decisions. But it is a non sequitur to say that because capital gains taxes affect business decisions, they therefore be should be as low as possible. Instead, we should properly consider capital gains in the context of the tax system as a whole:
- Taxing capital gains at lower rates than other forms of investment income does not encourage investment in general so much as it encourages structuring investment decisions in ways that avoid taxes, even if they are less efficient.
- A separate regime for capital gains taxes is likely to increase the degree to which inflation erodes the equity and efficiency of the tax system.
- When we consider corporate income taxes and capital gains taxes jointly, a strong case emerges for revenue-neutral reform that taxes capital gains as ordinary income while lowering or even eliminating the corporate tax rate.
It looks like John Delaney is right, then. A higher tax rate on capital gains would be a simpler way of raising revenue from wealthy Americans than Elizabeth Warren’s wealth tax. It would also avoid the risk of years of court challenges on constitutional grounds. Whether Delaney is elected president or not (it seems unlikely as I write this), let’s hope that whoever does win remembers his words of wisdom on tax policy.
Based, in part, on a commentary previously published at Economonitor.com. Photo courtesy of Pixabay.com.
