Capital Gains Overview

INTRODUCTION-- WHAT ARE CAPITAL GAINS?

With all the recent talk about Mitt Romney's taxes and the impending "fiscal cliff," I realized that I, as well as many people, had only a rudimentary understanding of the taxation of capital gains. Indeed, I feel many retain some misinformation on the topic.

Long-term capital assets receive preferential tax treatment under the Internal Revenue Code. Long-term capital assets are any property held for more than a year EXCEPT for property that is the normal source of business income (e.g. inventory held for sale, business equipment, office space, etc.). Perhaps the most familiar form of capital gains are those associated with stock in companies. For those realizing capital gains whose marginal tax rate is 15% or lower, they pay NO tax on capital gains (0%). For those in higher tax brackets, capital gains are taxed at a maximum rate of 15%. However, the rates on capital gains are slated to go up to 20% on December 31, 2012 unless Congress does something to change it (part of the "fiscal cliff").

PROS & CONS OF PREFERENTIAL TAX TREATMENT ON CAPITAL GAINS

Justifications advanced for the preferential treatment of long-term capital assets are generally threefold:

1. Part of the gain realized on the sale of capital assets represents inflation. Thus, although the market price of property increases after ten years, the true value has not after factoring in inflation. Taxes should be lower on capital gains to take inflation into account.

2. Lower taxes on capital gains incentivizes responsible savings. 

3. Preferential tax treatment of capital gains makes for mobile capital and more efficient markets. Lower taxes on capital gains makes it easier for investors to take money out of stagnant or failing companies and put it into more promising businesses. Lower capital gains taxes helps socially beneficial or popular enterprises raise capital.

But, there are strong counterarguments too:

1. Differentiating gains and losses as capital or ordinary requires complex and hard to understand regulations. The administration of preferential treatment of capital gains, this argument goes, is too expensive and cumbersome to be worth it. Opponents of lower taxes on capital gains argue that there are better ways to accomplish the purposes of favorable capital gains treatment. For example, tax bases can be adjusted for inflation. 

2. The strongest repost of opponents is that favoring capital gains is just not fair. Only those with lots of capital with which to invest have capital gains. In 2010, the top 1% of income earners realized over 70% of the capital gains.

SOME SUGGESTIONS FOR CHANGE

Regressive Capital Gains Tax: Clayton Christiansen of the Harvard Business School, and others, suggest taxing capital gains regressively over time. In other words, the longer you hold on to an investment, the lower the tax rate should be on that investment. He believes that the relatively minor loss in tax revenues for the government ($38 billion in 2012) are well worth the increase in capital available for job creation and innovation. Indeed, many or probably most economists agree that lower capital gains increase revenues in the long run through quickened economic growth. But, this notion is challenged. The true effects of high and low capital gains rates are hard to measure because there are so many other historical factors that affect the state of the economy. Evidence seems to support and deny the benefits of low taxes on capital gains.

No Capital Gains Tax: There are many voices calling for the government to stop collecting taxes on capital gains entirely. This would have effects on businesses' choice of entity (i.e. pass-through entities like LLC or LPs may lose importance) which may require some legislative tweaking; but, would increase capital mobility and, in theory, make for a more efficient market.

No Preferential Treatment for Capital Gains: Another option would be to tax all gains at the ordinary rates. Whether a gain is realized on stock or through lending services, the tax on income would be the same. This would raise government revenues and make for more equality and result in more fairness. After all, why should income from labor be taxed more than income from investments in big corporations.

Comprehensive Change: Perhaps my idea would be to alter the entire structure of the Code. I would widen the base and flatten the taxes for all but those making more than $5 million per year except for income from patent and copyright royalties. The rate could then be steeper from there. I would do away with a number of counterproductive tax subsidies. I would cut spending and regulation. Perhaps I will elaborate my nascent tax plan in a forthcoming post. 

Equality of Opportunity and Equality of Outcome

There are two notions of equality that drive different political ideologies. The first is equality of opportunity. An equality of opportunity approach seeks to level the playing field by making the law apply equally to everyone. The second kind of equality is equality of outcomes. Equality of outcomes seeks to ensure that everyone ends up in the same conditions. The two are mutually exclusive to some degree as equality of opportunity implies certain inequality of outcome. Only equality of opportunity is consistent with pure liberty. But, what kind of “equality of opportunity” should we seek in America? And, is the line between the two as clear as one might like to think?

Let’s look at a case study of affirmative action. The issue is obviously complex and some oversimplification will unfortunately be necessary to fit this into a neat little blog post. Racial inequality is measurable by educational indicators, socio-economic circumstances, crime rates, single mothers, and by a number of other sociological gauges. To correct for these inequalities, various affirmative action policies have been put into effect. Affirmative action policies can perhaps be grouped into two primary types. First, there are systematic remedies that seek to level the playing field and make the rules apply to everyone the same. Secondly, there are redistributive policies that seek to open up new opportunities.

What would justify affirmative action? Presumably, most all affirmative action policies would be unjustifiable if racial inequality arises from (1) innate biological inferiority (overwhelming evidence refutes this notion entirely); (2) cultural pathologies that deemphasize hard work, education, etc (some empirical evidence supports this); or (3) voluntary choices to pursue the paths that they do (very unlikely). However, what affirmative action policies are justified if (a) discrimination and stereotypes play a role in keeping a race down (informal barriers) or (b) structural based obstacles like segregation or a lack of family connections work against a race (formal barriers)?

Even libertarians think that structural or systematic obstacles stemming from government’s duplicitous treatment of different races should be abolished. But, to the extent that discrimination (overt and unconscious) still exists, should quotas, recruiting campaigns, or employee support programs be provided to members of a disadvantaged race? Although express quotas in hiring and school admissions are prohibited by law, unspoken redistributions of opportunity in many careers and school admissions are measurable statistically and legal. So, should discrimination be remedied by redistributions of opportunities? Such an approach would be an equality of outcomes approach. 

Affirming a belief in equality of opportunity implies a belief that government should make sure everyone starts off in the same place, not that everyone ends up in the same condition. However, the issue is complicated by the fact that people aren’t born in the same place. Although we are all of equal value in the eyes of our Heavenly Father, some of us are born to poor parents, others to rich parents; some are born in the United States, others in Somalia; some to parents who love one another, others never know one of their parents; etc. The only way to get everyone started off equally would be to institute some Spartan program of community child-rearing and a total prohibition of any gifts whether given inter vivos or after death. However, that just seems inherently wrong and completely inconsistent with freedom.

Should we simply ignore birth inequalities? I am tempted to say that it is better to let mysterious fate distribute opportunity rather than the arbitrary or fleeting preferences of government. But, I don’t think such an extreme view is the only answer to this puzzle.

A certain degree of economic inequality is desirable. Inequality provides rewards for hard work, talent, and achievement. It provides lubricant for social enterprise and progress. However, when inequality becomes too great, it animates pride, exploitation, discontent, and rebellion that cause societal decline. When crafting solutions to inequality, government should not focus on where to strike a balance between inequality and equality. Rather, I think the focus should be on balancing economic mobility with the freedom to bequest good things to our loved ones. That isn’t very precise; but I don’t think precise is possible. The slightest possibility of reaching the top of the Forbes Richest People list in a single lifetime is all that is necessary for proper income mobility in my view. 

I am thus only in favor of redistributive policies to the extent that all people have the minimum necessities of education, food, shelter, medical care, and life guidance to change their own fortunes and achieve unlimited success with the probabilities of economic success (for full-time, committed individuals mid-career) being chartable on a bell curve. With a more virtuous society, the bell curve will shift towards the prosperous; with a society in moral decline will shift towards the poor. But, the possibility to succeed or to lose should always be present. Real freedom can only be present if we are responsible for the consequences of our choices.

Given my acceptance of some forms of redistributive policies, it is worth mentioning that such policies have been egregiously mismanaged. First, the government not only redistributes things that are not the minimum necessities I described, but are actually detrimental to a disadvantaged person's chances of improving his or her situation. People don’t need a T.V. In fact, TVs do more damage than good. Somehow, people on government stipends for poverty, unemployment, etc afford televisions. People don’t need more bedrooms than there are people in their family; yet I see that in my service to those in government subsidized (or furnished) housing.  And, even the things government provides that people do need as minimum necessities are mismanaged on a large scale. Student loans are given in excessive amounts and without any risk assessment. Medicare pays for unnecessary stuff and pays more for the same services when compared to Veteran Affairs. Redundant programs (there are 23 agencies that provide independent and overlapping assistance to former USSR countries, 12 agencies that ensure food safety requirements are met, and the list goes on for a very long time) are the norm. The mismanagement of what should be proper government redistribution and regulation purposes cannot be understated.

I should also say that income mobility is not the most important thing in the world. Even people who end up not able to break through their birth social class can live joyful and meaningful lives. Indeed, the rich are often less happy, probably because they focus too much on money and too little on the more important things of life like faith, family, friends, and developing an honorable and virtuous character. Equality and freedom are instrumental in bringing forth a virtuous society. But, neither is the end in itself. Government policies should reflect that emphasis on virtuous living through freedom and equality rather than freedom and equality at the expense of virtue.