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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.
