You say your friends at Microsoft will pay too little in taxes when they cash in on all those stock options and pay capgains tax rates (28 percent) well below the top rate on ordinary income (40 percent). The injustice will be worse if Congress lowers the capgains rate.
But Microsoft employees should read this article before getting too depressed. Your message will be warmly received by the guilt-is-good crowd with mainly inherited wealth. But people who earn their own capgains should be able to enjoy their success guilt-free. So consider why your eight reasons for taxing capgains are wrong and why we should simply abolish this heinous tax.
Bad Argument No. 1: Capital-gains income is no different from any other kind of income. It isn't? The national income and product accounts for the United States do not include line items called "capital gains." And guess what? Capital gains is not part of our gross domestic product either. Nor is it part of the GDP of any other country. So apparently there is something different about capgains. And here's what it is:
Like every other country, the United States mainly taxes income as it is realized. Taxes are levied on a corporation's actual profit, not what its profit is likely to be in future years. Taxes apply to a building's actual rental income, not expected future rents. The same principle applies to human capital. Doctors' actual earnings are taxed. Medical students' earning potential at graduation is not.
Capital-gains taxation is an exception to this rule. Share prices rise and fall (generating gains and losses) based on changes in expected future profits. The sales price of a building rises and falls based on changes in expected future rents. Should these changes in expectations be taxed when they are consummated in a transaction? What happens if they aren't? See the next argument.
Bad Argument No. 2: If capital gains were untaxed, people could easily exploit this "loophole" and pay no taxes. Really? You wrote, "simple accounting alchemy can turn almost any form of income into a capital gain and will do so if the tax rate is different enough." If true, the folks who park their yachts at Boca Raton and Laguna Beach must have awfully bad accountants.
Back when the top tax rate on ordinary income was 70 percent and the capital-gains tax rate was 28 percent, capgains were equal to less than 3 percent of GDP. They were almost as puny when the rates were 50 percent and 20 percent respectively. Obviously, the opportunities to convert ordinary income into capgains are quite limited. And the IRS has made it increasingly difficult to convert solely for tax avoidance.
Further, it is a mistake to assume that people with capital gains escape the burden of the ordinary income tax. They don't. If the federal government imposes a 40 percent income tax, all assets (including all shares of stock) will be worth 40 percent less than they otherwise would be. That's because the after-tax future income from those assets will be 40 percent lower than otherwise. In this sense, owners of assets "pay" ordinary income tax rates, even if they don't write the checks to the IRS.
Bad Argument No. 3: So what if the government taxes purely inflationary capital gains? Other parts of the tax code are not indexed for inflation either. Actually, the tax code is indexed for wage earners. No one can be pushed into a higher tax bracket by the effects of wage inflation alone. The problem is the taxation of capital. And the effects are far from neutral.
The failure to index both depreciation schedules and capital gains penalizes investments in long-term assets (e.g., used in manufacturing) relative to short-term assets (e.g., used in the service sector). In this way, the tax code encourages hamburger flipping at the expense of steel production! I know it's more fun to blame foreigners for our problems, but to a large extent the structure of American industry is shaped by the IRS, rather than by competition in the international marketplace.
Bad Argument No. 4: Capital-gains taxes impose no special burden on the economy. All taxes burden the economy, but the capgains tax is in a class of its own. It dispenses harm that is totally disproportionate to the revenue it collects. Although capgains tax revenue is tiny compared with the size of the economy as a whole, the tax affects the entire capital stock, which is many times the size of GDP. The reason is that the capgains tax is really a transactions tax. It applies only when the holder of an asset sells it. The tax, therefore, discourages the sale of every capital asset. What difference does that make? See the next argument.
Bad Argument No. 5: Capital-gains taxes do not lock money into "old" investments. True, but misleading. On the one hand, all money and assets are held by someone. An investor can get rid of an "old" asset only by transferring it to some other investor. On the other hand, the tax does lock in investors. Someone who is not very good at managing real estate may be discouraged from selling a building to someone who is good at it by the capgains tax. In this way, the tax makes the entire capital market less efficient than it otherwise would be.
Bad Argument No. 6: Capital-gains taxes are needed to raise revenue. The 1986 tax reforms raised the average tax on the average cap-gain by about 50 percent. As a result, fewer people are reporting gains. In fact, capgains in 1994 (latest year available) were lower than they were a decade earlier. Forget any large-scale econometric model. My back-of-the-envelope calculations show that had capgains maintained their (early 1980s) share of economic activity, the old tax rate would have raised just $6 billion less revenue than the new rate. And since $6 billion is a rounding error in this context, there's no reason to think that the 1986 hike raised any revenue. Conversely, there is no reason to think that cutting the capgains rate in half would significantly reduce revenue.
But even I have to admit that completely abolishing the capgains tax would reduce revenue. So why do it? In addition to considerations above, see the next argument.
Bad Argument No. 7: Please don't make me be consistent in discussing capital losses. If sound economics or Aristotelian logic or common sense is employed, any discussion of capital losses should mirror that of capgains. But as all investors know, the government's position is: Heads they win, tails you lose. The sky is the limit when taxing gains, but deductions for losses (net of gains) are limited to $3,000.
Forget all the indefensible excuses for this policy and jump to the bottom line. What would happen if capital losses were fully deductible? The capgains tax would continue to wreak about as much havoc in capital markets as it does today, but economists have concluded that the government would collect very little net revenue! When all's said and done, a consistent advocate of capital-gains taxation must conclude that the tax is ultimately pointless.
Bad Argument No. 8: Capital-gains taxes are paid mainly by the rich, who can afford to pay more taxes. True enough, finding a rich person without a capital-gains problem is about as easy as passing a camel through the eye of a needle. But that's not the whole story. Middle-income and low-income taxpayers have capital gains as well. IRS data show that (when extraordinary capgains are separated from usual income) a fourth of all gains goes to those with below-average income and only a fourth goes to those earning more than $200,000. Barry Seldon and Roy Boyd, senior fellows of the National Center for Policy Analysis, have found that families in the lowest income group would have the highest percentage gains in after-tax income if the capital-gains tax were cut.
That's not all. The very rich can avoid capgains taxes altogether on shares of stock by employing a complicated technique called "selling against the box." This tax dodge is impractical for average investors, but works well for those with considerable assets. So abolishing capgains taxes would not be a big boon to the super-rich who often can avoid the tax anyway. It would simply level the playing field for everyone else.