I see that my direct approach with you is not working, so let's approach this topic from a more lofty direction. How would an ideal tax system tax income? I propose that all income be taxed 1) only once; 2) at its source; 3) when it is realized; 4) at one low rate.
I know that you and I will disagree on point 4. You probably prefer one high rate. Or perhaps a series of rates that cascade upward as people experience modest success. Never mind. I'll forgive you that sin if you will accept points 1 though 3.
These are the principles (I'm sure you have already guessed) behind the flat tax--stripped of demagoguing by the New York Times and Republican primary opponents of Steve Forbes. Since you moderated our Firing Line debate on the flat tax, I'll count on you to remember why it's fair and efficient. Readers also can learn about its virtues at the National Center for Policy Analysis' Flat Tax Web site.
The last time I looked at Dick Armey's postcard tax return, guess what I didn't find? There is no line item for capital gains! And why not? Because a capgains tax violates principles 1 through 3 of a good tax system. Take your example of the woman earning $100,000 a year. She incorporates herself into a company that contracts to provide her services to her old employer for $100,000, paying her a salary of $40,000 and keeping the $60,000 profit as retained earnings. After one year, she sells her company for $60,000. If she doesn't pay a capgains tax on $60,000, won't she be getting tax-free income? Of course. But that's only because we're cheating by construction. In a flat-tax world, her company pays a business income tax on the $60,000 at the same rate as she pays on her $40,000 of wages. So all income is taxed. To add a capgains tax when she sells the company would be an unfair, indefensible, unjustified, inefficient, totally-without-merit act of double taxation!
Michael, if you agree there should be no capgains tax on the sale of the woman's business in an ideal world, you should have no trouble seeing why we should not tax the sale under our less-than-perfect tax system. As you acknowledge, we have a corporate income tax. Applying a corporate income tax to the $60,000 profit and a capgains tax on the $60,000 gain on the sale is taxing the same income twice!
Take your second example. A company has only one asset: $100 invested in a 5 percent savings account. At the end of the year, there is $5 of interest income. If the company is sold, we assume the owner would have a $5 capgain--reflecting its $5 increase in value. In a flat-tax world, this $5 would not be directly taxed. Since all income would be taxed only once at its source, the interest payers, not the receivers, would pay. That is, companies that earn profit to pay interest would pay taxes on that profit without any interest deduction. The sale of the company would not be taxed because no real income would be generated--selling the company consists of nothing more than trading one asset ($105 in cash) for another ($105 in cash).
In our imperfect world, entities that pay interest get a deduction, and interest recipients pay a tax (in this example, a corporate income tax). Surely you can see that to impose a capgains tax on the $5 "profit" from the sale of the company constitutes double taxation of the $5 of income. (Incidentally, entities that pay dividends don't get to deduct them, so if the $5 is dividend rather than interest income, it will be subject to triple taxation under our current system!)
Michael, I'm having so much fun using your examples to prove my points, I almost forget why you constructed them in the first place. You were trying to show how, in the absence of a capital-gains tax, people could "easily" convert taxable ordinary income into untaxed capgains income. Reread the last five paragraphs and verify for yourself. Even without a capgains tax, all income in your examples gets taxed. Q.E.D.
I suspect I'm way ahead on points right now. But at the risk of unseemly piling on, I would like to clear up a few more things.
Michael, you're missing the point about capital losses. You say that if people could fully deduct their losses, they would manipulate the timing of gains and losses to cancel each other out and avoid paying capgains taxes altogether. I agree! But this result does not arise from anything special about capital losses. It arises because the capgains tax is a tax on transactions. No one has to ever pay a capgains tax unless he (to balance your overuse of "she") decides to sell an asset. Impose a tax on asset sales, and people will naturally arrange their affairs to avoid tax-generating transactions.
Basically, there are two choices. On the one hand, we can treat gains and losses symmetrically, allowing full deductibility of losses and full taxation of gains. This would be consistent with your stated desire for a "neutral" tax system in which government doesn't "rig the game." Unfortunately, consistency on your part would yield no net revenue for government. On the other hand, we can arbitrarily limit deductions for losses as we do now, allowing government to become a full partner in all gains, but forcing taxpayers to bear almost all the losses themselves. This heads-the-IRS-wins, tails-the-taxpayer-loses policy is not neutral. It discourages risk taking and entrepreneurial capitalism. Plus it's unfair. Have you no sympathy for life's losers, Michael? Shame.
But wait! Isn't there a third alternative? Why tax transactions at all? Since all taxes must ultimately be paid out of income, why not tax income directly? (By this I mean real, gross-domestic-product-producing income, not the consequences of trading stocks and bonds and other pieces of paper.) A truly neutral system would tax income as it is realized, leaving people free to trade assets at will, unhampered by government intrusion.
On another matter, I am shocked by your suspicion about the studies I cited on who realizes capgains. (Barry J. Seldon and Roy G. Boyd, "A General Equilibrium Analysis of a Reduction in Capital Gains Taxes," Public Finance Quarterly, Vol. 23, No. 2, April 1995, pp. 193-216. Or, read my layperson's summary of that study.) The bottom line is: Many farming families are land poor. They have low incomes, but own valuable property. A capgains tax cut helps these families, as well as others of modest means. Overall capgains income is distributed much more evenly across income classes than you may think if you spend much time watching C-SPAN coverage of Dick Gephardt and Barney Frank railing away on the floor of the House of Representatives.
In my last memo, I pointed out that on stock transactions, rich investors can sell shares without paying the capgains tax through a complicated technique called "selling against the box." I notice you didn't respond to that point. If silence implies consent, you are defending a system that gets its pound of flesh from the middle class but lets wealthy investors off scot-free. Seems unfair to me. Even the Clinton administration, no friend of the poor these days, is bothered by this arrangement.
But enough of altruism. I prefer to appeal to self-interest. The revenue produced for government by the current capgains tax is relatively small. Its effect on the economy is large. Remember, the capital market is many times the size of the GDP. By discouraging the flow of assets to their highest-valued uses, the capgains tax renders the economy less efficient than it otherwise would be. That means fewer jobs, lower output, and less wealth. Both government and taxpayers would have more net income if we simply abolished the tax.