Why Tax Capital Gains?

Today I’m taking a break from health care issues in honor of the 16th Amendment.

Income tax day is an appropriate moment to go to the heart of President Obama’s complaint about the taxes Warren Buffett and other rich people pay, or don’t pay. What the president is really complaining about is that the tax rate on capital gains is too low.

But there is a more basic question to be asked: Why tax capital gains at all?

Did you know that the term “capital gains” does not even appear in the official income accounts for the U.S. economy? That’s right. No matter how high stock prices climb, they do not affect the official reckoning of national income one iota.

“Capital losses” aren’t included either.

When stock prices soar, stock owners are wealthier — at least they feel wealthier. When stock prices plunge, owners of stocks feel less wealthy. But none of these ups and downs have any bearing whatsoever on the official calculation of the income for the economy as a whole.

So here is the policy question: If we are going to have an income tax, should we tax only income? Or should we tax activities, events and transactions that are not counted as part of our national income?

At the New York Times Economix Blog, Princeton University economist Uwe Reinhardt argues that capital gains should be taxed at the same rate as ordinary income (which is included as part of national income, by the way). I had a debate about all of this with Michael Kinsley at Slate some time back. Interested readers may want to refer to the text of that debate for more details than I plan to go into here. Also, don’t miss Steven Landsburg’s  devastating critique of Uwe’s piece.

‘Cause I’m the taxman, yeah, I’m the taxman
And you’re working for no one but me.

Imagine a poker game. At the end of the evening, some players walk away winners. Some are losers. No real income has been produced at this event. It’s strictly entertainment. The winnings of the winners are exactly equal to the losses of the losers. Should the IRS get involved? If your answer is “no” I like the way you think.

As it turns out, however, the IRS does get involved and it does so in a very unfair way. It taxes the winner’s gains but limits the ability of the losers to deduct their losses. (Gambling losses can only be deducted from gambling winnings, not from other income.) If the IRS treated everyone fairly (symmetrically) there would be no point to taxing gambling income. The deductions by the losers would offset the gains of the winners and there would be no net revenue for Uncle Sam.

Now let’s turn to stock prices. One way to view the stock market is to see it as a place where people also make bets. They are betting on the future income of corporations. Eventually the future will arrive, however. The companies will realize their actual income and they will pay taxes on it. If the firms return some of this income to investors (stockholders), the investors will pay a tax on their dividend income. If the firms pay interest to bondholders, they will be able to deduct the interest payments from their corporate taxable income, but the bondholders will pay taxes on their interest income.

Here is the bottom line: There is no need for the IRS to tax the bets that people make along the way — as stock prices gyrate up and down. Eventually all the income that is actually earned will be taxed when it is realized and those taxes will be paid by the people who actually earned the income.

But, as in the case of the poker game, let’s suppose the IRS decides to foolishly get involved anyway. What will be the outcome? Uncle Sam almost certainly won’t collect much money unless (as with gambling) it treats people asymmetrically. And that is exactly what it does. It taxes capital gains ferociously while limiting the ability of people to deduct their losses.

Moreover, unlike the poker game, I have complete discretion over when I choose to sell a share of stock. I can time my gains so they fit into this taxable period or the next. I can time my losses in the same way. It is because of this discretion that the federal government would get almost no net income from the taxation of capital gains if it treated losses the same way it treats gains. That’s why the government imposes so many arbitrary restrictions on how both losses and gains can be realized. But these restrictions interfere with the flexibility of the capital market. And they do so for no good reason — because eventually all corporate earnings will be realized and taxed anyway.

Uwe’s post was in response to a post by Greg Mankiw, in which Greg gives five examples of capital gains — all involving housing. The problem with all five examples is that a home is an asset that produces income that is counted as income in the national accounts. If the house is rented, the income is rental income. If the homeowner lives in his own house, he is enjoying “imputed” rental income. The IRS taxes the former, but does not tax the latter. If tax policy were consistent, all “income” from housing would be taxed the same way and (as in the case of a share of stock) there would be no reason for the IRS to worry about capital gains and losses from home sales.

Greg also addressed the question of “carried interest,” which I want to handle as part of a more general problem.

Suppose one person sitting at the poker table is not just enjoying an evening of pleasure and entertainment. Suppose he makes a living gambling, just like you and I make a living in some other occupation. How should the tax law treat that person? Answer: differently. Similarly, suppose someone makes a living trading stocks and bonds. If she works on commission, her income will be taxed as ordinary income. But suppose her income comes in the form of a share of some of the trades she makes. Should her income be treated differently than the gains and losses of the passive investors she is managing money for? Answer: yes.

I am not going to propose a technical solution here. I only want to say that these special cases (which certainly include Warren Buffett and perhaps Mitt Romney as well) are problems that can be dealt with in special ways without taxing capital gains generally.

Finally, I want to address an argument Paul Samuelson once made. If capital gains are taxed at a lower rate than ordinary income, Samuelson argued, he would find ways to convert ordinary income into capital gains. Actually, the IRS has created a lot of obstacles to keep him from doing that. But a more basic response is: why not avoid all these problems by reforming the entire tax system along the lines of a flat tax?

The idea behind a flat tax can be summarized in one sentence: In an ideal system, (a) all income is taxed, (b) only once, (c) when (and only when) it is realized, (d) at one low rate.

Comments (11)

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  1. Devon Herrick says:

    It is popular among progressives to bash hedge fund managers as “paying lower taxes that their secretaries. But the decision to invest is based on a risk/reward ratio. If you cut the projected reward by boosting taxes on capital, the risk/reward ratio falls and many projects that would otherwise have been invested in are never funded. Instead, government spends more money on what is basically consumption. Consumption has fewer rewards in the years down the road than investing.

  2. Al says:

    “should we tax only income? Or should we tax activities, events and transactions that are not counted as part of our national income?”

    Isn’t a tax system arbitrary and always unfair? Wouldn’t the best way to decrease unfairness be to reduce taxes and have money spent at the most local level possible taxing based upon consumption?

    Suppose two similar people work at a factory one part time @ 30 hours/wk spending the other 10 hours fishing and farming solely for personal needs while the other spends 40 hours at the factory where 10 hours of work goes to buy food. Why should the 40 hour worker be paying 25% more on taxes?

    We work to enjoy life. If two people get the same benefits of this beautiful country why should a person that has 128 hours/wk of free enjoyment time pay less taxes than one that has only 68 hours of free enjoyment time if both earn the same hourly wage?

  3. brian says:

    It makes economic sense to not tax capital gains. For some reason though, there is still an oddly large number of conservatives that support taxing capital gains.

  4. Ken says:

    Good post.

  5. Greg says:

    Excellent analysis.

  6. Greg Scandlen says:

    I am reading Dinesh D’Souza’s 1997 “Ronald Reagan.” People should pick it up. We’ve forgotten the contempt the elite had for him, and how little the language has changed — “social Darwinism,” etc. And the extent to which Keynesians were not just proven wrong but humiliated by what Reagan accomplished (though they never acknowledged it).

  7. Greg Scandlen says:

    Okay, I just read Uwe’s piece. He seems to hang his argument on the fellow who makes $1 million on his home during our “recurrent” housing bubbles. He believes this should be taxed at the same rate as the hard working physician. Of course housing bubbles are often followed by housing crashes and this fellow might (like me) also lose $1 million on his home. How are the losses treated?

    This would seem particularly pertinent at a time when so many people invested more than they could afford in the hope/expectation of future gains.

  8. Chris says:

    The bottom line is do you want tax policy that is “fair” or tax policy that optimizes economic growth. The soviets had “fair” policies, it didn’t work too well for them. I put fair in quotation marks because it is a subjective word that means different things to different people and is used by politicians to cover up all manner of ills.

    Liberals will readily contend that you tax something to get less of it, which is why they favor gas taxes and carbon taxes and cigarette taxes. They want less of these things.

    They seem to have a brain fart though when considering business investment. Why do you want a higher tax on business investment? What do you think drives economic expansion (GDP growth and job creation?). So, why do you want to tax the fuel of job creation and economic growth?

    Furthermore, for many people, who aren’t hedge fund managers, capital gains realizations are outlier events and this policy would screw them (like they’re screwed by the death tax). Consider the family farmer or small business owner. A family farmer might draw $50,000 a year in income off his farm, he is not rich, but his farm might be worth (because farming is very capital intensive with the land and a single tractor can cost more than a house) $3 million dollars. If the farmer wanted to sell his farm today, he would get $3 million dollars, pay $450,000 in taxes, and have 2.55m to live off of for the rest of his life (since he sold his means of producing an income).

    He isn’t a rich man, but he had a huge income for one year, and one year only.

    Under Obama’s plan he’d pay instead somewhere between $900k and 1.2m in taxes. God help him as well if he lives in California.

    Maybe we need to make it more complicated, a rate for assets held 1 year, a rate for assets held 10 years. But there are always going to be unintended consequences and in this mad rush to punish hedge fund barons you’ll going to hurt a lot of mom and pop small business owners who hope to sell their business one day.

    Even if that wasn’t true though, a tax on the fuel of economic growth is a bad thing.

    Nevermind the fact that historically the government realizes less revenue when capital gains taxes are raised.

    So just ask yourself, which is more important, nominal tax rate fairness or economic growth. Also, if you answer fairness, as yourself what a fair share is.

    See http://www.taxfairshare.org/

    Should 50% of households not be paying income tax? Is that “fair”?

  9. Uwe Reinhardt says:

    So every time an investor in a company’s stock has a capital gain on it, someone else must have an equal loss on it. Is that the argument here? Duitto for ther house? If not, why bring up Las Vegas style bambling?

    My memory may be faulty, but did not Reagan’s tax reform of 1986 tax capital gains and ordinary income at the same rate? As I said, I’d have to look it up.

  10. John Goodman says:

    Uwe, your memory is correct. The 1986 act set the top tax rate at 28% for capital gains, dividends, interest and ordinary income. At the time, this was an increase in the tax on capital gains and an increase in the overall tax rate on capital. Good as the act was on tax simplification, it probably led to the recession, a few years later.

  11. frank timmins says:

    It seems that with the inequity of the “taxable gain” vs. the “deductible loss” as pointed out in the gambling illustration, the House (government) gets the juice no matter the fate of the gamblers. Gee, that’s almost enough incentive to make a man stop gambling unless he is rigging the game.

    Wait! Is there a lesson here for liberals? Let’s see, if we punish the successful investors too much they will stop investing (unless of course they have political connections that promise to bail them out of any bad management decisions). Wow, this really isn’t all that complicated is it?