Cap Gains Taxes - What is Fair?

[Midpack]

I've always meant to do the math just to see how the current cap gains 15% tax rate would compare to cap gains taxed as ordinary income. At $100K/yr and saving/investing 10% per year, at the end of 15 years it doesn't make a big difference. In that the money invested has already been taxed (and reduced what you have to invest for yourself), does it make sense for gains to be taxed as ordinary income - double taxed?"

I am not as interested in the impact on the super-rich, that doesn't apply to anyone here AFAIK.

I am not talking about Corp income, hedge funds, etc. - just personal income and cap gains. What's "fair" isn't readily apparent to me...

Effective Tax Rate:
- on income (no investing/cap gains) = 15.6%
- on income with cap gains @ 15% = 15.5%
- on income with cap gains as ordinary income = 16.3%


NO POLITICS PLEASE, BUT FIRE RELATED IN THAT MOST IF NOT ALL OF US WILL HAVE CAP GAINS TO DEAL WITH IN RETIREMENT.

 

[MichaelB]

Midpack, sorry but I don't follow what you are comparing or analyzing here.

 

[Hamlet]

There appears to be something wrong in your calculations.

How can the tax rate be higher with no capital gains tax than with it at 15%?

I've always meant to do the math just to see how the current cap gains 15% tax rate would compare to cap gains taxed as ordinary income. At $100K/yr and saving/investing 10% per year, at the end of 15 years it doesn't make a big difference. In that the money invested has already been taxed (and reduced what you have to invest for yourself), does it make sense for gains to be taxed as ordinary income - double taxed?"

I am not as interested in the impact on the super-rich, that doesn't apply to anyone here AFAIK.

I am not talking about Corp income, hedge funds, etc. - just personal income and cap gains. What's "fair" isn't readily apparent to me...

Effective Tax Rate:
- on income (no investing/cap gains) = 15.6%
- on income with cap gains @ 15% = 15.5%
- on income with cap gains as ordinary income = 16.3%


NO POLITICS PLEASE, BUT FIRE RELATED IN THAT MOST IF NOT ALL OF US WILL HAVE CAP GAINS TO DEAL WITH IN RETIREMENT.

 

[Midpack]

How can the tax rate be higher with no capital gains tax than with it at 15%?

Greater income...

 

[Hamlet]

Why would you have greater income with a capital gains tax than without?

I would expect you to have less income, since some of your capital has been taxed away over the years.

I don't appear to understand at all what you are calculating.

Greater income...

 

[Midpack]

Midpack, sorry but I don't follow what you are comparing or analyzing here.

The calcs may confuse the issue, I just wanted to actually see the exact result for the three scenarios. Just curious what people think is fair and why? Is paying taxes on cap gains as ordinary income "fair" remembering the double tax aspect? Is the lower rate an incentive to save and invest?

Maybe that's all semantics and it's just a total tax revenue question...

Not helping myself here probably. You're welcome to kill the thread if you think we can't have a non-political exchange (seriously), that's not what I'm hoping for.

 

[Midpack]

Why would you have greater income with a capital gains tax than without?

I would expect you to have less income, since some of your capital has been taxed away over the years.

I don't appear to understand at all what you are calculating.

The capital gains are additional income vs not investing at all, then it's just a matter of what rate those gains are taxed at.

 

[Hamlet]

I wouldn't think that not investing at all would be a scenario we'd be looking at. I assumed that the investing behavior was staying the same and that the only thing changing was the tax rate on cap gains.

The vast majority of us are going to invest regardless of the tax rate on capital gains. The rate may change some behavior at the edges, and if rates got ridiculously high it might change behavior more dramatically, but most people are not going to stop saving for retirement to avoid paying capital gains taxes, even at ordinary income rates.

The capital gains are additional income vs not investing at all, then it's just a matter of what rate those gains are taxed at.

 

[Hamlet]

I'm a big advocate of treating all income the same, whenever possible.

If corporations did not pay income tax, I would be in favor of having cap gains (and dividends) taxed at ordinary rates (with cap gains indexed to inflation).

Since that is not the case, I am ok with a modestly lower rate to compensate for corporate taxes and inflation (say 20%). I would note that the double taxation caused by corporate income taxes is becoming less and less important as most of our large corporations seem to be getting better and better at tax avoidance.

I think 15% is a little too low compared to our earned income tax rates, and I think the efforts to remove cap gains taxes entirely are ill-advised.

Just curious what people think is fair and why? Is paying taxes on cap gains as ordinary income "fair" remembering the double tax aspect? Is the lower rate an incentive to save and invest?

 

[MichaelB]

The calcs may confuse the issue, I just wanted to actually see the exact result for the three scenarios. Just curious what people think is fair and why? Is paying taxes on cap gains as ordinary income "fair" remembering the double tax aspect? Is the lower rate an incentive to save and invest?

Maybe that's all semantics and it's just a total tax revenue question...

Not helping myself here probably. You're welcome to kill the thread if you think we can't have a non-political exchange (seriously), that's not what I'm hoping for.

Thanks for the explanation, it is much clearer. I'm not sure taxes and fairness can be discussed anywhere without getting political (or disagreeable) but we can try. Another question - what is the double tax aspect you refer to?

 

[Midpack]

Thanks for the explanation, it is much clearer. I'm not sure taxes and fairness can be discussed anywhere without getting political (or disagreeable) but we can try. Another question - what is the double tax aspect you refer to?

It can be argued that income taxes reduce the money you have to invest, so your capital gains have already been reduced by the initial investment basis. Then the gains are taxes "again."

From the Corp side, instead of me butchering the explanation.

One other peculiar aspect of the capital gains tax has made many economists conclude that it is economically inefficient: it is a form of double taxation on capital formation. Economists Victor Canto and Harvey Hirschorn explained:

A government can choose to tax either the value of an asset or its yield, but it should not tax both. Capital gains are literally the appreciation in the value of an existing asset. Any appreciation reflects merely an increase in the after-tax rate of return on the asset. The taxes implicit in the asset’s after-tax earnings are already fully reflected in the asset’s price or change in price. Any additional tax is strictly double taxation.6

Take, for example, the capital gains tax paid on a pharmaceutical stock. The value of that stock equals the discounted present value of all of the company’s future proceeds. If the company is expected to earn $100,000 a year for the next twenty years, the sales price of the stock will reflect those returns. The “gain” the seller realizes from the sale of the stock will reflect those future returns, and thus the seller will pay capital gains tax on the future stream of income. But the company’s future $100,000 annual returns will also be taxed when they are earned. So the $100,000 in profits is taxed twice—when the owners sell their shares of stock and when the company actually earns the income. That is why many tax analysts argue that the most equitable rate of tax on capital gains is zero.

 

[farmerEd]

Is paying taxes on cap gains as ordinary income "fair" remembering the double tax aspect? Is the lower rate an incentive to save and invest?

I never have really bought the 'double tax' argument. You are not really being double taxed. You earned some money, presumably paid taxes on it, then invest what's left. The capital gains becomes due on the income, or increase in value, that that after-tax investment made. You don't get double taxed on the original income...or perhaps I am just not understanding it.

As far as fair, I see no reason why investors income should be taxed less than 'worker' income personally. Especially since you already don't have to pay SS/Medicare on investment income.

HOWEVER, I am all in favor of lowering spending (by the govt) and lowering taxes as well. I'd prefer to pay none.

EDIT: Now I see what you are referring to with your latest post, and I still don't really buy it. Perhaps it makes a difference if you are talking about holding something for 20 years (in your example), versus 20 minutes. If I flip a stock in 20 minutes, which I often do, its hard to argue somehow that taxing my gains as income is 'unfair'. I could possible be in favor of very low, or inflation adjusted basis, on capital gains that are held for a very long time, but even then I am not sure. Wouldn't that just let the wealthy keep growing their nut, generation after generation, and tax the 'worker bees' for the needs of govt. IMO, better to cut the spending, before we decide who should get to keep more of their money.

 

[Alan]

Since the thread is all about taxes on money, I moved it to the FIRE & Money forum.

 

[Hamlet]

The places in the world with no taxes at all are pretty scary.

I subscribe to this taxing philosophy--

“I am proud to be paying taxes in the United States. The only thing is – I could be just as proud for half the money.” — Arthur Godfrey, entertainer

HOWEVER, I am all in favor of lowering spending (by the govt) and lowering taxes as well. I'd prefer to pay none.

 

[donheff]

I don't get it. Companies make money. They subtract expenses (complicated topic itself) and end up with profits. They pay taxes on the profits and return the remainder to owners as dividends. Beyond that the owners get general growth in the value of the stock. I can see why economists would say the dividends have already been taxed but what about the growth (more than 2/3 of investor's income, right). How has that already been taxed?

 

[donheff]

As to fair, I don't think there is a right or wrong answer. I am more interested in what is practical from an economic impact POV. At some level increasing CGs would presumably be counter productive in terms of the US economy. I don't see any reason to assume that zero is best from that perspective or that 15% is ideal. It does seem that the market has done fine in periods with substantially higher rates so why did we drop CG rates in the absence of a balanced budget?

 

[jIMOh]

Better question, would you be willing to see taxable capital gains rates increase (say to 20% or 25%) with an increase in deductable amounts to 401k plans and higher contribution limits to IRAs (maybe 20k 401k and $10k Roth).

 

[marko]

My humble two cents:

I see threads here (and elsewhere) where the impact of a mutual fund's expense is debated to death. All the investment advice says that your portfolio's expense cost is a major factor in reaching your goals.

Nobody seems as worried about taxes as an impediment to their retirement as they do a .75% expense hit.

After 2013, I understand that Cap Gains will be taxed as ordinary income. Now there is something to consider in how it will hit your retirement plans!

 

[Animorph]

Back when I had to pay my first cap gains tax I couldn't believe cap gains were taxed at all. That was my money that I had paid taxes on already! Guess I'm used to it now.

Of course it's not just income taxes, it's SS and Medicare as well. Seems like a case could be made for medicare taxes on cap gains. SS a little less if it was actually like buying an annuity.

On the plus side, income tax brackets are inflation indexed, which might help out a little bit.

Given the tax/AGI numbers in another thread, looks like most of us would benefit from treating cap gains as regular income. That might be especially true if the cap-gains tax goes back up to 20% and the 15% tax bracket stays put.

Then there was that year that I moved from individual stocks to mutual funds/ETF's. I took a very high capital gain. In fact it moved me out of the income region where deductions and exemptions were rolled back, with an effective cap-gains rate well above 15%, and back into straight 15% cap gains. If I had to do that with progressive income tax rates instead I would have had to move very slowly across several years to gete it done inside a reasonable tax bracket.

Guess I'd stay with a flat tax for cap gains just to avoid that drag on changing investments.

 

[Animorph]

My humble two cents:

I see threads here (and elsewhere) where the impact of a mutual fund's expense is debated to death. All the investment advice says that your portfolio's expense cost is a major factor in reaching your goals.

Nobody seems as worried about taxes as an impediment to their retirement as they do a .75% expense hit.

After 2013, I understand that Cap Gains will be taxed as ordinary income. Now there is something to consider in how it will hit your retirement plans!

Cap gains tax rate goes to 20% when the Bush cuts expire in 2013.

 

[old woman]

The thing about capital gains is they hit all in one year on big investments. So say you bought an apartment building for 100K many years ago and now sell it for a million that is a capital gain. If you add that to your annual income it is taxed at a high rate. Knowing a huge amount of taxes are due you might not sell it since you couldn't replace it on the money leftover. You also might not get cash if you sold on contract so would need to find the cash some where else.

That is why we need a reasonable capital gains rate like 15% and to spread installment sales to the years the money is collected and to have section 1031 exchanges.

It doesn't really matter much when you are only buying stocks because you can spread the sales over many years too or harvest losses to offset.

We currently tax 401K gains at ordinary income rates where if we invested after tax it is capital gains or ROTH is tax free. That doesn't seem fair and limits most people into only withdrawing the RMD to avoid really high rates.

 

[Hamlet]

I doubt that current law will be what actually happens.

There is no predicting what taxes will actually be in 2013 and beyond, because it depends on the results of elections that are not predictable at this point (IMO).

After 2013, I understand that Cap Gains will be taxed as ordinary income. Now there is something to consider in how it will hit your retirement plans!

 

[marko]

Cap gains tax rate goes to 20% when the Bush cuts expire in 2013.

Sorry, you're right! Dividends go to ordinary income in 2013.

 

[ERD50]

If corporations did not pay income tax, .... Since that is not the case, I am ok with a modestly lower rate to compensate for corporate taxes and inflation (say 20%). ...
I think 15% is a little too low compared to our earned income tax rates, and I think the efforts to remove cap gains taxes entirely are ill-advised.

Since the title and OP is all about what is 'fair' - I will say that any fixed inflation adjustment on cap gains is not fair at all. It's been discussed here before, but if we want to adjust for inflation, then do it. A table will give the inflation factor, and it's simple math (and easy for any tax program).

Someone 'earning' $1,000 in cap gains over 20 years is far different from someone earning it over 2 years, yet the current tax code treats them the same. Please note, after adjusting for inflation, many capital gains would become capital losses, and should be allowed to offset other capital gains. Why tax someone on a 'gain' that was really a loss in buying power? I don't think that is 'fair'.

I'm a big advocate of treating all income the same, whenever possible.

And I think the fairest way to do that is to tax spending (National Sales Tax). I honestly think that is a better measure of your ability to pay. If someone has $25 million in fixed investments making near zero (or stock not paying divs and no cap gains sales), and spends $1 million a year, they have more ability to pay taxes at the same rate as someone who had $1M income and spent $1M.

The thing about capital gains is they hit all in one year on big investments. So say you bought an apartment building for 100K many years ago and now sell it for a million that is a capital gain. If you add that to your annual income it is taxed at a high rate. ...

That is why we need a reasonable capital gains rate like 15% and to spread installment sales to the years the money is collected and to have section 1031 exchanges.

Good example. The inflation adjustment would at least soften this.

My humble two cents:

I see threads here (and elsewhere) where the impact of a mutual fund's expense is debated to death. All the investment advice says that your portfolio's expense cost is a major factor in reaching your goals.

Nobody seems as worried about taxes as an impediment to their retirement as they do a .75% expense hit.

OK, but remember that the .75% expense hit is on the whole nut. The tax deltas are only on the part that represents 'income', and that is probably closer to the 4% 'SWR' number, so that .75% would be X25 to compare, which would be about an 19% point tax hit. 19% points would get our attention, I assure you.


-ERD50

 

[Independent]

NO POLITICS PLEASE, BUT FIRE RELATED IN THAT MOST IF NOT ALL OF US WILL HAVE CAP GAINS TO DEAL WITH IN RETIREMENT.

I think it's impossible to have a discussion of "fair" that's not also a political discussion.

My political opinion is that we should tax all capital income (interest, dividends, capital gains) at the same rate as ordinary income. I can see an inflation adjustment. I would favor making dividends tax deductible on corporate income tax returns to avoid the "double taxation" of dividends.

But, I see no reason to load up taxes on labor income just so we can reduce taxes on capital income.