Cap Gains Taxes - What is Fair?

[Hamlet]

I think a National Sales Tax is a terrible idea.

It would reduce the amount paid by the wealthy and increase the amount paid by everyone else.

It would create a huge incentive to increase black market activity.

It would encourage Americans to leave the country to make purchases and discourage tourism by foreigners.

I suspect that it wouldn't actually end up replacing the income tax. We would eventually end up with both an income tax and a national sales tax.

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.

 

[Hamlet]

I'm fine with indexing the gain to inflation if it is taxed at ordinary income rates (or say 25% to compensate for corporate income taxes).

I suspect that most people will end up paying more that way than with a flat 20%, although I don't have any numbers to back that up.

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'.
-ERD50

 

[Midpack]

I guess I should have known all POVs would surface (0%, 15%, ordinary income - and even broader tax recommendations), so I didn't learn much if anything, but I tried...

 

[Texas Proud]

This is a tough subject to discuss because of so many different parts....

To the OP question, NO, I do not think it is fair to tax cap gains at the same rate as ordinary income.

But one of the problems is why is there cap gains? IOW, what makes it up. Most people talk about a stock. So let's use ABC as an example. I buy the stock at $10. It explodes and is making huge profits which it pays a very high tax on. But it does not pay out a dividend. The sales keep growing, the money keeps piling up etc. etc. In 5 years I sell at $100. The question is why is it now worth $100? It is because the company has a higher book value with all that cash (which has been taxed) and that it will be earning lots of money going forward (which will be taxed) Would it make a difference if I had only held the stock 1 year? Not in my opinion.

Now, if you get rid of the corporate taxes, then I would agree that the income had not been taxed and should be taxed as ordinary income.


But, lets take the case of property. I bought land at $1,000 and acre. Little town grows up and surrounds my land. The value is now $100,000. Was there any income that had not been taxed? No. The land is still the land. It did not earn anything the whole time. It is just that someone now wants it more and is willing to pay a high price to get it.


The other problem with taxing cap gains as ordinary income is that people will not want to take on as much risk. IOW, the actual cost of capital to business will go up. When someone invests capital in a business they want a certain return AFTER TAXES on that investment. If they can get that same after tax return by investing in bonds or something else, then why put your money at higher risk? You will not. So, the cost to business to attract common shareholder investors will go up. This will cause a number of businesses to fail, or even worse not to ever get started. Our economy would grow at a slower rate.

 

[Texas Proud]

I guess I should have known all POVs would surface (0%, 15%, ordinary income - and even broader tax recommendations), so I didn't learn much if anything, but I tried...

Sure you did.... that what is 'fair' is very hard to pin down.

 

[Finance Dave]

I don't see "double taxation" of the earnings on cap gains. Yes, you paid taxes on the amount invested already...but you've not yet paid taxes on the gains themselves.

Sometimes I think the cap gains rate should be HIGHER than ordinary income...as for the most part it's passive in nature....and therefore would be an incentive to have "earned" income.

 

[ziggy29]

IMO, Long term capital gains should be taxed as ordinary income BUT have the gains indexed to inflation. If an asset bought for $10K is sold at $20K but prices have doubled over that time, there is no *real* gain even though half the sale price is taxed as a gain.

 

[ERD50]

I think a National Sales Tax is a terrible idea.

You are entitled to your opinion.

It would reduce the amount paid by the wealthy and increase the amount paid by everyone else.

Not necessarily. I gave an example where a rich person has no report-able income for the year, yet spends $1M. I think that in the long run, spending is a better measure of someone's ability to pay taxes, than the current spider-web of code that defines and excludes 'income'.

The fairtax.org people propose a 'prebate', to offset the taxes on the first $X of income, which means people below a certain spending point effectively pay no federal sales tax (just as they pay no FIT today). So it is a progressive tax when the prebate is included.

It would create a huge incentive to increase black market activity.

There is already a huge black market in hiding income today. Some of it is literally 'criminal' (drugs, non-reported cash transactions, etc), and some of it is part of our tax code which favors certain types of income and might be considered 'criminal' by many (I won't go further to avoid getting too political, but taxes are set by Congress, kinda hard to completely ignore the 800# gorilla in the room).

So the real question is: Which system would produce the least hiding of taxable transactions? The fairtax.org people claim theirs is better, but I'm not sure there is any clear answer. But it's not all-or-nothing.

It would encourage Americans to leave the country to make purchases and discourage tourism by foreigners.

I'm pretty sure that the expenditures would be captured if they brought the purchase back to the US. I doubt that the amount of expenditures moved outside our boundaries and kept there would be very significant, and don't most of those countries include ~ 18% VAT? Not really escaping anything, are they?

Would we need to apply the sales tax to visitors? They don't pay income tax now. Maybe it could be rebated to them when they leave? Even at that, with the elimination of corp taxes and cost of compliance, prices would come down some, offsetting the tax to some degree.

I suspect that it wouldn't actually end up replacing the income tax. We would eventually end up with both an income tax and a national sales tax.

This always strikes me as a circular argument. Couldn't I say the same about the income tax? They could always add a sales tax to it, so let's not have an income tax?

I guess I should have known all POVs would surface (0%, 15%, ordinary income - and even broader tax recommendations), so I didn't learn much if anything, but I tried...

Sure you did.... that what is 'fair' is very hard to pin down.

+1 - you beat me to it!

Hopefully not getting too political here, but I think it partially explains the tax code tangle we have now. People have different views, and different people have different amounts of political sway at different times. So we get tax code that favors one view for a while, and then some from the other, then some from yet another. So it is just a mess of conflicting views rolled into one, rather than some structured top-down approach to 'fair'.

-ERD50

 

[ziggy29]

I will say in addition, regardless of where tax rates are set, that the constant tug of war over tax policy and the uncertainty it creates about how today's financial decisions could be impacted by tax law changes is very damaging to the economy. Even more than whether taxes are a little lower or a little higher, I think it's important to lock them in place for a while at some point, giving more certainty to individuals and businesses deciding how to invest for the long term.

 

[Independent]

I guess I should have known all POVs would surface (0%, 15%, ordinary income - and even broader tax recommendations), so I didn't learn much if anything, but I tried...

Probably you should have had a different title on the thread. Maybe, "Did I do the math right?"

IMO, the answer there would be that you used a marginal rate for capital gains and an average rate for earned income, so you are comparing apples and oranges.

Suppose John and Jane have the same wages and file a joint return. If we think of John's wages as the "base" income, and Jane's as "excess", we'll discover that they are paying more on Jane's earnings than on John's.

OTOH, if we say that Jane is the base and John is the excess, then they pay more on John's earnings than on Jane's.

I don't see how either of those calculations can be used to conclude anything about "fair".

Similarly, you decided the earned income would be the "base" and the cap gains would be the "excess". Try doing the math with the roles reversed and see what happens.

 

[Midpack]

Probably you should have had a different title on the thread. Maybe, "Did I do the math right?"

IMO, the answer there would be that you used a marginal rate for capital gains and an average rate for earned income, so you are comparing apples and oranges.

Suppose John and Jane have the same wages and file a joint return. If we think of John's wages as the "base" income, and Jane's as "excess", we'll discover that they are paying more on Jane's earnings than on John's.

OTOH, if we say that Jane is the base and John is the excess, then they pay more on John's earnings than on Jane's.

I don't see how either of those calculations can be used to conclude anything about "fair".

Similarly, you decided the earned income would be the "base" and the cap gains would be the "excess". Try doing the math with the roles reversed and see what happens. If cap gains are taxes as ordinary income, the results would be exactly the same.

That all seems like semantics to me. In the 'tax cap gains as ordinary income case,' any increase in income will be taxed at the applicable marginal rate for that level of income.

The calc was optional reading. Out of my own curiousity, I was simply trying to quantify how much did the eff tax rate go down with the current 15% cap gains rate, and how much did the eff tax rate go up if cap gains were taxed as ordinary income. I regret posting the calcs now, as it seems to have confused the issue for some, sorry.

 

[MichaelB]

Bruce Bartlett often posts about taxes and this week his blog entry is an excellent short summary of the two competing philosophies of taxation - taxing income or taxing consumption - and then links to a Treasury study published in 01/1977 that describes both. Bartlett's column here Bruce Bartlett: How to Avoid Reinventing the Wheel on Tax Reform - NYTimes.com and the US Treasury study here http://www.treasury.gov/resource-center/tax-policy/Documents/full.pdf titled Blueprints for Basic Tax Reform

 

[GrayHare]

I'm fine with indexing the gain to inflation if it is taxed at ordinary income rates (or say 25% to compensate for corporate income taxes).

I suspect that most people will end up paying more that way than with a flat 20%, although I don't have any numbers to back that up.

Per the following table, the average income tax paid in 2009 was 11% of AGI:
http://www.taxfoundation.org/blog/show/27899.html

 

[ERD50]

Per the following table, the average income tax paid in 2009 was 11% of AGI:
The Tax Foundation - Romney

We have to be careful with wording here.

That 11% is the average of collections as a % of AGI. The 'average' person (and I'm just ballparking/eyeballing here from the table - it looks like the median is in the $30-$50,000 range) is paying ~ 4%-5% of AGI as FIT. And that 30-50K group pays about 5% of the total FIT, though they represent about 18% of the population of those filing.

I make no statement here as to whether that is 'fair' or not, I just wanted to break out the numbers so no one (or even noone) got the wrong idea.


MichealB - thanks for those links I will check them later.

-ERD50

 

[Texas Proud]

I don't see "double taxation" of the earnings on cap gains. Yes, you paid taxes on the amount invested already...but you've not yet paid taxes on the gains themselves.

Sometimes I think the cap gains rate should be HIGHER than ordinary income...as for the most part it's passive in nature....and therefore would be an incentive to have "earned" income.

That is why I put down that it make a difference in where the gain is coming from... IOW, if you buy a small company stock, and it grows like gangbusters... then the increase in price is due to the company making lots of money and keeping it (and paying a high rate on that income).. so the company paid income tax on their income and you pay cap gains tax on the increase in price...

Now, I had not thought about the gain in price due to the future income of the corp that will also be taxed when earned... that would indicate that gap gains on stocks etc. should be zero.... as all income will be taxed inside the corp... or that all corp taxes should be zero as all income will be taxed at the individual shareholder....

 

[devans0]

Hmmm, 52% say capital gains should be the same tax rate as wages.

Most Americans agree with "Buffett rule" concept, poll shows - Political Hotsheet - CBS News

 

[ERD50]

Hmmm, 52% say capital gains should be the same tax rate as wages.

Most Americans agree with "Buffett rule" concept, poll shows - Political Hotsheet - CBS News

Sure. But I wonder how many of those people know anything about cap gains and the effects a tax would have?

I could take a poll of the public on whether I should use 12 Ga or 14 Ga wire on a project, but I wouldn't expect the results to be useful. I think economics is at least as complicated as house wiring.

As an example, we have mentioned adjusting cap gains for inflation several times in this thread and others. And it seems that people are agreeable to that, once we bring the issues to light. I see no discussion of inflation adjustments in that piece, and I doubt that 90% would grasp it, and that 99.9% have never thought about it. I hadn't really thought about it much until it was brought up in these forums.

Policy decisions by (uninformed) populist vote is a dangerous thing.

-ERD50

 

[Hamlet]

Bingo.

There is a good reason that we have elected representatives, rather than just put everything to referendum.

See California for the results of veering too far towards direct democracy.

Sure. But I wonder how many of those people know anything about cap gains and the effects a tax would have?

I could take a poll of the public on whether I should use 12 Ga or 14 Ga wire on a project, but I wouldn't expect the results to be useful. I think economics is at least as complicated as house wiring.

As an example, we have mentioned adjusting cap gains for inflation several times in this thread and others. And it seems that people are agreeable to that, once we bring the issues to light. I see no discussion of inflation adjustments in that piece, and I doubt that 90% would grasp it, and that 99.9% have never thought about it. I hadn't really thought about it much until it was brought up in these forums.

Policy decisions by (uninformed) populist vote is a dangerous thing.

-ERD50

 

[donheff]

Bruce Bartlett often posts about taxes and this week his blog entry is an excellent short summary of the two competing philosophies of taxation - taxing income or taxing consumption - and then links to a Treasury study published in 01/1977 that describes both. Bartlett's column here Bruce Bartlett: How to Avoid Reinventing the Wheel on Tax Reform - NYTimes.com and the US Treasury study here http://www.treasury.gov/resource-center/tax-policy/Documents/full.pdf titled Blueprints for Basic Tax Reform

I'm sure nothing in life is new but I think Bartlett is wrong about the "typical" liberal view of income for income tax purposes. He says liberals define it as including all earned income and all capital gains, realized or not (i.e. including positive changes in net worth as income). But I don't remember hearing any liberals suggest taxing unrealized capital gains. Every CG proposal I have heard in decades involves realized CGs. Many liberals (me included) would address unrealized CGs through a continuation of some level of estate tax.

 

[GrayHare]

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

hmm, rather than consume all tax loss harvesting in 2012, might be smart to postpone some into 2013

 

[donheff]

Sure. But I wonder how many of those people know anything about cap gains and the effects a tax would have?

How many of us really know anything in this regard? Economists are all over the place on the topic with statistics to prove both that the current 15% is choking the engines of industry and that under previous 35% rates those same engines roared.

 

[ERD50]

But I don't remember hearing any /people/ suggest taxing unrealized capital gains. Every CG proposal I have heard in decades involves realized CGs.

I'm trying to keep any appearance of partisan politics out of this, so let's just say 'some people'.

I do think that some people have suggested a wealth tax. That would capture unrealized gains. I'm not saying it is widespread approach, but I think it has been thrown out there.

-ERD50

 

[ERD50]

How many of us really know anything in this regard? Economists are all over the place on the topic with statistics to prove both that the current 15% is choking the engines of industry and that under previous 35% rates those same engines roared.

The trouble with that is they are using 'statistics' (and IMO, with an agenda), rather than reason.

35% versus 15% did not occur in a vacuum. It 'proves' nothing. We've been around on this before.

If I add insulation to my house, and then we have an unseasonably cold winter and my heating bill rises regardless, I can use 'statistics' to 'prove' that increasing insulation is bad for my heating bill. You buy that one?

-ERD50

 

[MichaelB]

I'm sure nothing in life is new but I think Bartlett is wrong about the "typical" liberal view of income for income tax purposes. He says liberals define it as including all earned income and all capital gains, realized or not (i.e. including positive changes in net worth as income). But I don't remember hearing any liberals suggest taxing unrealized capital gains. Every CG proposal I have heard in decades involves realized CGs. Many liberals (me included) would address unrealized CGs through a continuation of some level of estate tax.

Including unrealized capital gains as taxable income is part of the Treasury study.

 

[ziggy29]

Including unrealized capital gains as taxable income is part of the Treasury study.

Terrible idea, IMO. For many people, this would force you to sell the asset in order to pay the "imputed" taxes. That might discourage investment altogether.

Would this also provide write-offs for unrealized capital losses?