Financial vs. Operating Investors

Kevin Drum argues that Conservatives have vastly over-estimated the effects of capital gains tax changes on investment.

I can't agree with parts of the article that seem to argue that all taxes have limited effects on behavior (this is easily disproved, just look at what the tax code does for preferences of issuing debt vs. equity, or even look at the mortgage market).  But I have always suspected that the political focus on the capital gains tax represents another piece of evidence that financial players (Wall Street, banks) dominate much of economic regulation.

All things being equal, a low capital gains tax is fine.  If I sell some stock, its nice to pay a lower tax on the profits, particularly since at some level those profits have already been taxed once at the corporate level.  Financial players who buy and sell securities live and die by the capital gains tax, and I suppose for businesses there is some advantage in that it perhaps reduces the cost of debt and equity.

But as a business person with my own company, that capital gains tax is largely irrelevant to my investment decisions.   That is because all my investments are made to generate cash flow, and thus the regular tax rate is the ordinary income tax rate.  Perhaps one time in my life, if ever, the capital gains tax will be hugely relevant when I sell my business, but that is at some time in the future so nebulous that it does not affect my behavior.   Other than the double taxation argument, I have never understood why those who take their investment gains in asset value appreciation rather than in income should get different tax treatments.

  • will

    Fixing both the "financial vs. operating" and "double taxation" problems seems to require a complete overhaul of the tax code.

    Specifically, it seems like the right thing to tax is total income minus net investment & savings. This would create, essentially, a progressive consumption tax.

    Then, if you invest money, no matter how you plan to make it back, you have to pay taxes on it later, but in compensation you don't have to pay taxes on it now. Similarly, if you take out a loan, you have to pay more taxes now and less later.

    Unfortunately, this is a major overhaul of the tax system to deal with a wonky problem that few people understand, and so it's going to happen in Washington just after the Aerial Pig Safety Act is passed.

  • Cardin Drake

    Other than the double taxation argument, I have never understood why those who take their investment gains in asset value appreciation rather than in income should get different tax treatments.

    Another solid reason is that if you hold an asset for ten years, a large chuck of the appreciation tends to be nothing more than inflation. You haven't really made anything. In some cases you have lost ground to inflation, but you are still paying a tax on your "gain".

  • http://evilredscandi.blogspot.com Evil Red Scandi

    If you want more proof that it's just Wall Street cuddling, just look at the stupid caps on "passive investment losses" in real estate .

  • steve

    The reason is housing. Many people would have to pay very high rates when they sold a house if the capital gains were taxed as income. They would be taxed as if they were millionaires when in reality it is nearly their entire life savings and they are anything but rich. This may becoming less relevant since the housing crash.

  • bud

    "Other than the double taxation argument, I have never understood why those who take their investment gains in asset value appreciation rather than in income should get different tax treatments."

    Rewarding deferred gratification?

  • George Edwards

    Just wait until you are retired and have to manage your own pension fund. You will view capital gains differently then.

  • http://www.raggedindividualist.blogspot.com Craig

    "I have never understood why those who take their investment gains in asset value appreciation rather than in income should get different tax treatments"

    It's in our best economic interest that capital be moved from one, perhaps, profitable venture to another that is potentially more profitable. Capital gains taxes tend to encourage money to be left in the former.

  • http://commonsensewonder.com John Hudock

    The reason capital gains should be taxed at a different rate than income is the time element. Capital gains are supposed to be a long term phenomenon while income is current. Ideally your capital appreciation should be indexed for inflation, which would severely limit the amount of taxes paid. This is too difficult for the accounting geniuses in Congress and at the IRS, so they just divide into short term (which is taxed as income) and long-term which is lower. One can argue all the specifics (ie long-term should be longer than a year, etc...) but in reality if you hold your capital for more than a few years (say 5), you're still getting screwed and paying tax on the government inflated portion of your asset value growth.

  • Chris G

    As a CPA, I can see the effects of taxing capital gains - it's a matter of mobility of capital. People are reluctant to sell investments because they don't want to pay the tax. Shoot, my mother has stock she's owned for 40 years that she won't sell because she doesn't want to pay any tax - and that's with the preferential CG rates. Securities markets operate more efficiently when there is less of a disincentive to move from one investment to another.

    And yes, taxing inflation on long, long, term holdings is inherently unjust.

  • http://blog.horton-brasses.com Orion

    Megan McArdle at the Atlantic did a bit about this last week. There are in fact two reasons for a lower rate on capital gains. One is so that partnerships work when one partner has more capital than the other-allowing one person to generate "sweat equity". She summed it up much better than I can. A second issue, which I feel has validity, is that capital does have many more options for use than labor. IE, everyone needs to work (with a few exceptions) but capital can sit back and not be used. Lowering the tax rate makes it more enticing for people/institutions with capital to put it to work. All in all those are two very fine arguments for lower capital gains rates-or even no capital gains taxes-. Like Coyote the capital gains rate has absolutely nothing to do with any business decision I make. I have no horse in this race.

  • Harlan French

    I would agree that capital gains should be taxed at higher rates if you were refunded at the same rate for capital loses.

  • Snowmon

    Besides the double taxation, the most perverse aspect of the Cap Gains tax is that you have to pay taxes on inflation. I recently sold some stock I had owned for 10 years for a gain, but the gain was less than inflation, so I was paying taxes on a real loss. One more disincentive to save and invest for the future.

  • Craig Lehman

    I agree with the double taxation argument, but let me put it a slightly different way.

    Suppose I work at a job, earn a salary, and am taxed on my income. Now, with my savings, I buy a small farm, and feed myself and my family with the livestock and crops that are raised there. Should I have to pay tax on the food that we eat?

    That is what capital gains taxation amounts to. I have already been taxed as I accumulated the wealth to buy the farm. Now, as I literally reap the fruits from my investment, should I be taxed again? Farmers are not taxed for eating the food they get from their farm. Why should I be taxed if I reap my fruit in a different way, from making a profit on a successful investment?

    Conceptually, income tax is a tax on paychecks. Nobody has money to invest unless somebody earned that money in the first place. Capital gains taxation is more like a property tax: now someone has accumulated some wealth, and they are being taxed on the benefits they earn from it, whether it's owning a house they can live in, a farm they can derive sustenance from, or an investment that they can realize appreciation on. If you're in favor of property taxation, then fine, you can justify capital gains taxation. Just don't pretend it's fundamentally the same as income taxation.