It is Time to End Favored Tax Treatment of Capital Gains

My new column is up at Forbes.com, and asks why we fetishize capital gains over regular income

Let's consider two investors.  Investor A buys a piece of land and builds a campground on it, intending to run the campground for decades.  Investor A gets her return on investment from the profits each year running the campground, profits that are taxed as regular income  (Full disclosure:  In my business life, I am essentially investor A).

On the other hand, Investor B buys the same piece of land and builds the same campground on it, but in about a year Investor B sells the newly developed facility, making a profit on the sale over his original investment.  Investor B likely will pay taxes on this gain at reduced capital gains tax rates.

But why?  When Investor B sold the property, the price he got was probably something like the present value of the expected cash flows from operating the campground.   Both Investor A and B created essentially the same value., but Investor B took the value as a single lump sum rather than as a stream of income over time.  Why is Investor B's approach preferred in the tax code?  Or, stated another way, why does the tax code favor asset flipping over long-term operations?

  • NL7

    First, you're skipping over double tax. Capital gains and qualified dividend rates are generally levied on investments that are otherwise taxable businesses (plenty of exceptions, of course). So the true rate is 20% (plus net investment tax, if applicable) on the after-tax earnings. So if an entity pays 40% tax and then you pay 20% tax on your gains from selling equity, then your return is Profit * (1-40%) * (1-20%) or 48%. With the net investment tax, your return might be under 46%.

    Second, it's not that capital gains are favored so much as ordinary income is disfavored. OI is more vulnerable to taxes, so it gets higher rates than CG. Capital gain is flexible as to time, place, and type. You can advance your losses and delay your gains if you have the wealth to cover current needs (subject to individuals' loss limits). Capital gains can often hold for a decade or more without a problem (and very often do), and if taxes are 40% then they will hold longer. High CG tax locks in investments.

    Meanwhile, people earning OI (other than qualified dividends, which get effectively CG rates) have far less flexibility. They mostly need to work to support themselves, so they can't afford to delay salary for years or to work for (delayed) equity instead. The lack of flexibility means that taxes are less distorting. Note also how corporations and entities get no beneficial rate for CG, so they track CG and OI separately but generally pay their ~40% on each.

  • Cardin Drake

    A lower capital gains rate is the admission that inflation exists. If you hold an asset, let's say a stock for 20 years, and it doubles in value, you most likely have not made anything at all in real terms. Paying taxes as ordinary income adds insult to injury. Indexing for inflation would be the fairest way to do it, but the price would be an overly complicated tax code. Lower rates on capital gains are a compromise between fairness and complexity.

  • Matthew Slyfield

    Capital Gains are not favored in all situations. Take a look at the treatment that stock options get in the AMT. Someone can end up having to pay tax on a huge profit that they never got because they held onto the stock and the price tanked latter. For the purpose of the AMT you have to take income at the difference between the option price and the market price on the day the option was exercised even if you hold onto the stock and the price later collapsed to below your option price before you sold.

  • esoxlucius

    In the scenario above you make a decent case for cap gains to be taxed as regular income but how about this scenario:

    Investor C buys a campground as a small business to run as a sole proprietor (probably the typical small business format) for $125,000. He eeks out a meager living of $30,000 per year average and never sees a profit at the end of the year after expenses (aside from his meager salary). In 30 years he sells it to the next guy for $250,000. In that year, the government sees his income as $155,000 (He's RICH!). But with inflation at 3% per year, compounded over 30 years his $125,000 capital gain is actually $20,000 increase from his initial $125,000 invested in present dollars. The government sees $125,000 of cap gains, taxes at 35% and taxes $44,000 making about a $25,000 loss for his risk, hard work and meager existence.

    So the build and flip are rewarded (Invester B), the profitable build and hold are rewarded (investor A) but the unprofitable buy/build and hold are not?

  • johnson85

    I think you're missing another argument against capital gains taxes. Worker A and Worker B both make $100,000 a year. They pay $25k in taxes each. Worker A spends his remaining $75k. Worker B spends $50k and saves $25k. Worker B invests well and in a year cashes in for a $2500 profit, pays 15% in capital gains tax ($375) and nets $2125. Worker B is already paying an extra $375 of taxes basically because he chose not to consume all he produced immediately. That seems more than fair to Worker A and probably a little unfair to Worker B. I know classifying capital gains versus sweat equity can be difficult in real life, but the lower capital gains rate moves us a little closer to taxing consumption as opposed to things we want to encourage.

    Of course a similar argument could be made to justify doubling the tax brackets for people that work part time. If a person chooses to work 25 hours a week instead of 50 (or 20 instead of 40), why should they pay less taxes just because they are enjoying more leisure.

  • Ignoramus

    There's another way to look at it.
    Taxes on capital investments in effect make Uncle Sam a kind of partner, but with skewed risk vs. returns. Uncle Sam takes a share of the winnings, but not the losses. If Uncle Sam takes too big a cut, investors are mathematically better off taking less risk. We all benefit from at least some investors making smart but risky bets.
    This argument isn't as strong when applied to ordinary income -- but it can still apply.

  • a non

    Warren, in the article you are ignoring the tax problems caused by deferring the income by many years. Suppose you buy a piece of property worth $100,000 today. It appreciates at 4.9%, but the inflation rate is 5%. That is, it is worth about $163,000 in ten years, but you need $165,000 to buy the same amount of goods and services. Yet you will pay income tax on $63k when you sell in ten years, putting you even further in the red.

  • brandonberg

    See Steve Landsburg's post, "Getting It Right," in which he explains why investment income isn't actually privileged, but taxed more heavily than wage income. The real problem in the scenario you describe is that the law doesn't correctly distinguish between capital gains and labor income, since they're mixed together.

  • Ben

    I think the issue is what, exactly, is considered income versus capital gains. Check out Greg Mankiw's "Capital Gains, Ordinary Income and Shades of Gray" -- Landsburg is talking about Abe while Meyer is talking about Carl and Dan.

  • Ben

    I think the best description I've seen for why the reasoning that capital gains should be treated as normal gains is wrong is Scott Sumner's "Income: A meaningless, misleading, and pernicious concept." (Apparently direct links aren't allowed in these comments).

    In Landsburg's words, "Can you please write down the optimization problem which has as its solution 'tax the doctor’s income and the homeowner’s capital gain at the same rate'?"

  • DensityDuck

    He covers double taxation in his column.

  • DensityDuck

    There is also the fact that investment is typically seen as a risk, whereas income is seen as a guarantee. Investment returns are, presumably, taxed at a lower rate to mitigate the riskiness of the proposition.

  • Mondak

    Right. This is why a graduated scale would solve a lot of problems. Bubbles in real estate, stocks or other capital gains are a real problem. Inflating income Enron style is another. We respond with oversight and legislation, but what if our tax policies did the work for us?

    < 1 year = 90% Tax
    1-2 years = 75%
    2-5 years = 60%
    5-10 years = 25%
    10+ years = 10%

    Running a multibillion dollar organization for quarterly results is asinine. This policy would keep people from flipping stocks they held for 1/8 of a second that do NOTHING positive for the economy and instead encourage people to invest in companies that had stable, long term business plans.

  • Eric Johnson

    The flaw in your analogy is right here:

    " When Investor B sold the property, the price he got was probably something like the present value of the expected cash flows from operating the campground."
    Investor B's investment will sell for the expected value of future cash flows NET OF TAXES. So if the income tax rate is 35%, the investment sale price will be 35% below what it would be without an income tax. So, in effect, Investor B is out that money, even if it didn't come directly out of his pocket.

  • Maximum Liberty

    Warren:

    Your article left out a couple of things that might have made it stronger, though I understand the space limitations.

    You say, "all business earnings over time must flow to either capital gains or dividends." One thing you could have said here would have addressed the populist misidentification of a corporation with its management. You could have added, "And, of course, compensation that a company pays to its executives gets taxed immediately as income."
    You also could have added that taxing only on the individual is more progressive, when calculated only among those with investment income. That is, it is pretty odd that we impose the corporate income tax on corporate income that would have become dividend income for a retiree living in poverty at the same rate as on corporate income that would have become dividend income for Bill Gates. Taxing it when it hits the individual gives greater effect to progressivity. Of course, it is also true that a retiree who only has dividend income is better off than a retiree with no income at all, but that can be addressed appropriately through the individual rates.
    Many of the other comments talk about the difference between capital gains and income from work. Some of these comments miss your point that you are proposing to have the same rate for all investment income. That rate could be different from the rate on income from work. For example, you could have an earned income date of 25% and an investment income rate of 15% without missing the point in your column. Any difference would also lead to gamesmanship, but probably a lot less than when you concentrate it into a single organization as the corporate income tax does.
    A couple commenters noted that capital gains has a time component that is minimal in other types of investment income, such as dividend income. I believe this only matters if tax rates change over time. With a single tax rate applicable to both types of investment income in all periods, both the present value of future taxes paid and the end-of-investment value of all taxes previously paid is identical between the investments. Capital gains does give the investor the ability to chose the timing of taxes, which matters if tax rates are inconsistent over time, either because the government changes the rate or because the investor moves between progressive brackets.
    Max

  • herdgadfly

    Overarching all other arguments is the simple observation that finding any rationale between and among the many tax rates for the many types of income isolated in the legal monstrosity called the U.S. Tax Code is crazy-making at best. There simply is no logical reasoning applied and the real effects of tax law have grown like Topsy ( "I s'pect I growed. Don't think nobody never made me.") over the years.

    But beneath that, Warren Meyer has described two alternatives available to him in his own business and is questioning why his choice was being taxed heavier - so up jumps the "fairness" issue again. While tax laws drive investment strategies, not everyone will choose the best tax strategy - we are humans after all. And personal preferences trump all other reason.

    Risk-taking tolerance, business skills, investment skills, social and family situations - so many things influence our lives. Only those of us possessing a genie in a bottle will be predictable.

  • obloodyhell

    Because when you produce capital gains you are increasing the growth of the economy. When you are making "ordinary income", you are generally just milking the economy for what already exists.

    It makes vastly sense to encourage things that expand the economy, thereby increasing wealth generation.

  • obloodyhell

    Good point.

  • obloodyhell

    You mean this link?
    Income: A meaningless, misleading, and pernicious concept

    Or this one:
    http://www.themoneyillusion.com/?p=7091

    ???

    :^) Sorry, could not resist being snarky. You were just doing something wrong. You can post links using either a simple cut and paste or you can "get fancy" and use the semi-standard HTML mechanism of
    [a href="link here"] Link Text Here [/a]
    with angle brackets &gt &lt in place of the square brackets.

    You can even put pics into these comments:
    http://3.bp.blogspot.com/-U7hht8NyH9s/T28IW7HVc5I/AAAAAAAAAG4/zR4Zisx8vZE/s1600/lily-white7.jpg

  • jdgalt

    This is why any fair scheme to do away with capital gains rates would need to allow people with long term holdings to inflation-adjust their basis before calculating gain. No one should have to pay tax on inflation.

    While we're at it, let's do away with the exclusion for selling your home, too. Anyone who owns one is rich enough to be paying tax on that investment.

  • Penkville

    In the UK most entrepreneurs rail against proposals for any similar change in tax handling on the basis that they start businesses with the explicit intention of cashing out in due course, to either move on to another opportunity, or to simply retire on the proceeds. It's an interesting dilema for governments; do you want to promote new business creation, or stable long lasting businesses? It's not as simple as that of course but that's the basic choice made by the tax approach.

  • FelineCannonball

    From a policy perspective what probably matters is the amount of money sitting on the sidelines, going into fake derivatives, building real things with real people being hired, going overseas, etc.

    Rewarding real investment and real job growth probably doesn't involve giving tax breaks to hedge fund managers by treating their no risk fees as capital gains.

  • mlhouse

    No, what the analogy is missing is that in this case both investors have a capital gain and ignores basis. Investor B realizes a capital gain on the amount of money he makes from the sale of the property. If the analogy is reasonable he "invested" a non-zero amount of money in the property. When he subsequently sells it, to make it simple, he realizes a capital gain on the sales price minus the original investment, and pays a capital gain tax on that amount. Notice that Warren's assumption that the amount taxed via capital gain is the entire present value of all future cash flows is incorrect.

    In fact, Investor A also had a capital gain in this scenario. It just was no-realized. In the end, human beings are not infinite dynasties and the capital gain will have to be paid one way or the other.

  • Michael Moran

    In the 1986 tax reform act, capital gains and ordinary income were taxed at the same rate, 28%. This changed under Clinton, as the top ordinary income rate went to 39.6% and the top capital gains rate went to 20%.

    The real answer is they should be taxed at the same rate, but that requires a low ordinary income tax rate because the capital gains rate is a voluntary tax in the sense you must sell something for the tax to be incurred. If you have a high capital gains tax rate, like 39.6%, fewer assets are sold. This reduces the total tax rate and harms the economy. While high ordinary income rates are also bad, the effects are not as clear or immediate. So the result is high ordinary income tax rates and low capital gains tax rates.

  • tfowler

    1 - Capital gains are in many cases taxed at a higher real rate than the nominal rate would suggest Even an infinite (or devide by zero) rate when there is no real gain. Capital gains taxes are not adjusted for inflation. You could pay taxes on a "gain" that are a real loss.
    2 - As Eric B points out, the value the property sells for is affected by the fact that the profits earned will be subject to taxation. In a sense the seller is paying the discounted future value of the estimated after tax profits from the property, not the before tax profits.

  • Akiva

    You're also skipping the fact that capital losses can only be deducted up to $3,000 per year. That's a serious drawback that evens out some of the advantages of the lower tax rate on capital gains.

  • skhpcola

    If you starting taxing equities at those rates, you would have an immediate and immense market liquidity problem. People that know nothing about the stock markets can bitch and moan all that they wish about day traders and other frequent traders, but those people are vital and useful in the marketplace. Rewarding the risk with lower rates is sensible...it isn't like making a fortune is formulaic and/or automatic.

  • dave

    If your economic policy is to promte risk taking and capital formation eliminate the tax on capital, if however your goal is to reduce entrepreneurial risk taking and capital formation then raising the tax on successful risk taking will certainly accomplish that policy goal.

  • craigkl

    Agree with Cardin Drake's fundamental point. But what is so "overly complicated" about indexing for inflation? Thanks to the Reagan tax reforms, that's what we now do with income tax rates. It's no more complicated than applying a divisor based on government statistics to the tax rate. So I'd say, EITHER a preferential rate for capital gains, OR, for more of a level playing field, indexation.

  • Mondak

    People that know nothing about markets think that they don't adjust and they always stay the same.

    The liquidity problem would be that now, companies would have to be held to a higher standard to attract money. If there are real opportunities where an adjustment is needed, there still can be money to be made at the higher rates.

  • ATTILA727

    Different treatment of long termg ains vs short term, were designed to reduce large fluctuations in the market. To stop the "churning" that rapid turnover creates.

  • john mcginnis

    Dear OP surely you know the answer! The preference for B or A has to do with politicians. Under which scenario does the government get their slice of tax sooner? But of course under scenario B. Our tax code is structured to favor the government and no one else.