Abolish capital gains taxes

There’s another post at Greg Mankiw’s blog about carried interest, this time linking to a NY Times column written by Alan Blinder. Blinder starts out with a good explanation for why it’s unfair that hedge fund managers pay a lower tax rate than everyone else who gets paid to do work. But then he segues into an argument for raising the capital gains tax.

Now this is exactly the problem with partnership loopholes that allow people to pay capital gains tax on what ought to be ordinary income. It threatens the very good idea of having a lower tax rate for capital gains. In fact, after thinking about this issue, I think the correct tax rate for capital gains is 0%.

In many cases, capital gains taxes represent double taxation.

Scenario 1: At year 0, a corporation’s shares are worth $1/share. The corporation has a 10% pre-tax return on equity and never pays dividends. Income is reinvested in the company. During the first year, the corporation has had $0.10/share in pre-tax profits, pays the 35% corporate tax rate, and has $0.065 after-tax profits per share. At this point in time, year 1, the shares now sell for $1.065/share, representing the year’s profit. Repeat this over several years, and at year 10 each share is now worth $1.87. The $0.87 increase in the share price since year 0 represents the after-tax profits of the company. This company has paid $0.47/share in taxes during the 10 year period. If the shareholder now sells the shares, making him pay more tax on the $0.87 profit would clearly be a case of double taxation. Those shares would be worth quite a bit more than $1.87/share were it not for the corporate tax already paid.

Scenario 2: Now, some people will ask about the scenario in which a person buys shares on day 1. On day 2 the company announces good news, and the share price rises by 50%. On day 3, the person sells his shares at a 50% profit. Has there been double taxation here? Well yes there has. The reason why the stock went up is because the market’s estimation of the discounted value of the company’s future cash flows has increased by 50%. Those future cash flows are subject to the 35% corporate tax rate. In this scenario, the taxpayer is paying tax on the estimate of the company’s future increased profits which will then be taxed again. Double taxation.

The above two scenarios apply to the sale of any asset that generates cash flows, not just corporate shares. This could include apartment buildings, oil wells, or commercial airliners.

What about the sale of property that doesn’t generate cash flows?

Scenario 3: Bob buys a house in 1995 for $200,000. In 2007 he sells his house for $400,000 because he’s moving to a different city which has identical real estate prices. He has to pay 35% capital gains on his $200,000 profit so he only has $330,000 left to buy a new house. Bob won’t be able to afford as nice a house in the new city. Bob has really been screwed on account of moving!

The scenario above is considered so unfair that Bob is allowed not to pay any capital gains taxes. He can take advantage of the like-kind exchange rule. This rule doesn’t only apply to little guys like Bob, but even big evil corporations get to take advantage of it. Because of the like-kind exchange rule, most capital gains never get paid. But why is this fair? Why should a swap of a house in Texas for a house in Virginia be treated differently than a swap of shares in IBM for shares in Microsoft?

A person can avoid ever paying capital gains tax on his property if he keeps it, or properly exchanges it, until he dies. Upon death, all assets in the estate get a step-up basis to their current fair market value.

As we see from the above example, the like-kind exchange rule results in a lot of decisions made for tax avoidance purposes. Bob may prefer to rent an apartment, but the higher the capital gains rate, the more likely he will remain a homeowner until he dies so he preserves the value of his estate for his children. Throughout our economy, individuals and companies, instead of putting their money to the most productive use, often put it to less productive uses in order to avoid capital gains tax. The higher the capital gains tax, the greater the distortion in the economy.

For these reasons, the ideal capital gains tax is 0%.

[I was reminded in comments that Bob will more likely take advantage of the special $250,000 capital gains exclusion for homeowners selling their primary residence. But that doesn't change the point of the post, because it further demonstrates how current tax rules allow so many capital gains to be avoided. If the ideal capital gains rate is 0% for a guy selling his house, why isn't it the ideal rate for sales of other types of property?]

UPDATE

Read my follow-up post, Why corporate tax is necessary.

Comments

[bluprint]

Should Bob the homeowner have to pay taxes on any appreciation caused by his labor? For example, assume Bob built an addition on the house, which resulted in a net gain of 10,000 to the value of the house. Should (if you were king) that amount be subject to the capital gain rate?

[bluprint]

It’s true that carry is mostly derived from gains on capital — but it’s mostly someone else’s capital.

I think here is the disconnect for those who support taxing this gain. (setting aside those who would raise cap gains rats all together for the moment). The term "capital" in "capital gain" does not mean "initial cash investment". That's just an incorrect correlation.

And I like how he says:
I don’t recommend trying to master the details unless you have either an accounting degree or insomnia.

As if any serious understanding of the issue is inconsequential.

Of course, since tax law, like most law, is a consequence of political currents more than anything resembling consistancy or reason, none of this means anything to most poeple. The law should be whatever arbitrary thing you feel it should be, and you can find a reason later.

[hrbtaxguy]

Bob gets to exclude $250,000 of gain on the sale of his home if it has been his primary residence in two of the last five years. If he's married, he and his wife can exclude $500,000 in gain.

[bluprint]

Bob gets to exclude $250,000 of gain on the sale of his home if it has been his primary residence in two of the last five years. If he's married, he and his wife can exclude $500,000 in gain.

HS is discussing the issue of capital gains. HS doesn't really know about taxes, demonstrated by his discussion of "like-kind exchange" in the "Bob" example. Don't get caught up in the actual tax code. HS's position for the purpose of the Bob example is that capital gains rates should be lower, in particular 0%.

[Dan Morgan]

"For these reasons, the ideal capital gains tax is 0%."

From a blue collar worker's perspective this sounds like the upper middle class and the rich will get out of paying taxes on a lot of the income they make by selling stocks and other things. So to the working class this will sound like a loophole for the rich who get to sit around buying and selling stock and other properties.

[Half Sigma]

Half Sigma doesn't know the minutiae of personal income tax. The fact that there are various ways to avoid paying capital gains taxes on the sale of one's home demonstrates the political opinion that a capital gains tax, applied indiscriminately to homeowners, is somehow unfair.

There used to be a bunch of rules about being older than 55, or buying another more expensive house within 2 years. But this was reformed in 1997.

I didn't feel the need to investigate and write about the exact rules here, because that's not part of the point. This post is not intended to be personal tax advice.

[ddonovan]

As a tax attorney, I can tell you that this analysis is fundamentally flawed, in that this issue is, in essence, a "tax policy" question.

First off, your assumption that 10% "pre tax profit" results in an actual tax paid of 35% ignores the reality of how taxes are prepared, filed and paid. As an example, the tax code contains a very large number of what might be termed "tax expenditures": that is, policy preferences expressed through (for instance) deductions granted "as a matter of legislative grace" through the tax code. One glaring example of such a "preference" for economic activity is the concept of depreciation. For those not familiar with this concept, the Congress in their wisdom has decided to give businesses (but not individuals) a break for investing in "capital assets" in their businesses by making them deductible. Indeed, under section 179, many businesses can expense certain investments in a single year, in contrast to the conceptually more accurate "lifespan" of the item in which the investment was made (building, computer, car, truck, etc.). While such benefits can be "recaptured" upon sale, the businesses still benefit from the so-called "float" supplied by governmental policy.

This one tax expenditure alone accounts for a huge preference given to business over individuals. An individual cannot depreciate , for instance, clothing purchased solely and exclusively for work, investment in transportation (ie, car, purchase of public transportation fares, etc.) that permits the individual to engage in economic activity more efficiently, etc. There are, of course, numerous other tax expenditures given to businesses that are denied to those working for a wage or salary.

Perhaps this is a proper approach, but under the analysis given, the assumptions underlying your argument are entirely ignored.

With respect to the policy of taxation of carried interests at the preferred capital gains rate, this policy analysis lies at the center of the controversy. To ignore the economic assumptions underlying the present system --many of which were implemented by what must be conceded were "ideological changes" wrought to the Internal Revenue Code in the 1986 Act-- is to engage in flawed analysis.

In other words, perhaps the policy preferences implemented in current law are optimal, but you won't really be addressing this fundamental issue by assuming the desired outcome as a consequent.

You might do better by first acknowledging that modern society requires government and someone must pay for it. If you impose an "income" tax, the issue becomes "how do you define income"? If "income" is an "accession to wealth", you might inquire, why is there any difference at all between the tax rates imposed on wages, salaries, capital gains (of various kinds, whether or not "realized" or "recognized"--some at 28%, some at 15%, some at 10%, some at 5%), gifts, bequests, royalties, rents, "nontaxable" income, etc.). [Of course, you could parse the issue differently, by imposing a "wealth tax" or a "consumption tax" or a "poll tax" or some other paradigm.] However, once you begin to differentiate between the various "accessions to wealth", you enter the realm of tax policy and are really just engaging in a form of line drawing--who prefers what and why. There are "good" reasons for drawing such lines in many different ways: a survey of international approaches to taxation is informative in this regard. Yet, as a practical matter, those with the axe to grind, expend the funds to ensure that the axe is sharp indeed. Those without are hit by the blunt edge. Where is the large monied lobby that seeks to drive down the regressive employment tax borne by both employer and employee?

Don't pretend that one "rational" explanation makes more sense than another "rational" explanation.

Finally, don't put much credence in the "double taxation" shibboleth. All economic activity is taxed, taxed again, taxed again and taxed again, ad infinitum. The "double taxation" argument is, in essence, a special pleading for exemption from tax under the ordinary scheme, as are many transactions for businesses (e.g., exemption from sales tax for "resale"). Consider this example: a bank lends $ to a borrower and receives interest income (taxable), it pays some of that income to a depositor (taxable to the depositor), the depositor uses this income to purchase a good (taxable sale), the business that receives this income is taxed on its profit, the business then pays out a dividend to a shareholder (or not, if it's a sole proprietorship, partnership or LLC), which distribution is taxable to their shareholder/LP/LLC member, etc, etc, etc. What is so special about a dividend that exempts it from tax? Nothing, except the policy preference.

Unlike a wage or salary earner, an asset owner has a far greater ability to structure economic activity to obtain a more favorable tax rate: that's the way the system is structured as a matter of policy preference.

In the end, it is the policy preference that must be justified. Thus, if you are arguing that a capital gains rate should be 0%, you really should justify why that is so as a matter of policy, and not rely on the assumption that avoidance of so-called "double" taxation in this particular situation is de facto the preferred policy.

Finally, if you really believe that the current dismal science theorizing should govern tax policy, you might acknowledge at least that so-called "double" taxation is built into the market price of stock: in other words, in your example you imply that the tax cost of gain recognition and taxation of future corporate income streams are not taken into account by investors who have run stock up by some 50%. I respectfully suggest that current economic analysis takes such tax costs into account in pricing of assets, such as the shares of stock of a corporation trading on the public market.

Of course, the old joke: Q: How many economists does it take to change a light bulb? A: First, assume a ladder....

[GMR]

Instead of making the capital gains tax zero to avoid double taxation, why not make the corporate income tax zero, but tax capital gains and dividends as ordinary income?

That would make the whole issue of carried interest go away.

There are a lot of really smart people at big corporations, accounting firms, and so on that devise ways for corporations to avoid paying income taxes. If corporate income taxes were to be abolished, these people would all do something else, and would actually be adding value to the economy. No more weird transfer pricing, subsidiaries in Bermuda, etc.

[Russ]

ddonovan,

What do you think of HS's plan to get an LLM and become a tax attorney over ten years after getting his law degree from the University of Arizona. He'll be 40 without ever having practiced law when he's done. Think he'll be employable?

Russ