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