It’s like this: No matter what income tax bracket you’re in, if you wait a year before selling your investment you only pay 15% on the profit (this goes up to 20% in 2011, a small step in the right direction).
It’s not complicated… The wealthier a person is, the greater proportion of their income is likely to be capital gains. So you could pull in $20M/year and effectively be in a lower tax bracket than someone making $100K. I suspect this is quite common considering how many wealthy folks make their money by investing money they already have.
It’s not hard to find a Fox News commentator ranting about the Robin-Hood injustice of the progressive income tax. But it’s pretty rare to hear someone supporting a full-on regressive income tax (yes capital gains is income, sorry).
There is an advantage to distinguishing between short- and long-term investments; the latter encourages serious entrepreneurial investment. Short-term investing is another word for sheer speculation or just moving money from one pile to another pile. It contributes nothing useful to anyone except the person doing it.
That’s why I am going to stick my neck out and say that if anything, short-term capital gains should be taxed higher than regular income. We pay a 10% penalty for early 401K withdrawals after all, this isn’t so different. Long-term capital gains should be taxed as regular income. Capping the rate at 15% or 20% just seems wrong.
After-tax income is the money you take home after you’ve paid income tax on it. As opposed to pre-tax income (say, 401(k) contributions, or Traditional IRA contributions, IIRC).
My point being that capital gains income is just income, and it is given preferential treatment primarily because policy-makers have decided that it is in the best interest of the economy to incentivize capital investment (or, more cynically, policy-makers are more beholden to the capital investors than folks whose income is entirely salary). As far as I know it has nothing to do with it being “taxed twice”.
Just a guess but I think SB might be thinking of dividend income. Companies pay taxes on their income, issue a dividend based on that income, and investor pays taxes on dividend.
There are few simple answers to this, one of which is that the money invested is subject to risk. There needs to be adequate reward for taking that risk, because the rest of society relies on a few people to take a lot of risk. Taxing gains shrinks the potential reward.
The really big gains from investing require substantial risk: these are the tech start ups, drugs and medical devices, oil and mining exploration. A lot of money has to be put at risk, and by risk I literally mean the potential to lose it all. A new drug costs millions to develop, and failing FDA approval means you get nothing in return.
If you go after those gains using punitive measures the way you tax alcohol and tobacco, you’ll shrink the available pool of capital.
Anther is that by distinguishing between short term and long term capital gains, a person’s money is tied up and unavailable for other things. So like the 401k penalties, there is a penalty for taking out capital gains early in the form of higher taxes.
To me that’s not double-taxation either. The company was taxed on its income, and I was taxed on mine.
If that’s the argument then everything is double (actually, much, much more) taxed. I pay tax on my income, and then use some of what’s left to buy a coffee at Starbucks, and then they have to pay taxes on that income. Then they use some of my (already taxed twice now) money to buy coffee beans, and the coffee bean farmer has to pay taxes on that!
But yeah, referring to dividends makes marginally more sense than claiming that capital gains were double-taxed. I do believe that they are considered separate from capital gains taxes, however, and are only the same because of the changes during the Bush administration.
This is probably the most optimistic/realistic defense of lower tax rates for capital gains. It goes along with the saying “if you want less of something, tax it”. If you want more capital investment, then decreasing the tax rate on the gains is a reasonable way to accomplish that goal.
Similar to why home mortgage interest is tax-deductible - to encourage home ownership. Or why credits are given for buying energy-efficient windows. And countless other complications in our tax policy. It’s one of the reasons I don’t really like using tax policy as social policy, but that’s another argument entirely.
Maybe capital investment should be incentivized, but this policy reflects an idealized version of capital investment where you help a company get on its feet, then share in its profits. That’s called “Buy and hold” and these days seems to be a sucker’s game. Derivatives (short-term bets on an asset’s future value, not necessarily higher) seem to be where the smart money is.
If you buy or short a put/call on a stock, the underlying company doesn’t get to invest the money you put in. If you win, yay for you, if you lose it goes to the house. That doesn’t sound like capital investment to me, so I guess I lean more towards the cynical version of your explanation
It’s all about liquidity and encouraging investment. The higher the tax rate the less likely folks are to invest and the less likely folks are to move their capital to better projects. If you own a stock that is getting you 0% return, you would not move that capital out until you found something getting you a 15% return (very simpified) so the higher the tax rate the less likely folks are to re-invest. Any tax would create this inefficeincy. But taxes are necessary for a working society so it has been collectively decided thourhg our representative government that a rate lower than the marginal rate is appropriate.
Self-check, just realized that derivatives would usually be short-term cap gains, taxed as income… though the short-term churn might be hidden behind shares in hedge-funds or banks that are long-term holdings. I am at the end of my knowledge here, hoping someone smarter comes along to carry the torch.
If you’re talking about buying and selling options, that’s still part of the stock system. Options are available based on shares that someone already owns. And is essentially a way of transferring some of the risk in exchange for some of the rewards.
I bought 100 shares of Apple and $300, I gain if it goes up and lose if it goes down, and Apple has that money to work with. To avoid loses to the downside, I can sell the option to buy my stock at a fixed price, say $302. I’m not selling the stock, I’m selling the option, which would cost something like $5 per share.
If the stock goes down to $285, the option is worthless but I get to keep that $1500 I avoided taking a loss. If it goes up I make less of a gain.
Meanwhile, the person buying the call option only has to put up $1500, but stands to either lose it all, or make substantial gains if the stock goes over $305. I’ve put up the $30,000 worth of capital, and the other guy is assuming most of my risk.
ETA So in conclusion, again if we tax the capital gains on options, we’re discouraging the risk. If I can’t sell covered calls, I’ll be less likely to invest in high risk ventures.
ETA2 Yes, it does seem this would all be short term gains. But again, we need to allow for these gains in order to encourage risk.
Just to nitpick this, Starbucks would deduct the cost of coffee beans from its income, so it wouldn’t get taxed on that. You take your after tax money and buy a cup of coffee – the tax that Starbucks would pay on that would be what’s left over after they pay for the beans, the cup, the water, the barista, the rent on the store, the marketing costs, the electric bill, wi-fi bill, etc.
It’s not net of the dividends they pay, though, so that’s where one can claim it’s doubly taxed. And, if they don’t pay dividends and instead reinvest or hold onto the cash, inflating the stock price – when you sell the stock, it’s kind of the same double taxation.
Lets not leave out the other side of the equation. Capital losses are tax deductible - so it’s not like the government is ‘only’ putting it’s finger on the up-side risk, it’s also lifting on the down-side risk.
Well, surely some part of the 4 bucks I pay them for my coffee will be profit, no? And that part of it will be double-taxed. And some part of my (already taxed) 4 bucks will go to coffee bean growers, of which some part of it will be profit (and thus be taxed again). I guess what I’m getting at is that we don’t tax the dollars themselves, we tax the transactions. Enough of this thinking can almost get me convinced that a consumption tax would be better (assuming progressiveness were somehow baked in)…
I’m not opposed to the idea that long-term capital gains and dividends should be taxed at a lower rate than ordinary income. I’m just not convinced by the “double-taxation” part of the argument, although I grant that it is a bit stronger for dividends than it is for capital gains. I think that a justification based on encouraging liquidity in capital markets is more convincing.
So if we’re looking for a defense of the 15% rule, it’s based on wanting to encourage longer term investing.
Short-term (or speculation) is taxed at the normal rate for your income bracket. This neither encourages nor discourages. To *encourage *buy-and-hold, a special rate is offered for investments held longer than a year. To further *encourage *buy-and-hold, an even better rate is offered after 5 years.
One could make the argument that if we remove those incentives, we’ll be encouraging short term speculation, since they’ll be less reason to hold. This would likely increase the volatility in the market, thereby increasing risk.
Offering up your capital for 5 years is no small task. That’s five years that someone else gets to enjoy your money. It seems only fair that compensation would be offered.
Investors generally have some level of choice as to whether to sell an asset (and realize the capital gain) or hold it. The higher the capital-gains rate, the greater the incentive to hold their assets and not realize the gain. This means that at some point, increasing the rate is going to decrease the overall amount of tax collected.
I have no idea whether 15% is the optimal rate or whether it should be higher, but it is probably true that investors have more leeway over whether to realize their gains than wage-earners have over whether to earn a salary or not, so it’s not unreasonable to think that the revenue-maximizing rate for capital gains would be less than it would be for wage income.
It creates all sorts of problems in the tax system to have that sort of a gap between capital gains and ordinary income. Tax lawyers make a lot of money these days writing opinions that some transaction or another has successfully converted ordinary income into capital gains.
The traditional defenses of the preferential capital gains rate no longer apply. The biggest one used to be that when our progressive tax system was highly progressive and top marginal tax rates were in the 90% range, you could have several years of gains hit your return all in one year and drive you to the top marginal tax rate for gains that had accumulated over possibly over decades.
Obviously this rationale no longer applies with our incredibly flat tax structure.
The second rationale is that there is double taxation when you sell stock because the value of stock is (theoretically) supposed to represent all future cash flows and it is unfair to tax it once at the corporate level and again at the shareholder level.
This rationale fails in the real world because much of the financing of a mature corporation is debt and retained earnings.
The primary reason for a special capital gains rate is that capitalists want it and they threaten to take their ball and go home if they don’t get it.
If you think encouraging investment is a good idea then you have to ask youself, whether you really want to make investments that need special tax breaks to attract capital.
After-tax income is the money you take home after you’ve paid income tax on it. As opposed to pre-tax income (say, 401(k) contributions, or Traditional IRA contributions, IIRC).