While President Obama was ensuring that his trains would continue to be full of oil by delaying and denying the keystone XL pipeline.
Not going near that one in GQ.
I agree with this, but I think the same should also apply to interest income. If you have your money in the bank earning 1% income and inflation is also 1%, then you’re not really earning any income.
I think he’s got more the same mentality as Bill Gates - “I’ve got more than enough money, who cares?” He’s not making money because he wants more, he’s doing something (investing in and fixing companies) as a challenge to show he’s the best. If he ends up a few billion below where he might have been, as long as everyone’s in the same situation, who cares? He doesn’t. He can afford to be noble.
I agree that there needs to be an allowance for inflation on capital gains. But part of the problem is that the “hit” happens when you sell - so it appears larger. I doubt there would be a liquidity crisis. As the recent mortgage bubble proved (and all previous bubbles) there’s more money chasing good returns than opportunities. People will invest in the best available. Nobody turns down an investment because “I’d make enough money if capital gains were taxed differently, but not this way”. All investors hope to make more than enough profit.
Right, but if I understood him correctly he was pointing out that he paid a smaller percentage of taxes on his entire income (including CG) compared to his secretary, largely because the CGT has a relatively low percentage. I took this to indicate that he thinks CG should be taxed at a higher rate.
If we’re indexing gains to inflation, can we take a loss if our investment has earned less than inflation?
I am generally in favor of indexing things to inflation, but one problem with doing so for capital gains is that it privileges liquidity because we pay taxes on an annual basis. An example:
Consider two people, one of whom invests in the stock market, and one who plows his investments into a small business. 30 years later, they’ve both ended up with a good chunk of gains (inflation adjusted) that will see them to a comfortable middle class retirement. Maybe $1m or so. The guy who has stock can sell it little by little to fund his retirement. The stock market is very liquid, and he can easily structure his sales to optimize his tax bracket. The market in small businesses is not very liquid. This guy who wants to sell out and retire may not have the option of selling off 5% a year, and even if he does, it’s a much riskier proposition than a diversified portfolio. So he sells the whole thing, which means all of his gains get taxed in that one year. Don’t get me wrong, both of these example people are doing pretty well, but should we be taxing one of them so much more than the other?
There are very very few people like Warren Buffet. I agree that we should figure out how to have the 0.01% pay more in taxes. But we probably shouldn’t do so at the expense of people without a ton of financial sophistication who start their own reasonably successful businesses. Someone who makes $1m a year is super rich. Someone who makes $1m in one year and has to live off the proceeds for a few decades isn’t, but the tax code pretty much treats them the same for that year.
That’s sort of how S corporations work; they are the bulk of US corporations (by number). There is some complication in that the shareholders are taxed on the profits regardless of whether they are distributed. I’m not sure that you’d have to do it that way.
Note that when a C corp distributes profits, those are dividends, not capital gains. Qualified dividends are taxed at the long-term capital gains rate.
Such a small business owner was neglecting his retirement plan in such a situation. It would be like someone saying “screw my company’s 401(k), I want access to my money now” and then complaining that he didn’t have enough for retirement. Sure, it’s easier to plan when you have a 401(k) other people have set up, but there are plans for the self-employed that are similar. If he decided to forgo those options and plow his income back into his business, that’s his decision and he should have been aware of the consequences. My uncle runs his own business and sets aside a portion of the salary he draws from it into a pension plan (I’ve worked on their books in the past). He could instead try to expand the business, hire more people, open an office outside his home, etc., but he instead saves for retirement.
Ok. Let’s start with some preliminaries.
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Economists are not too keen about tinkering with rates. They tend to prefer tax reform (closing loopholes) followed by vastly reduced annual tinkering. Because that creates a predictable tax system which decision makers can plan on. We last did that in 1986. I say that if we do that again, we should combine them with reform to the budget process to reduce annual tinkering. Good luck with that. Anyway, I’m just saying that there are a number of concerns that are seldom discussed.
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Speaking generally, Slemrod (2001) notes there is a hierarchy of behavioral responses to taxation. The biggest effect is on the timing of income. For example, if capital gains rate are set to rise, folks will sell shares to lock in a lower rate. A smaller effect involves accounting and financial responses. For example, when there were restrictions placed on deducting consumer interest payments in 1986 (i.e. credit cards), home equity loans increased as they could be deducted.
The final behavioral response involves changes to hours worked or changes to the savings rate. These effects are smallest. We had big changes to tax rates in the 1980s. However, “Although the evidence on this question is mixed, the weight of the evidence suggests that these variables did not change in a significant way in response to the tax changes of the 1980s.”
Cite: Joel Slemrod: “A General Model of the Behavioral Response to Taxation”
- Higher budget deficits when the economy is in expansion and conventional monetary policy is not maxed out (as it was from 2008-2015) reduce national savings which tends to cut into investment. So if you don’t fund your tax cut with corresponding cuts in wasteful government spending (or government spending that does not add to future national income - let’s just set infrastructure stuff aside) then tax cuts will tend to reduce investment and national income. Ouch. But! If the economy is in recession, putting money into the public’s pockets tends to increase aggregate spending. Which is what the economy needs at that point in time.
"The historical evidence and simulation analysis is consistent with the idea that tax cuts that are not financed by immediate spending cuts will have little positive impact on growth. On the other hand, tax rate cuts financed by immediate cuts in unproductive spending will raise output. "
and
“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel. However, theory, evidence, and simulation studies tell a different and more complicated story. … The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”
I think the Brookings Paper is a little optimistic about the beneficial effects of tax cuts - I like Slemrod’s take. Note that I haven’t quoted EPI, CEPR or other tax cut skeptical sources. But I haven’t quoted Heritage either.
Capital gains taxes
Growth aside, the rich pay the bulk of the taxes to capital gains. (The middle class puts their money into IRAs and pension plans that are tax deferred anyway.) So the 0.1% will do very well with a capital gains tax cut.
To the extent that a capital gains tax cut benefits the economy, I can imagine 2 stories.
a) Lock-in. Investors don’t want to sell their stocks because they don’t want to pay capital gains taxes now. They would rather pay it later. So they have their money, “Locked in” to old dying companies rather than fresh entrepreneurial ones. Some of the best work on this subject was done by Burman and Randolph (AER 1994).* They say that the long run responsiveness of tax realizations to capital gain tax rates is probably low, but so was the accuracy of their estimates. Not their fault: blame reality and noisy data.
Also, changes in stock prices only affect investment via changes in new shares issues or maybe additional borrowing based on higher stock prices. To tell this story, you need to establish a number of links in the argument. I say dubious.
b) Faced with lower taxes on capital gains, the rich will save more. Note this would be bad during recession. But during expansion it would lead to investment in plant, equipment and R&D. Yay! Of course you could get the same sort of addition to national savings by cutting the budget deficit. Oh. Also the magnitude of this effect is likely to be small. See 2) above.
Finally. For those saying that any tax cut will lead to Nirvana: let’s see the evidence. The economy boomed after Clinton’s 1993 tax hike. It didn’t do didley after GWBush’s tax cut. The idea that tax cuts are the key to economic growth is more of a mantra than anything that’s based on strong evidence.
- Best work according to Slemrod and Bakija (1996) Taxing Ourselves, footnote 30, ch4.
This is completely orthogonal to my point. Neither person in my example put any money in a 401k or other protected retirement plan. Why should the guy who invests his taxable money in a publicly traded stock pay less in taxes than the guy who invests it in growing (and eventually selling) a private company?
Is it prudent to put money in a retirement account? Of course. But that’s not what we’re talking about here.
Should we choose a tax structure that taxes small business owners more heavily than people who invest in public companies? I’m not sure.
This is what I was going to post. Investing non-retirement money - after funding a retirement account - in either an owned business or in stocks has nothing to do with retirement accounts. Many small business owners count on selling their business when they retire, and also count on complicated schemes to minimize taxes. Nothing wrong with that when you have a tax code that extends for thousands of pages.
As to CG tax rates, I’ve often thought exactly what several here have mentioned, that it would be fairer to index gains for inflation, and then tax as income. It is not fair to tax gains as income without indexing for inflation. If I invested $10,000 in a stock 25 years ago and sell for $20,000 today, I owe tax on the “gain”. This is despite the fact that a typical modest car (or whatever) cost about $10k then and costs $20k today. There is no real gain at all in purchasing power.
And, yes, if taxed at the same rate as income, then you should be able to claim a loss if your “gain” didn’t exceed inflation, which is the problem with taxing interest. You earn a measly 0.90% in Discover or Ally Bank, which trails general inflation, yet are taxed on that interest.
Ireland allows indexing to a published inflation table, but I don’t know the details other than a sentence I read on wikipedia.
Proposed solution: waive CGT for investors who reinvest in securities within one year of selling (as we do for homeowners who buy a new primary home with the proceeds of the sale of the old one).
My point is that the business owner is choosing to invest his money in his business as opposed to the stock market. If his business’s value has increased through his work, then there in general shouldn’t be any reason why he has not had the opportunity to take that increase in value in cash rather than as an increase in the scope of his business. It’s possible that most of the value is tied up in goodwill and thus only exists as future earnings which would only be possible after retirement if a successor is found, and in such a case the business owner has failed in his retirement plan by not finding a successor. In such a case he can easily get the value of the business back as a part of the income stream from the business and thus be taxed on it when it is earned by the successor. I did not mean to restrict my view to tax-deferred retirement savings plans, but merely the idea of taking steps to ensure that one has a retirement plan as opposed to just a bunch of goodwill in a business, although I can see how my lack of specifying that specifically may have been confusing. Yes, such a retirement plan is not as easy as just investing your extra money in the stock market, and so you may have a point that someone whose net worth is specifically tied up in goodwill due to future earnings has a more difficult time exiting the investment with as favorable of tax consequences. Perhaps I am just used to the idea that business owners have to do more and different kinds of tax planning than employees, and don’t have much sympathy for this particular case.
Thank you, M4M, very well presented and understandable. We appreciate your efforts here.
Additionally, there is a thing called “like-kind exchange” which allows investors to defer their capital gains tax if they re-invest the proceeds into similar securities. If one sells stocks and buys more stocks, then there’s no tax event at that time, not until one sells the second set of stocks. The IRS has been restricting what actually qualifies as like-kind, but generally one can ditch their loser stocks and buy winner stocks without having to pay the capital gains taxes until later.
ETA:
I believe the capital gains on your primary residence that you’ve lived in for two or more years is exempt from CGT. A better example is a house you rent out. If you sell it and buy another house to rent out, CGT are deferred, never waived.
It is assumed by the markets that a higher capital gains tax will disincentivize but motion of money and initial investment.
However, the motion of money issue is largely dealt with by the higher rate - one’s personal tax rate - on short term Cap Gains. Essentially, there’s an assumption that holding investments for a longer term is better for the economy overall and therefore should be encouraged.
Raising the CGT rate will likely have the downstream effect of providing greater incentive for buy-and-hold which I personally think is a good idea. However, for those investors and hedge funds that operate under the buy, creatively destroy and dump philosophy it will become somewhat less viable.
Those are definitely good points. A business owner could choose to take profits and then go invest them in some other asset. But we’re coming at this discussion from very different angles. Much of the reason he should make different choices is that the tax structure incentivizes liquidity. If we do away with the capital gains rate, it’s much better to have assets that can be sold a little at a time to provide a steady income stream in a lower tax bracket than it is to have assets that have to be sold in one big chunk.
You’re saying my business owner example is making foolish choices given the tax structure. I’m saying that perhaps we shouldn’t have a tax structure that provides that incentive. Do we actually want to incentivize investment in public companies over private ones? Sure, business owners, in the real world, have to do some planning to minimize their taxes. But is that a desirable goal? Wouldn’t it be nice if the returns to careful tax planning weren’t large, and we could all spend more time on things other than optimizing our assets with respect to the tax code?
Rephrasing my general argument: One reason capital gains perhaps should not be treated as normal income is that, in many cases, the gain was accrued over many years, but booked in a single year, and a progressive tax applied to annual income isn’t necessarily a very fair way to handle that.
1031 like-kind exchanges are restricted to certain types of assets, mainly to those used in some kind of business. Investments like stocks are not eligible to be traded. And it’s a bit of a nit, but it isn’t the IRS restricting the eligible assets, it is Congress. The IRS has some latitude to interpret, but fundamentally they enforce the law as written.
Of course, Congress could modify the 1031 law (or create a similar one) to allow investments and stocks to be traded with deferred gain.
Addressing the bigger issue of preventing a massive sell-off when higher rates are announced, you could always provide some kind of election to pay tax on the current gain so that only future gain is taxed at the higher rate. This has the same tax effect as selling and re-buying without requiring the transactions to muck up the markets.
However… Obama already hiked the capital gains tax indirectly for high-income taxpayers. There is a 3.9% NIIT surtax and the LTCG rate reverts to 20% instead of 15%. Did we see a huge selloff in response to what’s essentially an increase from 15% to 24%? Not to my knowledge, and you know that Obama’s opponents would have been talking about it nonstop if they found so much as a blip in the data.
This is part of why I have a hard time supporting the lower LTCG rate. It does not seem closely correlated to behavior.
I would argue that the free market is quite capable of incentivizing investment through normal profits. Any company that relies on preferential tax rates deserves to fail. Let the free market determine where investment flows, instead of the government deciding Wall Street is too fragile to compete for capital without subsidizing investors with special tax rates.
I think this is the wrong way to think about it.
There’s some optimal tax rate out there that will generate the best outcome for society as far as investment and economic activity are concerned. We can (and do) argue about that that rate is, and about what societal effects we’d like to get (more growth, greater equality, more fairness, etc.). But there’s no particular reason that the optimal rate for income from labor and the optimal rate for income from investment and the optimal rate for income from inheritance and the optimal rate for income from the lottery are all the same.
You can argue that they should be the same for reasons of fairness (which I think is what you are arguing), but it might not be that simple. See my previous posts for how not having the “preferential” capital gains rate results in a preference for liquidity, which isn’t particularly fair.