at no point will taxation make a investment go negative. It can result in lower profits, but the way taxes are set up, a loss mean no tax.
You’re missing his point.
Any individual investment can’t turn negative based on CG taxes. But the expected value of the investment can.
Imagine an investment which has a 55% probability of making $1M, and a 45% probability of losing $1M, and assume a 20% tax on capital gains. Before tax the expected value of this investment is 55% x $1M + 45% x (-$1M) = $100K. After the 20% capital gains tax the expected value is 55% x $1M x 80% + 45% x (-1$M) = -$10K.
I largely agree with you here:
But I strongly disagree with you here:
Two points:
- For most people, income is guaranteed for a few weeks. If I lose my job and have a mortgage to pay then I’m losing money.
- Even if we define income as guaranteed I’m not sure why it matters.
That seems like a unreasonable scenario. Who’s going to risk a 45% chance of losing $1m if the expected “win” is $1m? I’m not interested in tax codes that protect morons.
I was just trying to illustrate the general concept and how the math works.
Except you get to write off your losses.
Are you kidding? People make investments like that all the time. Did you miss the chance that you have a 55% chance of making a million dollars? For clarity, a ‘win’ of $1m means you get you get your million back, plus another million.
That would actually be a crazy good investment, assuming a short enough time frame. If you could invest in 100 of those, you’d lose your million 45 times, and earn a million 55 times. Your expectation is then (55 million - 45 million)/100, or $100,000. So you’re getting a 10% return on your capital. Assuming the time frame is small enough that this represents a better return than you could get from a safer investment like a T-bill, people will choose to make this investment.
Now, let’s say you’re a ‘speculator’, and constantly making investments like this. You can write off the losses against the gains, and you only pay the 25% tax on the net, or the $100,000. You still make $75,000.
But if you’re a one time investor (your own business), the expected value is EXACTLY THE SAME. But if you ‘win’ you get a million extra dollars. Now you pay 25% on that, or $250,000. Your expectation just dropped to -$150,000.
Or look at it another way: Take a community of 100 entrepreneurs who are unconnected and unrelated, making exactly the same kind of investment with the same risk as one speculator who can afford to make 100 identical investments, but who can write off the capital losses of the failed ones. The community of entrepreneurs will pay the government ten times as much tax as the individual does. That punishes entrepreneurial investment. And the disparity between that community and a single large investor grows as the risk increases, as does the punitive cost of every additional point of capital gains tax.
Are you even reading this thread? The whole point is that entrepreneurs who fail have no capital gains that can be offset by their losses. They’re done. Or were you under the assumption that a capital losss without a capital gain would result in the government cutting you a cheque?
Indeed it does. Well, are you assuming these entrepreneurs have no other income at all? That if their investment fails- BOOM, their only asset is a shopping cart stolen from Kroger? :dubious:
You get to offset capital losses vs ordinary income.
Not to mention- investors are in the business* of being investors*. They offset the gain from one with the losses from another.
One time investors- those who build their own business- do not normally do so for the entire purpose of selling it. They often hope to make profits off the annual income/sales.
Good thing you saw my early point about Sec 1244. 
Small business owners are able to write off 100,000 of business loses as ordinary.
I’m going to pass over ideal tax systems as non-topical, as the OP inquired about “Cutting capital gains taxes”, and it’s an election year.
Blink. I hadn’t heard of this. It’s probably because it doesn’t apply to stocks according to dracoi. Still, interesting.
There’s something a little similar that happens when you sell a security at a loss, then buy the same security or one that’s virtually equivalent in less than 30 days. Then you run into wash sale rules. You don’t want to do that, because they say under those circumstances you cannot take the tax benefit (you cannot take the capital loss).
That would be a lot like removing the annual limits on money put into an IRA. The rich would love this.
Incidentally there is a way to dodge capital gains taxes. It happens at death: when your heirs inherit, the cost basis is adjusted upwards to the time of death. All those potential taxes evaporate. That said, for estates over something like $10 million there is an estate taxes to consider. Though those also can be dodged to some extent by setting up trusts.
I suppose that’s possible, but note that if a US citizen purchases and sells an asset abroad, he is liable for US taxes. The US tax code differs from most countries in their treatment of foreign income. So this sort of capital flight might involve illegal activity, which is frowned upon by the IRS.
Really. So you want to privilege stocks over junk bonds. Because junk bonds are not risky. Oh.
Now personally, I don’t see why the government should subsidize risky behavior. Because freedom. If somebody wants to buy risky Exxon shares rather than buying a AAA Berkshire Hathaway bond then god bless. But there’s no efficiency argument here: the market rewards (beta) risk with higher returns. There’s no reason for the government to subsidize it in one way or another.
Now there are actually some justifications for the status quo where capital gains are treated a little differently than ordinary income. But I’m a little dubious about unqualified risk arguments.
The great majority of capital gains are paid on share issued long ago. So this argument is a bit of a red herring. Now there are actually special tax breaks for entrepreneurial capital gains in the US. But those aren’t being discussed this election season. So your example is highly unrepresentative.
Anybody putting all of their investment money into a single make-or-break investment like that is a moron. If one has a $1m to invest they break it up and spread it across multiple make-or-break investments to diversify the risk. At the and of the year 40% of the investments fail and another 55% win; in the end they pay reasonable taxes because they subtract the losses.
That’s not my understanding. What you write would be correct if they sold all the winning investments, but not otherwise.
I was thinking of something else. You’re correct.
And why is capital gains tax more distortive than tax on ordinary income?
Don’t you lose some labor at the margins as tax rates increase as well?
So why do capital gains deserve preferential treatment over other types of income? Isn’t capital gains just a reflection of the increase in the present value of future ordinary income? Wouldn’t the ordinary income tax on dividends paid by your restaurant pose the same problem as the capital gains tax? why is the problem different enough to justify a preferential rate for when you sell the restaurant but not when you get ordinary income from the restaurant?
What benefit does a large write off give you if you’re broke?
The tax system is supposed to be set up so that every additional dollar you earn improves your life. Some other countries have had marginal rates go over 100%, but that’s really rare.
Again, the difference here is risk. Risk must be priced, or else no one would ever invest in risky ventures. Junk bonds return more for their investment than AAA bonds, or else no one would ever buy them.
The problem with capital gains tax is that it only prices risk properly when a single entity makes many trades, where capital losses offset capital gains. For small investors making one big play, the capital gains tax can actually change a positive expectation into a negative one - something the income tax doesn’t do.
$3000/year
I suspect that small businesses going broke might give you ordinary losses that you can write off against your income as a line cook somewhere. But that just moves the needle back a bit
he was positing someone using their life savings to start a small business. A lot of small business are started this way.
That’s probably true but you have to retire sometime.
Another common way small investors lose everything is to invest in a friend’s or relative’s venture. There, your investment is not treated as your own small business so you get none of the advantages. How many parents have mortgaged a house to help a grown child start a business with a promise of payback that never happens?
Then there are people with investments in the company they work for through stock purchase plans, who may have no other investments. They sell the stock due to a financial crisis and pay a huge capital gains tax. On the other hand, if the company goes bust they not only lose their job but their invested capital, and they may not have any other investments to use the capital loss against.