How can the US justify a 20% long-term capital gains tax rate?

Great Debates
#1

The explanation for why the capital gains tax rate should be lower than that for standard incomes basically (AFAIK) boils down to two arguments:
[ol]
[li]Income from investments has already been taxed once, so taxing capital gains is double taxation[/li][li]The lower capital gains tax incentivizes investment, helping create jobs and grow the economy[/li][/ol]

I call bullshit on both:
[ol]
[li]It’s not double taxation, because, while the money I invest may already have been taxed, the money that investment earns is new. If I earn $100 on an investment of $1000, it’s no different than earning $100 waiting tables.[/li][li]People don’t need extra tax incentives to invest money that would otherwise sit idle – the prospect of earning money on money is incentive enough. Would people really just stuff their money in mattresses if they had to pay full income tax on its earnings?[/li][/ol]
But I am not an economist. Can anyone here justify a top capital gains rate that’s barely half the top income tax rate?

#2

There are other uses for capital other than stuffing it into a mattress. You could put it in savings, tax free bonds, other safer investments, or spend it. You could also invest it in a country with a lower rate. The lower the taxes on investment the more investment there will be on the margin. The more investment the more the economy grows and everyone gets richer.

#3

You are correct that you haven’t paid tax on the earnings, but the reason the earnings are taxed at a lower rate than ordinary income is that you incurred more risk by investing, and also provided more stimulus to the economy and other people. So it is different from earning $100 waiting tables.

Regards,
Shodan

#4

I’m not an economist either, but aren’t you ignoring the risk factor? Investments can go down as well as up, and it’s incentivising the investor to take the risk. To continue your example, there’s no risk waiting tables, but you could lose all of that $1000 in a bad investment.

#5

Not buying it. Capital investments already have an incentive over lower-risk investments: higher potential return. Why should ordinary earners subsidize that higher return with a lower tax rate?

Savings, bonds and other safer investments all contribute to growing the economy, too. So does spending, for that matter. If we lowered taxes on all of them, there’d be more of them, too, and everyone gets richer yada yada. Hell, if all taxes were eliminated the economy would grow like gangbusters.

So why lower taxes on one particular kind of income, when the investments that produce that income already come with the built-in incentive of higher returns?

#6

Yes, but I could also double my investment. Why isn’t higher potential return enough of an incentive? Why do I need a tax break on top of that?

#7

Because the risk is also higher.

Regards,
Shodan

#8

Some number of them would certainly find something to do with it other than invest it in the stock market.

#9

Saying the same thing over and over doesn’t make your justification any more valid.

#10

Isn’t the risk balanced out with tax treatment of capital losses?

#11

You need a cite that investments carry risk?

Good luck with that.

Regards,
Shodan

#12

I’m not sure I buy the “risk” argument either, since low or high risk is already priced into the potential rates of return.

My understanding is that there are a number of historic justifications for the lower capital gains rate: (1) the tax isn’t indexed against inflation, so it is possible that you are taxed on a “gain” that isn’t a gain at all when you take into account inflation; and (2) a higher tax would discourage savings by diminishing the benefits of long term investing; and (3) a higher tax would discourage liquidity: you wouldn’t want to withdraw from a specific investment in order to invest elsewhere or say start a business if the resulting capital gains tax was too high.

Some of these seem like they could be mitigated (e.g. capital gains tax doesn’t apply if you move the investment into another one). It’s hard to be sure as a non-expert how valid these concerns are in the chaotic system that is the larger economy. But those are the justifications I’ve mostly seen.

#13

Either way is saying the same thing over and over again without further explanation.

There’s a quantitative relationship between risk and return. Investors on average (of invested $) will demand some particular additional return for a given increase in risk. Say there are a bunch of investment projects of a certain risk with expected returns of 6, 8 and 10%. None gteed, all equally uncertain. Say there are no taxes on investment returns. There are some investors for whom 6 is enough, for some 8 is enough, for some 10 is enough. Say in the particular market there are enough investors to fund all the 8 and 10% projects. Most projects get funded but the 6% projects don’t get funded. Now put in a investment tax of 25%. The after tax returns are now 4.5%, 6% and 7.5%. Now only the the 10% pre tax/7.5% after tax projects can attract investment. There’s less investment.

OTOH govts have to raise money and there are always competing ideas as to the ‘fair’ way to do this. So just any reduction in investment by raising taxes on capital is not necessarily a convincing argument against that tax on investment. But that is the effect at some point, taxes on capital returns reduce investment, long term productivity growth relies on investment. It’s not very controversial that a negative effects kicks in somewhere.

Singapore is now about the richest country per head whose economy isn’t based on extracting natural resources. No capital gains tax. That doesn’t make it the right policy for any country, but the idea of taxing capital returns at a lower rate is not some scam. There is an economic basis for it.

Also, zero taxes on capital returns doesn’t necessarily mean less progressive taxation. You could have a system where all savings including reinvested capital returns could be deducted from taxable income, but the remaining amount was taxed at progressive rates. Income-savings would be what was taxed, and there would not have to be any lower rates depending where that net amount came from, nor would the rate have to be as low as now for a given net amount to prevent disincentives to investing.

#14

Both sides would benefit by providing some data rather than just throwing out the pro/con side. But the risk of investing is well known and documented, so IMHO the side opposing the tax rate is more in need of support.

#15

For pete’s sake, I’m not arguing against the idea that capital investments involve risk. That’s an obvious given. My argument is that the potential reward of a riskier investment is incentive enough to engage in that investment without an additional tax incentive.

#16

It’s meant to maximize revenue, because capital gains income is much more discretionary than, say, wages. Congress’s concern is that if it were to raise the tax on capital gains to be equivalent to the tax on ordinary income, some significant fraction of transactions just would not happen. Some number of people would decide to hold onto their stock at least for another year and leave their gains unrealized. Thus far, Congress has generally decided that the higher rate of taxation would be outstripped by the shrinkage in realized gains, such that the government would lose revenue overall.

#17

The basic flaw in your argument is treating the issue as binary. People will invest, or they won’t invest. It doesn’t work that way. Rather, higher taxes on capital will make some investment opportunities which were just barely attractive at the old tax rate now outright unattractive at the new one. Some opportunities will be attractive before and after. Others will be unattractive before and after.

The question is how big is that middle ground of investments that won’t be made at the higher tax rate compared to the revenue collected.

Also for capital gains (as opposed to all taxes on capital returns) as they usually work, Tom Tildrum’s point is very important. If the tax is levied only when people sell the investment, a high tax is an incentive to postpone selling it. That can have a dramatic effect on revenue in the shorter term (no way does a 40% cg tax levied that way collect anywhere twice as much as a 20%, nobody serious claims so, it could actually be less at 40% than 20% at least for quite awhile). But it also makes the economy less efficient to hinder investors’ moving their capital to the best opportunities as soon as they see them.

All to be weighed against the subjective needs for revenue and what’s ‘fair’. But saying it’s just obvious ‘people would invest anyway’ at any capital gains rate, implying it would have no effect on investment, is a non-serious argument, sorry.

#18

I will say one thing on the double taxation argument. The taxation on the front end lowers the value of your eventual return on the gain. If I start a business with 100 thousand dollars. I get taxed on the profit from that business. If it’s a public company, I also get taxed on my dividends (so double taxed). This cuts into my profit margin. When I go to sell my company, the taxes I paid earlier depress the value for which I can sell my company. After I sell my company, I get taxed again. The value that was added to the company was added due to profits that were taxed and lower my company value, so it’s a double dip. Of course, a double dip is not necessarily a bad thing. It’s pretty common really. I buy a TV from a company and the TV costs x amount to make, but I pay customs to import it. The company that sells it pays taxes on its profits which it passes through on the price of the TV. I pay taxes on my income to buy the TV and then I pay a sales tax on top of it. The same transaction is really getting hit four or more times depending upon how many hands it passes through. So while the double dip argument is true, that isn’t necessarily a reason not to pay capital gains tax. The dividend tax was the one that I really disliked, but it is much better since Bush II so no real complaints.

#19

Thank you everyone who’s replied with substantive comments! I’d like to dig in a little deeper on my “potential reward is incentive enough” argument.

The average annualized total return for the S&P 500 index over the past 90 years is about 10 percent. (I know there are capital investments beside stocks – I’m just using the S&P as an easy example.) So if I have $10,000 to invest, I can reasonably expect to earn $1000 a year. At the current CG rate, that $1000 becomes $800, or an 8% return. Taxed as standard income, it becomes $630, or a 6.3% return.

Yes, 6.3% sucks compared to 8.0%. But where else can I get a 6.3% return? CDs offer 2.6% (pretax), which works out to 1.64% after taxes.

I still get nearly 4x the return on stocks vs a risk-free investment. I suspect many investors would find that sufficient incentive.

#20

Wealthy investor-type people have better lobbyists than those who rely on ordinary income.