Winner.
Phrasing to set my understanding to avoid conusion:
If you sell within a year, and are in the income bracket where your long term capitol gains rate is 20% the short term rate is 39.6% or the same as standard income. (ignoring the 3.8% net investment income tax for high value individuals)
The government has good reason to offer that lower long-term rate to encourage long term investments and saving but short term capitol gains are treated as normal income to avoid abuse. Note that the short term rate is also to avoid people with lots of money avoiding taxes by structuring their income as investments to avoid that extra 19.6% from income tax.
The only thing that justifies it to me is inflation. If you buy and hold a stock for 20 years it will probably have doubled from inflation alone but you’ll be no better off when you sell it. In fact if it merely kept pace with inflation you’ll be down 10% cause you’ll be taxed on 50% of the entire worth which in actuality hasn’t changed.
My solution is to tax capital gains the same as income but indexed to inflation. That way the little old lady with a nest egg of safe stocks won’t get hammered if her only income is investment, but the hedge fund manager who makes millions gambling on a lucky year won’t get to avoid a lot of taxes by recharacterizing his income as capital gains.
You’re right – in my haste to put together a simplistic example, I forgot about the “long-term” aspect of the CG rate.
But my argument holds true over the length of time required to achieve CG status. The overall expected return rate still vastly exceeds what you can get for a risk-free investment, whether it’s taxed at normal or CG rates.
This makes a lot of sense to me.
Re: (1), I recall just one country (Ireland?) indexes capital gains for inflation. It’s extra work but doable.
The average annualized return over the last 90 years is not at all the same thing as the ROI on any given investment. Maybe index funds are better for the average investor than venture capital overall, but that is not the same thing.
That is exactly the question that investors ask. And the answer is not necessarily “nowhere”.
See also what Corry El has to say - it is not binary. Economics operates largely at the margins. There is going to be a group of people for whom 8% is enough to overcome their fear of risk, but 6% isn’t. That isn’t everybody, but it is somebody, or somebodies. Maybe they will invest overseas, or take their compensation in non-taxable ways, or spend it on hookers and blow.
Sure, maybe we tax capital gains at ordinary rates. And people will adjust. But keep something else in mind - people will adjust. They won’t necessarily just shrug their shoulders and accept a lower ROI.
Regards,
Shodan
Many investors would find that sufficient incentive, but tolerance for risk varies greatly among the population. There are always going to be marginal cases.
However, that’s the case for all sorts of income - and the government, if it wants to pay for anything, has to get its income from somewhere.
If it forgoes, say, a million dollars of capital gains tax income by having a CGT rate slightly lower than it could be, then they either have to raise more money from sales tax (meaning some people at the margins will buy less than they would) or income tax (some people at the margins will work less than they would), or borrow it it (so they’d pay interest) or forgo spending that million dollars (which you can’t keep doing indefinitely and still have a government).
If you’re making an economic incentives argument, you should really show that investing is a more useful thing to the economy than working, spending, or any other sort of economic activity that is taxed, which seems non-obvious to me.
This.
Having a CG tax rate significantly lower than the general rate seems to me like a case of the government picking winners and losers among investment types. I thought conservatives were opposed to that.
Actually if the suggestion is raising taxes on investment, you should really show that government spending overall is more useful to the economy than investment.
Regards,
Shodan
Lets do a little more (simplified) math*.
Lets say you have 1 million in investments. You do well and make %10 a year. So you earn $100,000. (Note, it is likely that the earnings are more like 8% these days for most investors so this is being optimistic)
Rich! Wildly Rich! You can buy anything!!! says the person who soon ends up poor.
First, inflation. Inflation runs roughly 3% a year, historically. That means to keep your 1 million in buying power you need to add at least 3% onto the principle every year. 3% of 1 million is $30,000.
100,000 - 30,000 = 70,000 spendable.
Second, taxes. We will assume that the investments are long term holdings. That puts the tax rate at either 0, 10, 15 or 20%. Most people are likely to fall into the 15% bracket if they have a million in the market.
70,000-15,000 = 55,000 spendable.
State taxes. This is variable. For California, it is 9.3% for 100,000 (if the website I looked at is correct). Nevada is 0. New York is 6.85 (state) and 1.9 (local) = 8.75. We will do California.
55,000- 9,300 = 45,700
Fees. Fees can run between 1 and 2% of the total value of the account, sometimes much higher.
45,700- 10,000 = 35,700.
Wow, suddenly your $100,000 is ~$35,000 spendable.
Now, keep in mind that folks who live off of investments are likely to be too old to run out and get a job. If the capital gains rate is changed from 15% to 25%, the spendable amount drops from ~$35,000 to $25,000. A 10% hike in federal capital gains taxes causes a ~30 drop in spendable money for this scenario. That really hurts retirees. If you raise to to 35%, spendable drops to ~$15,000. At some point, people are going to say the return isn’t worth the risk and start living off of the principle which means investing less.
Now, I suspect the real problem isn’t the actual capital gains rate but rather folks like Bill Gates who are gazillionaires, the wealth gap. A big part of this (or at least as far as I can tell) is that in the 90s, the marginal tax rate increase from 28% to 39.6%. Folks who are in this category started taking stock options instead of large salaries. The reason is that incentive stock options are taxed as a long term capital gain instead of as income if held long enough. So, %20 max tax rate instead of %39.6. So CEOs started taking small salaries and large stock grants. Over time the value of the stock grants grew while the tax on the stock options stayed low and the owners of the stock grants got really, really rich. Now, people want to tax those really, really rich people by raising capital gains taxes. However in the process Grandma and Grandpa, who worked hard and saved their whole lives to retire, get killed. So politicians are stuck, cause if they go after the really rich people, they hurt poor Grandma and Grandpa. Grandma and Grandpa also happen to be very loud about these kinds of things.
Slee
*This a very simple run through and won’t be 100% correct, but it will be in the ballpark.
Some number of things that the government wants to do are always going to be more worthwhile than others. But if it turns out that raising money from having higher income tax is more economically damaging than raising money from capital gains, one thing you would never do is forgo spending the money and then lower CGT. You would forgo spending the money and lower income tax, or actually spend the money and keep both rates the same.
ETA: @Shodan, obviously
I don’t see that there is any argument based on risk or on the encouragement of investment that would justify having a lower tax on capital gains than on dividends. I don’t see any risk-based argument that wold justify the same capital gains tax rate on stock and on Treasury bonds selling at a discount. So I believe those arguments to be ex post justification.
In a related matter, I see no justification for both eliminating estate taxes and simultaneously allowing the cost basis of assets to be updated to the price at the time of death.
But the risks are not all equal, yet the “reward” for risk is. Maybe that’s what needs to change. Investing in Coca Cola ought not to be treated the same as investing in Space-X.
Unless I’ve missed it, I don’t think anyone has corrected this factual error in the OP. The double taxation issue is not what you describe here. It is the fact that both corporations and shareholders are taxed on the same earnings.
Corporations must pay pay tax on their earnings. Then shareholders must pay tax again on those earnings, either through the taxation of dividends if the corporation distributes those earnings, or through the taxation of capital gains if the corporation retains the earnings (retaining earnings implies a higher stock price).
If you want something to get angry about with cap gains tax, it’s the step-up basis, which is the way that the U.S. tax system wipes out any capital gains tax liability for assets with unrealized gains at death. Nominal U.S. estate tax rates are already low (or at least the exclusion is large), and this loophole makes the effective estate tax rate even lower, allowing wealth to be retained by wealthy families.
You’re right – that does make more sense as a reason people would cite double taxation.
However, I still don’t agree it’s a good argument for a lower capital gains tax rate. (Although it is, IMO, a good argument for a lower rate on dividends, and maybe even a good argument for the Friedman-esque idea of abolishing corporate taxes altogether.) There are lots of investments other than stocks that qualify as capital gains. If I buy a Van Gogh and sell it ten years later at a profit, the Van Gogh wasn’t paying taxes all those years. Why should my profit be treated differently than ordinary earnings?
Exactly, this loss of economic activity is called deadweight loss and should be the primary factor in the type of taxes leveled. Conventional economic theory is that the deadweight loss of taxation varies by the elasticity of what is taxed and is proportional to the square of the tax rate.
Most economists agree that the elasticity of labor supply is less than it is for capital because it is much harder to change jobs than it is to sell a stock. Thus the deadweight loss for capital gains is much higher than loss from income taxes. Since the loss is proportional to the square of the rate this means that the rates for capital gains should be much lower than for income. In theorythe optimal tax rate on capital is zero, however it is probably not actually zero because reality is not fully matched by the model.
I’ve never understood the idea that investors should have a lower rate because they have higher risk, because they don’t. When Warren Buffett makes an investment, his risk is extremely small. When a single mother works as a waitress, her risk is extremely large. Nothing that Warren Buffett does could possibly lead to him losing his home, for instance, but the waitress could lose her home just from one capricious decision by a manager. That’s what real risk looks like.