03/10/2013 08:14 pm ET | Updated May 10, 2013

Capital Gain, Social Loss

Investments provide two major types of returns: dividends or bond interest based on company profits, and capital gains based on increasing valuation of the asset. Dividends and interest paid from real earnings help power the economy. Capital gains also help power the economy; but in addition they serve as a powerful system transferring wealth to favored individuals -- basically those with money to start with. Favorable tax treatment of capital gains exacerbates this effect. The favored individuals who receive capital gains become relatively better off; everyone else becomes relatively worse off.

Increased valuation of an asset may come from increased capital investment, as when a homeowner modernizes a kitchen or a company modernizes its facilities. Such increases are generally not treated as capital gains, but simply as capital increases. For companies, increasing profits naturally raise valuation as the return on investment increases, rewarding those who set up companies or manage their real growth. As valuations rise, much of the gains, however temporary they prove to be, may be siphoned off by owners and managers. Valuation is often based partly or even exclusively on expected profits, which may be purposefully hyped or even illusory. The dot-com bubble certainly illustrated that situation. An extreme example was Global Crossing; it's market valuation reached an astounding $38 billion the year before it collapsed in bankruptcy.

Obviously people who buy early and sell when the valuation is high reap significant capital gains, while those who buy at the high point experience significant capital losses. Neither of them have made any real contribution to the economy. Overall, the capital gains made by the winning group will offset the capital losses of the losing group. But the two groups are not equal. The winners are more often those with the assets to continually assess the market and adjust their positions, perhaps using insider information or at least information not generally recognized. The losers are often the smaller investors. It has not been unusual for brokerages to tout stocks to small investors at the same time that they have been selling off the same stocks themselves. Shrewd speculators can reap fortunes without making any positive contribution to the economy. An extreme example of that is the recently developed systems for instant trading. Buying and selling stocks with microsecond efficiency can systematically skim capital gains from the market, clearly at the cost of those unable to compete at that level and certainly without any positive contribution to the overall economy.

Major amounts of capital gains are also made by the general appreciation of the market as a whole. An upward climb of the Dow Jones Index or the overall level of real estate valuations will result in major capital gains for investors and speculators. The actual rise in the real asset values will almost always be much less. This rising tide raises all boats; but those without boats -- everyday people with no significant market presence -- lose out. The share of societal wealth held by those with assets increases; those with more assets get more increases.

For successful speculators and many homeowners, the rise in valuation is simply a windfall. People holding these assets not only receive an unearned income, but they also receive a very favorable tax break on the capital gains. The basic justification for the favorable tax treatment is that such capital gains provide investor resources that fuel market growth. So the gains result not only in a significant increase in individual wealth of investors, but are an essential mechanism for funding further economic growth. But how much of these capital gains are actually re-invested in economic development is not clear. Certainly much of this new wealth does not go into investment and some portion goes into further speculation. Indeed, speculators can get rich without making any contribution to society as a whole, while their gains are given favorable tax treatment.

Recent years have seen a steady increase in the share of wealth held by the very wealthy. As a result, wealth inequality in the United States is in the same league with the Ivory Coast and Cameroon. Within the overall U.S. financial system which methodically shifts wealth into the hands of the upper class, the favorable tax treatment of capital gains is one of the major facilitators of this trend. It is of course easy to understand why people who benefit from this system support it -- the same financial elite that bankrolls elections and supports an extensive lobbying effort in Washington. It is harder to understand why people who are continually short-changed would support a system that systematically increases the gap between the wealthy and everyday citizens.

The bottom line is that capital gains in general and their favorable tax treatment in particular are major mechanisms facilitating the continuing flow of wealth to the wealthy. To the extent that this favorable tax treatment facilitates economic expansion, the overall economy is mis-structured. Moving more assets to the wealthy should certainly not be a prerequisite for job development and economic progress.