Inequality: Why the Capital Gains Tax Rate should be Raised

Now that the New York State Attorney General has started an investigation into the practice by some private equity firms, including Mitt Romney's old firm Bain Capital, of funneling management fees (which are taxed as ordinary income at 35%) back into their funds so that they could come out at the other end as capital gains (which are taxed at the lower rate of 15%), the debate about whether such tax dodges should be allowed is sure to get plenty of attention.

But the other issue that also needs to be addressed is whether capital gains themselves should receive the preferential tax treatment that they currently do. I first raised this issue months ago in my piece entitled Tax for Thought: Paying Less is not More.

Capital gains are a form of passive income that arise not from working but from realizing profits from investments. While there is nothing wrong with making money passively, there is no defensible reason to tax that type of income any differently than the wages of say, a policeman or a cashier at a fast food restaurant. After all, those people contribute to our economy as well, so why should they be treated differently?

The common argument goes that a lower tax rate on capital gains encourages Americans to invest more money and help grow the economy, which in turn leads to higher tax receipts for the IRS. That may be true up to a point but it is worth remembering that tax revenues from increased investment activity are also offset by revenues lost due to lower rates on capital gains. According to the Congressional Research Service, the capital gains tax break amounts to $71 billion per year, an amount that could put a handsome dent in our deficit.

The other argument for keeping the capital gains tax rate low has to do with double taxation, since businesses already pay taxes on their income, which is then effectively taxed again when passed on to investors. That is a valid point but it fails to take into consideration the fact that many companies, especially the biggest ones, rarely pay full taxes on their income due to the vast variety of tax loopholes and credits available to them. As a result, the problem of double taxation is often overblown and more a convenient myth than a reality.

And finally, there is the issue of fairness. While investment activity may not be limited exclusively to the wealthy anymore, it is still a much bigger source of revenue for the rich than for the middle class, which leads to an imbalance in the tax treatment. Most Americans live on paychecks and are therefore stuck with paying 35% or more on the bulk of their earnings. In that way, the preferential tax rate on capital gains becomes a form of "entitlement" for the wealthy, and penalizes everyone else. The actions of companies like Bain Capital that move money around to enjoy lower tax rates further amplifies this inequality, since ordinary citizens and even small businesses simply do not have the means to reduce their taxes via these mechanisms.

President Obama wants to raise the capital gains tax rate to 20%, which I think is a good way to restore some equality while preserving the impetus for investment. His challenger, on the other hand, does not want to raise the rate at all, which is not surprising given that Romney himself made a lot of money on the back of a preferential capital gains tax rate - first through his involvement with Bain and then via his private investments; and that renders his view disturbingly self-serving.

In any case, for the sake of sheer pragmatism, it is high time that the capital gains tax rate was raised. It will be good for our deficit, good for equality, and good for our economy.

Sanjay Sanghoee has worked at leading investment banks and hedge funds and is also the author of a financial thriller, MERGER. Please visit www.sanghoee.com for more details and to sign up for updates.

 

 

 

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Comments

[Jripjr]

09:02 AM on 10/31/2012

Majority owners of an LLC corporation that work for that company are K1 employee's not W2 employees. Therefore they pay at the capital gains tax rate. Many small businesses are LLC's just trying to stay afloat in this economy. Do you know what a percentage increase to the capital gains tax will do to all of these small entities!!!!!!!

[she-she]

08:33 PM on 10/26/2012

who will invest if they are taxed to death simply for investments. Raising the Capital gains tax will only discourage people from investing thus lessening the tax revenue. What gets me in those commercials that make the wealthy like Mitt look greedy and evil because all of his income was based on capital gains and he paid a 14% tax rate yet , they said a man making $50,000 pays 25% is so misleading. If that man making $50,000 made his income in capital gains then he too would only pay the now rate of 15%. The obama ads rely on people not checking the facts and on their ignorance. The Obama camp is putting fear into people especially the elderly about this totally inaccurate so called "voucher" system he says that Romney is going to turn our healthcare into also hooey. It isn't a voucher program and only applies to people who are under 55 now who are not receiving medicare benefits now. If you are under 55 now and on disability and are receiving benefits it won't apply to those people either.

[DoubleSecretProbation]

07:21 PM on 09/26/2012

There are two things the author overlooked. A taxpayer is not forced to sell a capital asset and therefore is not forced to pay capital gains taxes. That is why I am sceptical that higher capital gains rates will automatically generate more tax revenue. The second issue is how to treat capital losses. If gains are taxed at ordinary rates losses would have to be deductible at ordinary rates also. That in turn would encourage investors to sell their loss assets and hang on to their gain assets. Anybody who thinks this issue is simply a matter of "fairness" has not done their homework.

[Alan Rudo]

10:25 PM on 09/13/2012

Raising capital gains rates also encourages corporations to move oversee. I have a software technology company that can operate anywhere in the world. If I incorporate a star tup to operate in Singapore I can have my max tax rate is 17% only above $300,000 and there is zero double taxation. In the U.S. it's 34% tax rate starting at $335,000 of income. On $335k that's a difference of $56,950. Add some zeros behind those numbers and you can see why companies are flocking overseas. As a business concern you'd have to be nuts or receive huge local incentives to offset such financial incentives. Hello when MIT has Singapore facilities for hi-tech startusp, people need to get a clue.

[spriddler]

02:16 PM on 09/04/2012

There are abuses that should be curbed and people (the ultra rich) truly using capital gains as income should be taxed as doing so. However this tax increase will hit a lot of middle class people as well. I use investments to build up a nest egg. The more those gains are taxed the more money I have to save to achieve my goals which means the less money that I will be spending. That effect multiplied for everyone else in the middle and upper middle class that invests in the market outside of their retirement plans will cause a significant reduction in consumer spending.

I also think the estimate of $71 billion/yr in lost government revenue is a bit rosy. That may be true if investment flows remained unchanged, but if taxes on investments are raised significantly there will be a corresponding shift in investment flows which will result in fewer capital gains.

I'm not saying that nothing should be done by any means, but we shouldn't pretend that across the board tax increases that the author is advocating will be painless.

[Vince Almaraz]

01:25 PM on 09/04/2012

This is an overly simplistic view of the Capital Gains Tax. Bill Clinton lowered the Capital Gains tax and Gov't revenue INCREASED, which is exactly what his economic advisers told him what would happen.

"...there is the issue of fairness." Oh, please. The only "fair" is the County Fair.

[bgbytoys]

12:22 PM on 09/04/2012

how companies like bain operate. buy a undervalued company. leverage it to the hilt. pay yourself a dividend of the mortgage proceeds. taxed at capital gains rate. make the company fend for itself on its debt.

the tax code in general needs to be revamped. if you derive your income from capital gains items, you should pay more.

yes it is about what is fair and equitable.

[hroark314]

12:12 PM on 09/04/2012

There certainly is a defensible reason for low capital gains tax rates. It has to do, not with the taxation of corporate profits, but with the taxation of dividends. Capital gains taxes create a barrier to selling appreciated stocks because the after-tax income from selling the stock is less than the expected value of future dividends. This decreases liquidity and increases investor risk (which can, in turn, help exacerbate financial crises).

To explain in detail, the value of a share of stock is equal to the present value of the expected after-tax dividends. For example, take a stock that is expected to pay an annual $1 dividend in perpetuity. If an appropriate discount rate for the stock is 10%, then the stock should have a market value of $1/10% x (100% - 15%) = $8.50. The 15% represents the tax on dividends (assume, for sake of this example, that that tax rate is not expected to change). Let's take an investor who bought the stock at $3.50. If he sells the stock he will receive $8.50 - ($8.50 - $3.50) x (15%) = $7.75. So, the stock has more value to him if he holds it rather than sells it.

This isn't to say we shouldn't have capital gains taxes (that discussion is simply too complicated for a blog post). It's just there is a good reason why it should be low.

[FBO2012]

03:56 PM on 09/04/2012

This is of course correct, but the people on this forum don't care. They want their free stuff and any way to get more money, regardless of the distortions, is fine as far as they're concerned. We live in an age where consumption is good and saving/investment is bad so all the logic you just presented will never get through.

[hroark314]

05:51 PM on 09/04/2012

You're probably right, but it's fun to try.

[Wayne Caswell]

11:06 AM on 09/04/2012

Tax Capital Gains as ordinary income, NOT at a discounted rate of 15% or 20%. Encourage Work and Production, not just Investment. And for the double taxation argument, corporate profits go toward paying both investors AND workers. They should each be taxed the same way, based on a progressive income tax.

[FBO2012]

03:52 PM on 09/04/2012

"corporate profits go toward paying both investors AND workers"

First of all, a corporate "profit" is be definition AFTER paying all expenses so how can a profit go to paying workers? In America, workers have no claim on a companies earnings and please try to remember that corporations exist for only one purpose and thats to make money for owners/shareholders. Secondly, Bill Clinton, the Democratic Icon was the original cap gains tax cutter and I hope you're not going to talk badly about Slick Willie?? Encouraging investment is the key to growth so why would you want to discourage investment?

[MS Ind]

10:49 AM on 09/04/2012

The reason capital gains are taxed at a lower rate is because capital gains taxes is a form of double taxation - the corporate profits are taxed before they are passed down to investors, where they are taxed again.

But don't worry, Obama's Medicaid expansion already increases the tax by 3.8%.

[Brian Whittle]

01:22 PM on 09/04/2012

you are talking about dividends which is small change in investments where most of the money is made on share price which has nothing to do with tax paid

[MS Ind]

01:30 PM on 09/04/2012

No, I'm talking about capital gains (at least capital gains from investments). Although the corporation isn't actually giving investors a check, they pay taxes based on their percentage of the "gain" in the stock or other investment. This "gain" is reduced by corporate taxes before it is reflected in the stock price. 
Double taxation.

[nothingchanges]

10:46 AM on 09/04/2012

"Labor is prior to, and independent of, capital. Capital is only the fruit of labor, and could never have existed if labor had not first existed. Labor is the superior of capital, and deserves much the higher consideration." -Abraham Lincoln-

Yet in America today the top tax rate for "labor" is 35%..........while the top tax rate for long term capital gains is 15%.

"The rich get richer, and the poor get poorer"

Not just because the rich work harder, or are better educated. But because our SYSTEM is corrupt and unfair.

When "legalized bribery" is the means we use to finance our elections.

How could it be otherwise?

[Lorri354]

09:15 AM on 09/04/2012

The author is so one sided its not even funny its really high time that the capital gains tax rate was raised. It will be good for our deficit, good for equality, and good for our economy.

Lets hit each one of these items:

Deficit - saying you need to take more from others because you can't control your spending. This is like saying I'm planning to over spend my family budget by 100,000 but thats okay because the bank has money so I'm going in and take it from them (you know steal). Its theirs yes but I think I can do better with it.. REALLY? The Deficit is from SPENDING what you DON'T HAVE. Anyone's deficit gets better if you take from someone else.

NEXT: good for equality - those people who scrimp and save, spend inside their means and then invest so that they can do better for themselves and their family. THOSE people should should be penalized even MORE THAN THEY ARE because they are working and staying inside their means. Is that equality? Since folks making $10 /hour make more than minimal wage we should then split their difference and give that to those making less - equality. Let the waiters work hard & we'll give their money to those making less - that's equality too.. Maybe no one should save - instead spend everything we have immediately and just hope the govement will bail us out..

Good for our ecomony: How-keep feeding the irresponsible

[chanahan]

09:13 AM on 09/04/2012

The author does not do a good job of defining a capital gain. Does he mean when one buys a stock and then sells it for more money after the value increases? In this case, the tax paid depends on the length of time the stock was held. This is to discourage speculation and encourage longer term investing. If he means dividend income from stocks owned, that money has already been taxed once at the corporate level and is being taxed a second time when it is distributed to the individual so the rate should actually be 0%.

The income may be passive in the sense that the person is not physically doing anything like a policeman for his income, but the idea that the business is not using that captial actively is incorrect. The person has given the business capital to actively use.

One last point, the author in stating that lower rates on capital gains benefits rich people more does not include pension funds in his assessment. Pension funds are the largest shareholders and benefit mainly middle class people (I don't think Gates has a pension).

[vipersdad]

02:38 PM on 09/04/2012

You make a lot of good points. At the risk of further complicating our tax structure, there are capital gains and there are capital gains and there are capital gains, which you point out.

The behaviour of shifting revenues to investments to avoid taxes should be dealt with directly. I cannot comment on it's legality but it feels fishy.

[chanahan]

04:06 PM on 09/04/2012

Since the author wrote such a shallow piece on the subject, we really don't know what he meant.  There are certainly shenanigans going on to reduce taxes, which is a reason to simplify the income tax or eliminate it altogether in favor of a consumption tax.

[gunthli]

09:09 AM on 09/04/2012

Also, do away with traders paying 15% taxes on whathe earn rather than the 35% that eveyone pays. they make a tremendous amount of money so why give them a tax break?

[MrMaus]

01:05 PM on 09/04/2012

The 15% capital gains rate is only on investments held longer than a year. So if you are talking about day traders and speculators, they pay 35% on the income they earn.

[ErikKengaard]

08:59 AM on 09/04/2012

A concern is that so-called capital gains that result simply from depreciation of the currency are taxed at the same rate as other capital gains. A tax on inflation is insidious.