Capital Gains Are Ordinary Income to Many

During the last election cycle the issue of unique treatment of capital gains tax surfaced as it was determined that Mitt Romney and many other very wealthy Americans pay a lower tax rate than their secretaries because much of their income is derived from investments and not a salary. Those investments, if held longer than a year prior to their sale are taxed at 15% in most situations which is significantly less than the rate high income earners pay on ordinary income, usually around 35%. The rate is on par with the ordinary income level for a single tax filer who earns $8,926 – $36,250 annually based on 2013 rates.

What makes capital gains so special? A capital gain occurs when an amount received when selling an asset is greater than the amount paid for it. Sale of stock is the most common capital gain, however it includes almost any investment including bonds, real estate, equipment, and works of art but usually do not include personal use items. For tax purposes capital gains have been distinguished from ordinary income since 1913 though the rate at which they are taxed has changed several times since then. The drop to current level of capital gains tax of 15% was achieved through Bush II era legislation and represents the lowest it has ever been in US history. Though I don’t recall the Occupy movement ever claiming it as a specific gripe it well should have, and in 2011 Warren Buffett, one of America’s wealthiest (and most successful) investors, added to wealth disparity discussion when he claimed that the favorable treatment he receives on his earnings is unfair

A Rich Man’s Game

With a base in long-term investments capital gains disproportionately affect the rich, and luckily this is not a significantly disputed fact. However, it is my belief that this favorable treatment is unethical and detrimental to the collective welfare of our nation, which will be disputed by some. I propose that capital gains should be taxed just like regular income because after I disprove all the reasons the rich say it is necessary, all that’s left is an unfair mechanism which systematically helps rich to get richer.

The proponents of capital gains getting taxed lower than ordinary income rates usually do so under the guise that it sparks investment which sounds like it could be accurate. Lower taxes on an activity increases the propensity to do it, but it’s actually an argument based only on speculation. When you apply the policy to the behavior options of the investor the capital gains tax makes no difference in the level of investment.

The rich have only the same options that anyone else does with their money: spend it, save it, invest it, and I guess, light it on fire. Assuming these are rich people we’re talking about who already have all the worldly goods they want and can reasonably consume, I think we can rule out the possibility that they will decide to spend more money consuming things or that they decide to burn it out of protest for the new tax rates. So we’re left with the options save it or invest it. I often view those two things as the same thing with just different levels of risk, but the question is, if the capital gains tax rates increase is it likely that rich people are going to stop investing? And the answer is the same in this case as all savvy capitalists’ financial decisions, they will do what produces a greater rate of return. And as long as the economy is not in contraction investing will be a more lucrative option than saving and they will continue to invest.

Knowing that they are going to invest no matter what means that lowering the tax rate on the rich’s return on wealth only changes how much more of the total share is theirs and how much goes toward public services. It does not make investment more lucrative and create more money. It does not change the employment rate, it does not change the amount of economic growth or the amount of investment and savings, and nearly everyone who has studied the correlation between these numbers agrees (I’ll cite: Burman (2012), Hungerford (2010), and Guidolin and La Jeunesse (2007).

It’s All the Same Income

To distinguish investment income and wages might be a headscratcher to those who invest their own money for a living, though, except for Buffett, it’s unlikely they’ll ever mention it so as to sustain the benefits it provides. Either way, investment is their daily profession and the returns they generate are their salary. This should entitle and require them alike to equal treatment when it comes to the rate at which their ‘salary’ is taxed. I don’t view it as particularly noble to be an investor mostly because the only requirement to do it is already having money. It also happens to be the natural and selfish thing (well, second to excessive consumption I suppose) to do with personal wealth. Instead for some reason it is portrayed as a public service and investors are offered a huge tax break on the returns. If anything, the idea that they are not actually directly contributing to the GDP by producing any goods or services should make this a less desirable occupation. As opposed to capitalistic saints, perhaps it is more accurate to view rich investors as freeloaders taking advantage of the powerful stability of US economic system built in part by the consistent hard work of the lower classes, which creates a less risky environment to invest.

The nature of investment very closely resembles that of money lending in that cash is paid for assets which will be more valuable in the future. In investment it is due to appreciation, whereas money lenders call it interest, but the concepts of risks and reward and the time value of money which guide each sector are the same.  Like interest earned in money lending, capital gains should therefore be taxed as regular income.

Common False Support

The national budgetary implication of capital gains treatment is that the tax liability on income for rich investors when they sell some of their assets is roughly halved. That means reversing this policy and taxes at normal income rates will effectively double the tax revenue providing serious relief to national budget woes. “Not true!” the dissenters cry. Ok, yes, the data shows that in years just after a cut in capital gain tax rates occurs, the total revenue from capital gains tax increases despite the lower rate. It also shows that in the last 50 years as the capital gains tax rates have moved progressively lower there has been more revenue overall. I believe these two statistics are accurate but can be easily explained without supporting the notion that a lower capital gains rate is good fiscal policy.

First, the gross level of investment has been increasing dramatically over the last half century so an increase in raw capital gains revenues when these investments are sold would be expected irrespective of even large changes in the tax rates. What proves this best is that in periods when the rate stayed the same for period of time, the revenues increased. If tax rates were increased to the levels of ordinary income, as I propose, the first year or two might see a decrease in net capital gains revenue as some investors might hold off on selling hoping that the policy will get reversed, but eventually these gains will have to be realized and the increased revenue will be there when that occurs.

Second, the increases in total revenue collected from capital gains tax immediately following a decrease represents investors taking advantage of the new low rates. But this doesn’t indicate there is more investment, that anything is better off, or that this effect will last longer than two years. Since capital gains are only incurred when the assets are sold, this merely indicates that investors took advantage to get out of their investments and realize the gains while tax rates were favorable. Think of investments as a pool of water with a gate holding it in. As investment increase the water level over time gets higher. But when you open the gate a whole bunch will spill out. But just because a lot of water came out when you opened the gate doesn’t prove there is more water nor does it increase the amount of water. This flurry of transactions following capital gains tax rate decreases represents sales of investments, which if anything means that money is flowing out of the nation’s total investments. After a couple of years most of the spike effects are no longer seen and revenue levels return to where one would expect if the tax rate hadn’t changed. All up, revenue from capital gains tax is a terrible metric of investment taking place. A much better metric is gross domestic private investment for which the data was analyzed against the capital gains rate here, and funny enough the analyzed data refutes the claim that decreased capital gains taxes spurs investment. 

Other Invalid Concerns

Some have expressed concern that an increase in capital gains tax could insight a market crash with so many people pulling out just before the increases will take effect. Right now the market has been doing well, so you don’t want to discourage investment. Sure, but this can easily be prevented by increasing the percentage over a period of say five years. A 3% yearly increase would not cause a panic to pull out of the market. And since capital gains applies to all investments, where exactly would the money be going instead?

The real threat is that US investors will head overseas looking for more favorable tax rates on their returns. No wait, sorry I got that wrong. Even if US investors channel their money to foreign investments in foreign markets where there is a lower capital gains tax rate, they are still subject to US capital gain tax rates on the income unless they are actually living abroad. So there would be no incentive to invest overseas as some have claimed. I also doubt we’ll see a mass exodus of rich people if we increase our capital gain rates, and I think we might be better off if there was.

Class Warfare

It’s pretty amazing that this idea actually stuck around enough to comment on, but many still claim that raising tax rates for the rich is class warfare, though the same is not said about cuts to social security or other welfare programs. Here’s the thing. It is class warfare, if we must use that term, to decide that the rich alone should be entrusted with job creation. Aside from the fact that they should be the least likely trusted to such a responsibility since they don’t personally have to worry about employment themselves and won’t necessarily care whether jobs are actually created, there is still the point that you can give huge amounts of money to poor people, or anyone, and they will invest and spend just the same which will create jobs. The current system of comparatively lower capital gains tax rates is a gift, and it’s a gift to the wealthiest class. To try to correct that so most well-off group isn’t receiving gifts is not warfare, It’s an ethical attempt to fix the current class warfare on the poor already underway.

Another way capital gains assists the rich is through the benefits which can be leveraged by a more complicated tax code. Many who are unfamiliar with taxation would be lost by the first or second paragraph of this article, but those who are educated and understand the system thrive in it and can do comparatively better than others. A tax code which features varying rates, varying breaks and detailed rules and circumstances generally favors the rich because it creates opportunities to fit through the loop holes. Here is just one example of countless from the corporate world of those with wealth taking advantage of the tax rules by finding a way to set up operations to legally skirt around tax obligations. While the opportunities are technically available to everyone, the ones who are more able to take advantage are the rich who have both financial flexibility and the ability to hire crafty knowledgeable accountants. Having a simpler more uniform tax code including taxing capital gains like ordinary income could prevent many of these situations. Everyone has to play by the rules the tax code sets up, so wouldn't it be a better thing to make those rules more difficult to get around by making them simple and uniform?

Knowing the structure of the investment world and the false arguments that have been posed in support of these views, it's not too difficult to work out that this capital gains tax policy is really just a way for the rich to avoid paying taxes. It allows the income that primarily only the rich receive to be treated more leniently. How many blue collar working-class families heavily discuss their investment portfolio? Maybe some, but not in the dollar amounts to make it a comparable conversation. This is a mechanism for favorable tax treatment for the rich. It is nothing more than that. So the legislature should immediately take action to remove this unfair policy and restore the rate at which capital gains are taxed to the same level as ordinary income incrementally over the next five year. Make taxation rules fair, make it the same for everyone, make income from capital gains taxable at the same rate as any other income.