“Capital Gains” by John Edward

John Edward, a resident of Chelmsford who earned his master’s degree at UMass Lowell and who teaches economics at Bentley University and UMass Lowell, contributes the following column.

The day after President Obama’s State of the Union address, the front page of the Boston Globe had an interesting pair of headlines. The lead was “Obama wants higher taxes on rich, incentives for jobs.” Also above the fold was the headline “Romney’s returns open a window to the wealthy.” Intentional or not, that front page was full of contradictions.

On one hand, President Obama is calling for fairness. On the other hand, he may also be opening new windows for wealthy people like Presidential Candidate Mitt Romney to benefit.

In another example of Winners Stay, the wealthy get both exclusive access to opportunities to make more money and they enjoy a lower tax rate. Wages earned for work are taxed at rates up to 35 percent. What little interest we get on modest savings accounts at local banks and credit unions is taxed up to 35 percent. When the money does the work, the investment returns get a preferential rate of 15 percent.

What we need is less government interference in the form of preferential treatment for those who need it least. What we need is tax neutrality. What we need is a return to a policy of the Reagan era. The Tax Reform Act of 1986 established an equal tax rate for wages and capital gains. Anything else is unnecessary, inefficient, and harmful government interference in markets.

Another contradiction is that the reduced taxes on capital gains are designed to be an “incentive for jobs” as the President is seeking. The theory is that lower taxes will encourage investment and therefore create jobs.

Yet, comprehensive studies fail to find a significant cause-effect relationship between tax rates on capital gains and economic growth. Theory is contradicted by reality.

Warren Buffet has observed that he knows of no investor who will avoid a good investment because of the tax rate on capital gains. Many consider him the greatest investor of our times.

If the investment gets a good return, it will not matter if the tax rate is 15 percent or 35 percent. It will still be a good return. It will still do much better than putting the money in a bank or under a mattress.

Any tax on capital gains, even only15 percent, is an incentive for tax avoidance. The fact that some people will avoid taxes by investing in an offshore account is not a valid reason to lower the tax rate.

A lower tax rate on capital gains than wages does not create jobs. However, it does create a very strong incentive for taxpayers and policy makers to shift income from wages to capital gains.

For example, hedge fund managers receive a fee based on the returns their funds generate. They call this income “carried interest.” Current law taxes carried interest as capital gains. Some hedge fund managers make a billion dollars a year for doing their job. Almost all of that income is taxed at 15 percent.

Proponents of lower tax rates for capital gains claim it is necessary compensation for risk. The hedge fund manager is not assuming the risk.

Further, how much risk is an affluent investor like Mitt Romney actually taking? He reported $21.7 million in income in 2010. Venture capitalists are supposed to thrive on risk. He could put a million dollars in an investment, lose it all, and not blink an eye.

Low-income earners are the ones really at risk. If they put their hard-earned money in a savings account at a bank, they get very low interest. Their interest and principle can be wiped out in a blink of an eye. All it takes is one unexpected medical expense, one car that dies, one hot-water tank that breaks and floods the basement.

Preferential treatment of capital gains is an ineffective way to promote investment. It is harmful because it is a very effective way of making inequality more severe.

The gap between the rich and the poor in this country is extremely wide and getting wider. A lower tax rate for capital gains than for earned income is a big reason why.

Two-thirds of capital gains go to the top 1 percent of income earners. Almost half go to the top 0.1 percent, 95 percent of whom declare capital gains. Only 5 percent of low-income earners enjoy capital gains.

Two of the Presidential candidates advocate eliminating the capital gains tax. Many who take this position complain that taxes on capital gains and dividends represent “double taxation.” The argument is that firms pay a corporate income tax on earnings and the government taxes them again when they are distributed to shareholders. That claim is a red herring.

First, corporations are very good at avoiding taxes. The Tax Policy Center estimates that corporations pay no taxes on roughly half of profits. According to the Congressional Budget Office, corporations paid an effective tax rate of only 12 percent last year.

Second, if the corporation does pay taxes on profits, shareholders pay a separate tax on their capital gains or dividends. It is similar to labor owing income taxes on the pay they get from corporations. Workers also pay social security taxes (Romney paid no payroll taxes on his capital gains). When we get our after-tax paycheck, we then have to pay more taxes – property taxes, sales taxes, and excise taxes.

Finally, shareholders have many opportunities to avoid paying taxes. Shareholders defer taxes on capital gains until they are realized when they sell the shares. They can avoid capital gains taxes completely by passing unsold shares as inheritance. The heirs do not have to pay taxes on the accrued gains. They also use elaborate tax shelters and capital losses to avoid taxes.

Corporations are not unfairly double-taxed, over-taxed, or taxed so high as to discourage investment.

In the State of the Union address, President Obama said: “…we can restore an economy where everyone gets a fair shot, and everyone does their fair share, and everyone plays by the same rules.” The only way to achieve that vision is with a tax system that avoids granting unfair advantages.

When the President calls for eliminating tax deductions for outsourcing jobs, we should embrace it. However, when he calls for tax cuts for companies that stay here we should be skeptical. The “incentive to create jobs” he is looking for may be a new open window for the wealthy and again result in lower taxes for the rich.

5 Responses to “Capital Gains” by John Edward

  1. Joe S. says:

    Rather than raise the Capital Gains Tax Rate to a higher fixed percentage, it is recommended that a better balance between “fairness” and “investment incentive” be reached by taxing long term capital gains at a rate that is 10% (or15%) less than the ordinary income tax rate for an individual. For a person in the 15% bracket, that would be a 5% (0%) tax rate, and for the 25% bracket at 15% (10%) tax rate, and so on, with the 35% tax bracket paying a Capital Gains tax rate of 25% (20%). And if the top tax bracket is re-set to its prior value of 39.6% the Capital Gains rate for those individuals would be 29.6% (24.6%).

    1) Calculate tax based on total income, including long term capital gains.
    2) Calculate the percentage of total income from long term capital gains.
    3) Calculate the amount of total tax attributed to capital gains
    4) Provide a tax credit of 10% (15%) of the amount of tax otherwise due to capital gains.

  2. John Edward says:

    Your formula is fine, as long as instead of 10 or 15 percentage points the differential is zero. The idea is not a higher fixed percentage. The objective is not more revenue. The objective is neutrality and fairness. Equal tax rates. Anything unequal needs to have a compelling rationale, and no such rationale exists for a lower rate on capital gains.

  3. John Edward says:

    I agree with the approach suggested by Joe. S as long as instead of 10 or 15 percentage points the differential is zero. The objective is not a higher fixed percentage or to raise more revenue. The objective is neutrality and fairness. There would have to be a very compelling rationale to diverge from neutrality, and for capital gains taxation that compelling rationale does not exist.

  4. Joe S says:

    I think a preference is valid when one’s own funds are at risk, but not for those who take the benefit based on the investments of others.

  5. C R Krieger says:

    I worry the issue is Federal Debt and not the tax system, but regarding the tax system, I have worried that folks taking short term profits are distorting management strategic thinking.  What does the data show about investing for the long term vs the short, or is this a question the data cannot answer?

    Regards  —  Cliff