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  • About Those 15% Capital Gains Rates

    Posted by David Foster on August 21st, 2011 (All posts by )

    Warren Buffett has been talking virtually nonstop about how tax rates on “the wealthy” need to be increased, and of course the dinosaur media has been praising and amplifying this viewpoint. People who think this way are especially fond of citing the 15% capital tax gains rate and contrasting it with the considerably higher rates on ordinary income.

    This simplistic comparison, though, ignores the effect of inflation, which acts to increase the effective tax rate–especially on assets which are held for a long period of time. Consider a simple example: let’s say you bought a stock in 2003 and sold it in 2011, with a 30% price increase. To make the numbers easy, you bought $10000 worth and sold it for $13000. But according to BLS data, the consumer price index has risen by 22% over the years 2003-2011. Thus, your $13000 is really only worth $10655 in 2003 dollars.

    It gets worse. The IRS is going to tax you on the full $3000 of “gain,” even though it is largely illusory. At 15%, you will pay $450, which is a very big chunk of your true, inflation-adjusted gains. If you work through the calculations, you’ll find that your real capital gains tax rate for this example is not 15%, but more than 50%. (I’ll post the calculations if anyone wants to see them.) Indeed, if you buy and sell an asset whose value just keeps pace with inflation–ie, if you don’t make any money at all in real terms–you will still be paying capital gains taxes on wholly imaginary profits. If we get Jimmy-Carter-style inflation…say, 40% over the next decade…and you have an investment which just keeps pace with inflation, then federal taxes will take 6% of the value of your investment (15% times 40%) when you sell it. And that’s assuming that the current capital gains rate does not increase, and ignoring any state-level taxes on capital gains.

    Warren Buffett is surely aware of the preceding considerations, and anyone who writes about finance and economic policy should be aware of them.

    A good video by Christina Sochacki, for the Center for Freedom and Prosperity, about the problems with the capital gains tax, here.

     

    10 Responses to “About Those 15% Capital Gains Rates”

    1. tyouth Says:

      Owning physical metal such as gold or silver coins may have an advantage in this regard, for the small investor. While it’s not impossible that the government would obtain the various commercial seller’s records it would be quite a chore. Those coins bought would have preserved value and not be hit by capital gains at all when the investor (or should one say “hedger”) sold his coins piecemeal.

      With inflation at around 12%, it’s worth a thought.

    2. David Foster Says:

      Tyouth…the odds of getting away with this probably depend on the size of the transactions. If you report the sale of $100,000 worth of gold, I expect that the IRS may well want to see some purchase records…and if you *don’t* report the sale (and hope that the buyer doesn’t either), then you are concealing income, which IIRC carries some pretty severe penalties.

      This does make the point, though, that higher tax rates tend to encourage off-the-books transactions. It doesn’t justify them, though….I think we should leave illegal tax evasion to Democratic congresspeople and cabinet appointees.

    3. Robert Schwartz Says:

      The major justifications offered for the differential treatment of capital gains and other forms of income are:

      1. The 16th Amendment authorizes Congress to tax income, not capital. Capital gains are much like income, but they also also capital. The capital gains preference recognizes and harmonizes that tension.

      2. The income tax uses a table of escalating rates, and it is an annual system. Capital gains derive from holding assets for a period of time greater than a year. If there were no preference, capital gains would be taxed at higher rates than periodic income.

      3. Inflation as noted above.

      4. With respect to Corporate shares, capital gains taxes future profits that will also be taxed by the corporate tax system when they are earned. This is a double tax. The capital gains preference removes some of that sting.

      The NYTimes also ran a thumb-sucker about capital gains yesterday:

      http://www.nytimes.com/2011/08/20/business/questioning-the-dogma-of-lower-taxes-on-capital-gains.html

      It did not engage these issues, but digressed on the unfairness of treating hedge fund partners “carried interest” as capital gains, rather than ordinary income. There actually is a real issue there, but it derives from the system of partnership taxation that passes through characterization of income and expense to the partners, before taxing it. If the characterization were deferred through the capital accounts, the tax could be done differently.

      The rest of the column claims it is unlikely that the existence of the capital gains preference actually encourages investment and risk taking, although his case is thin on that item. His final fall back is fairness. Any time the subject of fairness is raised, a voice in my head whines: “But that’s not fair to ME, mommy”, like my kids did when they were young.

      My bottom line is that the current capital gains system has worked pretty well. If we raise the rates, we can be fairly certain that there will be less revenue realized from capital gains. However, if there is a major broadening of the tax base, by eliminating at least the home mortgage interest deduction and the exclusion/deduction of health insurance premiums, the top marginal rate is lowered to less than 25% and asset basis is adjusted for inflation, and the corporate tax is lowered and stopped at the waters edge, I would be willing to see the capital gains preference disappear.

    4. tyouth Says:

      David, we forget a recent development: “….Utah has passed a law intended to encourage residents to use gold or silver coins made by the Mint as cash, but with their value based on the weight of the precious metals in them, not the face value …”
      ” The legislation, called the Legal Tender Act of 2011, was inspired in part by Tea Party supporters, some of whom believe that the dollar should be backed by gold or silver and that Obama administration policies could cause a currency collapse. The law is the first of its kind in the United States. Several other states, including Minnesota, Idaho and Georgia, have considered similar laws. ”

      No problems, I guess.

    5. tyouth Says:

      using a Visa credit card that makes charges against the value of their holdings. Mr. Franco noted that state law, for now, left it to the private sector to figure out how conducting business with gold and silver should work.
      Referring to using a VISA card to debit physical gold holdings;

      “The regulation of the system?” Mr. Franco said. “There is no regulation of the system. We are working out the nuances of it.”

      “Mr. Franco is among several supporters who say the law’s most important feature may be that it eliminates state capital gains taxes on the sale of gold and silver, a move he thinks will prompt individuals and large scale investors outside the state to move their gold and silver to Utah. But federal capital gains taxes would still apply.

      “I would hope the federal government would simply concede: ‘O.K., you’re right, it’s money, so we can’t tax it,’ ” said Larry Hilton, a lawyer and insurance broker who first took the idea to lawmakers. “But that may not happen.”

      Article 1, Section 10 of the Constitution says no state shall coin money, though Mr. Hilton and some others argue that a phrase used later, saying no state shall “make anything but gold and silver coin a tender in payment of debts” can be read as a license for Utah’s new law and, perhaps, for a state’s right to mint its own coins.”

      http://www.nytimes.com/2011/05/30/us/30gold.html?pagewanted=all

    6. tyouth Says:

      “The regulation of the system?” Mr. Franco said. “There is no regulation of the system.

      Regggulassions? We don need no stinking reggulassions!

    7. Vader Says:

      I’d probably be okay with applying the usual tax rate to capital gains if indexing was used to adjust for inflation. Is there a problem with this that I, as a non-economist, should be aware of?

    8. C R Krieger Says:

      A friend of mine says that since one is paying in inflated dollars, it all comes out in the wash.  Is this the case?

      Regards  &mdash  Cliff

    9. C R Krieger Says:

      I so like comments preview.

      Regards  —  Cliff

    10. david foster Says:

      CRK…”A friend of mine says that since one is paying in inflated dollars, it all comes out in the wash. Is this the case?”

      No. It is true that you are paying in inflated dollars, but you are paying a rate based on an inflated gain, and the second factor outweighs the first. In my example:

      You pay $450 in 2011 dollars, which is 15% of the nominal gain of $3000. That $450, it is true, only represents $369 in 2003 dollars (450/1.22) But your pretax gain of $3000 was really only $655 in 2003 dollars (13000/1.22)-10000), so your effective tax rate was 369/655, which is 56%.

      Perhaps an easier example would be if you hold an asset whose price exactly keeps pace with inflation: say the inflation is 40% and your asset appreciates by the same amount. Obviously, you haven’t really made any money by holding the asset; however, the IRS will charge you 6% of the sale price (15% time 40%). Even though the money you use to pay the 6% tax is indeed devalued (it is “only” 4.2% of the pre-inflation value of your original investment), it is obvious that you are paying a real tax on a completely imaginary gain. Basically, this is a retroactive wealth tax.