Sunday, August 26, 2012

The problem with the capital gains tax

Tax policy can be frustrating.  A major reason that Mitt Romney pays a lower effective tax rate than many working stiffs is that most of his income comes in the form of capital gains, which is taxed at a preferential rate (the top marginal ordinary income tax rate is 35 percent, while the long term capital gains rate is 15 percent).  It may therefore seem that the easy way to implement a "Buffet rule" would be to match the capital gains rate to the ordinary income tax rate.

There are three policy dilemmas here, along with a practical problem.

The first policy dilemma is that some capital gains are nominal--they don't reflect changes in purchasing power.  We recognize this problem in other places in the tax code--for example, we adjust tax brackets for inflation every year.  The problem could be solved using indexing--we could tax real capital gains at the ordinary income tax rate.

The second dilemma is perhaps more controversial.  In a Solow-Swan world of economic growth, more savings produce a larger and newer capital stock, both of which are key to growth (Barro and Sala-i-Martin have a lucid description).  If they are correct (and the consensus is that they are), then policies that encourage both savings and flexibility are good policies.  To some extent we do this with our retirement tax policies: so long as savings remain in a retirement fund, their returns go untaxed, even when securities within the fund are bought and sold.  With respect to capital gains policy, this implies that we should discourage the consumption of realizations of gains, but should encourage investment flexibility.  In other words, if someone sells her winners in order to buy a Jaguar, she should be taxed, but if she sells winners in order to reinvest somewhere else, she should not.

The second dilemma creates a third dilemma--the investor who makes smart decisions accumulates considerable wealth, which could lead to disproportionate political power.  Capital gains preferences accelerate this phenomenon.  This is particularly vexing.

Now for the practical problem--the statutory capital gains rate can be considerably different from the effective rate (my approach here follows the argument in Dave Geltner and Norm Miller's Textbook, Chapter 11).  Consider an investment that pays no dividends that grows in value at 10 percent per year in a world with a statutory capital gains rate of 20 percent.  Suppose the investor holds that investment for ten years, and then sells it.  To put some numbers on it, a $100 investment will grow to $259.37 in value.  The capital gains taxes will be $159.37*.2=$31.87, so the net to the investor after capital gains taxes with be $227.50.  The internal rate of return on the investment drops from 10 percent before tax to 8.6 percent after tax.  Consequently, the effective tax rate is not 20 percent, but 14 percent.

If we stretch out the investment horizon to 20 years, the effective rate drops to 10.3 percent; if we reduce it to 1 year, the effective rate matches the statutory rate of 20 percent.  The point is that regardless of the capital gains rate, investors have considerable discretion at determining their effective rate.  So it is almost certain that a behavioral response to a higher capital gains rate would be longer periods of time between realizations, hence lowering the effective rate.  When it comes to figuring out tax policy, nothing is easy.



Walt French said...

An “unfortunate” side-effect of indexing is that the IRS might reasonably require you to file contemporaneous proof of purchase in order to reduce back-dating, etc, to scam the indexing rules.

While of no concern to ordinary, honest taxpayers, it could dramatically reduce opportunities for those who would wish to dodge ANY taxation at all. I'm sure many would oppose it on “excessive intrusion and paperwork” grounds.

Unknown said...

Perhaps people who consistently make smart decisions (and thereby become rich) should increase their political power, at least to a reasonable extent.

Unknown said...

Capital gains should of course be not only indexed, but imputed to all the years of the holding period. If that were done they can be taxed as ordinary income. If one wants a concumption tax rather than an income tax, then that's a different argument. It implies allowing tax deductability of all increases in assets, not just those purchsed fromt he sale of other assets.

Kaleberg said...

If capital gains are taxed as ordinary income they should not be indexed, because wages are not indexed even as the value of an hour's labor might increase for an individual. If you want a level field in the class war, the tax code should have no preference as to how money is earned or otherwise acquired.

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Unknown said...

Nice blog.interesting to read and useful to us.
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Unknown said...

Very interesting post! Thanks for sharing this information. It is certainly interesting, and I definitely agree that capital gains should be indexed.

David Martin said...

Investor who makes smart decisions accumulates considerable wealth, which could lead to disproportionate political power.

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