Capital-Gains Tax

Dear John,

       First, as my “friends at Microsoft” were quick to note, the profit on exercised employee stock options is taxed as ordinary income, not capital gain. Therefore, the concern I expressed in my article that opposing a capital-gains tax cut might make me unwelcome in the company cafeteria was unwarranted.
       Now to your arguments. Although we both refer to the “capital-gains tax,” there is in fact no such tax. There is an income tax, and capital gains are a form of income. The issue is whether this particular form of income should be taxed at a lower rate than, say, wages or interest on a savings account.
       Your first point is that capital gains represent increases in the present value of future income, not income itself, and therefore shouldn’t be taxed. Your analogies: “[A] building’s actual rental income” is taxed, but “not expected future rents”; ditto a doctor’s “actual earnings,” but not a medical student’s “earning potential.” The capital-gains tax, as it happens, works in precisely the same way! Increases in the value of a share of stock are not taxed until they are “realized” by a sale. If, as you say, a capital gain is just the present value of future income, the seller is, in effect, taking the income now–she certainly won’t get it later! Your friends in the Dallas real-estate world will not be amused by your apparent belief that profits on the sale of a building aren’t taxed. They are, of course (unless shelters or loopholes prevent it). A medical student cannot sell his earning potential, but an established doctor can sell her practice. The price partly reflects her future revenue potential, but it is still taxable income, and rightly so.
       (You make a related point that taxes are capitalized into asset values, so that a share whose future income will be taxed at 40 percent is worth 40 percent less than otherwise. Therefore, you argue, the share’s owner is in effect paying a 40 percent tax anyway. This is wrong, too. Obviously, if we accept your premise, the price she paid for the share also reflected the existence of the tax system. Her profits from the sale may reflect tax-rate changes–up and down–during her ownership, but not the basic fact of taxation.)
       Any income can be turned into a capital gain. To take an extreme example, imagine a company whose only asset is $100 in a 5 percent savings account. If it pays no dividend, its value after one year is $105. If the owner sells the company for $105, has he really not enjoyed $5 of income–exactly as if the $100 savings account was in his name? Or consider a person earning, say, $100,000 a year, who creates a company with two assets: a contract to hire herself at a rate of, say, $40,000 a year, and another contract to provide her services to her old employer for $100,000. At the end of the year, the company would have $60,000 in the bank. If someone pays her $60,000 for the company, has that money been metaphysically transformed from “income” into something else?
       The reason this isn’t done routinely, of course, is that I’ve left out the corporate income tax. (And if you want to talk about the double taxation of corporate profits, we might even find some agreement.) But opportunities for other such shenanigans exist. Many aren’t worthwhile at the current differential between the top tax rates on capgains and ordinary income (about 12 percent). But if the tax gap between capgains and other income is widened–let alone if capgains are made tax-free, as you advocate–opportunities for gaming the system will explode.
       John, you state that the tax on capital gains should be cut because it is a greater burden on the economy than the tax on other forms of income. As a believer in the free market, I think that the government should not try to outsmart individual investors about where their money goes, and therefore the tax system should aspire to neutrality among forms of income. You apparently do not believe in the free market. You think the government knows best and should rig the game. I’m shocked.
       We’re not arguing here about general tax levels. If you think that taxes in general are too high … well, you’re wrong about that, too, but that’s not our topic. My argument is that for any given level of taxation, it makes no sense to single out one particular form of income for preferential treatment.
       I conceded in my piece that, because one can avoid the capital-gains tax by not selling the asset, the tax does discourage economically efficient trading of assets. In your reply, you concede my point that this is quite different from the more common–and farcically incorrect–charge that the capgains tax starves new investment by “locking up” capital. (Every dollar “unlocked” by a seller is “locked” by the buyer.) Hats off to us both.
       Regarding your back-of-the-envelope calculation: As I explained in my piece, tax revenues labeled “capital gains” are a meaningless measure of the effect of changes in the capital-gains tax rate. People arrange their affairs to have income with the favored label. A main purpose of the 1986–Ronald Reagan!--tax reform was to reduce the incentive and opportunity for wasteful tax shelters, most of which involved turning ordinary income into capital gains. So it is not surprising that capital-gains tax revenue didn’t soar when reform (as you yourself note) drastically reduced the shelter industry.
       Regarding capital losses: The obsession with the annual $3,000 limit on capital losses among capital-gains-tax obsessives is fascinating and revealing. Who, after all, is affected by this limit? Since losses over the limit can be “carried forward” to the next year, until they’re used up, the only people the limit really bites are those who, year after year, have net capital losses of more than $3,000. Why the enormous concern for such losers? Answer: They (almost all of them) are not losers. They are people gaming the system: “realizing” losses and postponing gains. There is nothing wrong with gaming the system, within the rules, but there is also nothing wrong with rules that make it harder to do so.
       You repeat Martin Feldstein’s contention that if capital losses were fully deductible, they would equal capital gains and, therefore, the capgains tax would generate zero revenue. Your point: So what’s the point? My point: This proves my point, not yours (and his). Do you think eliminating the capital-loss deduction would produce an economy with no net capital gains–in which, on balance, the value of capital assets (stocks, houses, etc.) did not grow at all? And if so, why on earth are you for it? In fact, you are in effect conceding here that the main effect of an unlimited capital-loss deduction would be to block taxation of capital gains.
       Finally, regarding low- and middle-income taxpayers: I am suspicious of your statistics. What do you mean by “when extraordinary capgains are separated”? And I would like to know more about your man Boyd’s study ostensibly showing that “the lowest income group” would do the best from a capgains tax cut. I have seen stats before suggesting that poor people enjoy huge amounts of capital gains, in jarring contrast to life as it seems to be taking place around us. (“Who are you going to believe, me or your own two eyes?”) I suspect that many of these “low-income” taxpayers are actually comfortable or affluent people who have managed their affairs to minimize their taxes. That doesn’t make them bad people, but it also doesn’t make them poor.
       Of course not all capital-gains taxes are paid by rich people. (And the middle class is frequently bribed with crumbs to protect much larger benefits for the upper brackets–so, politically, your strategy may work.) But no honest person–and you are an honest person, John–would deny that the benefit of an expanded capital-gains tax break would go disproportionately to the well-to-do. That’s no reason not to do it, if it would benefit the economy. But I have been careful to frame my argument against a capgains cut in economic, not egalitarian, terms. And if, as you conclude, rich folks don’t even need it, they and their tribunes are being amazingly selfless in pushing for it so energetically.