Capital-Gains Tax

Dear Michael,

       This is Round 4 of our debate. Along the way, there have been so many detours that readers could easily have got lost. So let me recap where I think we’ve been.
       You claimed that if the tax rate on capgains were lower than the rate on ordinary income, people could easily convert ordinary income into capgains and pay a lower tax. I rejoined that you must be wrong. Even though there have been large differences in the two rates historically, capgains income has remained modest relative to total national income. Prima facie, conversion must not be “easy.” I challenged you to produce examples. Round 1 to me.
       You produced two examples in which individuals channel income into a corporation (created for that purpose) to avoid paying a personal income tax. If they sell the corporation (whose value is equal to the amount of cash in the corporate bank account), won’t they be getting tax-free income if capgains tax is applied to the sale? Ah, but there’s a corporate income tax! So the corporate income already will have been taxed before the sale, I noted. Imposing a capgains tax would amount to double taxation, which is bad. Income should only be taxed once. Round 2 to me.
       You then agreed that income should be taxed only once, although you demurred on the flat tax. In the Kinsley, perfect-tax world, corporate income would be taxed to shareholders. Fair enough. But you would tax capgains as well. My response: This stance obliterates the examples. If the individuals have already paid tax on all their income, how can you justify taxing the sale of the corporation, which, after all, consists of nothing more than trading cash for cash? That’s 40-love.
       You now concede there should be a basis adjustment for personal taxes paid on corporate income. So in the two examples, no capital-gains tax would be paid in the Kinsley, perfect-tax world! Debate over? Mainly. But then you assert that a capgains tax should be imposed if the sales price of the corporation rises for some reason. Why would the price rise? The only corporate asset is a bank account. The reason is: a buyer’s suspicion that the corporation might mysteriously earn income next year. And the year after that. Expectations about the future income can cause share prices to fluctuate. But do we really want to tax phantom income? Isn’t it better to wait until next year and tax income only if it materializes?
       The best policy is to tax income only once, when it is realized. In the meantime, let capital markets freely trade pieces of paper assigning ownership, without interference from the IRS. Game, set, and match.