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It’s Time to End the Preference and Tax Capital Gains as Ordinary Income

The United States entered the COVID-19 crisis with an
unusually large budget deficit for an economy at or close to full employment.
Even if employment,…

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This article was originally published by Ed Dolan's Econ Blog

The United States entered the COVID-19 crisis with an
unusually large budget deficit for an economy at or close to full employment.
Even if employment, output, and growth were to recover quickly to where they
were at the end of 2019 (something that is far from certain), the deficit, under current law, will
remain large.

The good news is that interest rates are likely to remain
well below the rate of GDP growth for the foreseeable future, as they have
since the beginning of the century. As long as that remains the case, there is no danger of an “exploding debt” scenario in
which a large but constant federal deficit causes debt to grow without limit as
a share of GDP. At this point, the greatest danger to the recovery is premature
austerity. Still, as the recovery proceeds, we are sure to hear it argued on
both economic and political grounds that the deficit should be reduced.

At that point, the search will be on for ways to close the
budget gap. Although everyone will roll out their favorite spending cuts, much
of the heavy lifting is going to have to come on the revenue side of the
budget. As former Trump adviser Gary Cohn put it recently, talking to
CNN’s Fareed Zakaria,

Our next Congress, the Congress that sits down in 2021,
almost has to sit down and look at our spending and our revenue side. … How we
spend money? There are a lot of places where we could cut back. In addition to
that, I think they have to look at our tax system and think of ways that we
raise revenue.

No area of the tax code is more ripe for reform than the
preferential treatment given to capital gains. While incomes from wages and
salaries face a maximum tax rate of 37 percent, capital gains on assets held
for more than a year, in most cases, are taxed at a maximum rate of just 20
percent.
The benefits of the capital gains tax preference flow predominantly to the rich. Some 70 percent of the
benefits go to taxpayers with annual incomes of $1 million or more, who enjoy
annual benefits of $145,000 each. Benefits for households with incomes of
$50,000 or less average about $10. For years, backers have tried to find
broader justifications for this tax break, contending that benefits to the few
somehow trickle down to the rest, but their efforts are less than convincing.

Here are some of the many issues raised by the capital gains
tax preference, and the many reasons why its elimination should be at the top
of the list in the search for additional sources of federal revenue.

Are capital gains really income?


One argument for lenient tax treatment is that even if
income is to be taxed, capital gains are not income at all, but only a
reflection of a transfer of ownership of an existing asset. If we want assets
to come under the control of those who can put them to best use, say defenders
of the preference, we should not erect barriers to their purchase and sale. Just
as we tax labor income when it is paid out to workers, we should tax capital
income only when it is paid out as interest, dividends, royalties, or whatever,
but not when ownership of an asset is transferred from one party to another.

That might make sense if it were possible to distinguish
cleanly between income and capital gains, but it is not. Instead, it is all too
easy to transform income from almost any source into something that looks like
a capital gain.

Consider a fanciful example: I make a contract with my wife
to supply 2,000 hours of labor over the coming year for a payment of $2,000.
Under the terms of the contract, she can, if she wants, call on me to use those
hours in any way she wants. She could ask me to mow the lawn and make lasagna
for dinner, but she could also sell the local university an option that would
allow it to buy my services at the same $2,000 she paid for them. The
university willingly pays her $95,000 for the option, which is a good deal for
them since they would otherwise have had to pay me $100,000 to teach my quota
of courses. When we file our joint tax return come April 15, we will be taxed
at the capital gains rate on my wife’s $95,000 income from the option sale,
while I report ordinary income of $2,000. Our before-tax income is a little
lower than it otherwise would be, but our total taxes are a lot lower.

Although this example seems absurd, the real world is full
of situations where businesses can do much the same — structure a transaction
to make it look like a capital gain instead of ordinary income. In fact, one law firm advertises an options-based strategy
exactly like that described above, except that it is used to shelter income
from real estate rather than from labor. Choices like organizing a firm as a
partnership instead of a corporation, paying executives with stock options
instead of a salary, or imaginatively structuring a real estate deal can also
convert ordinary income to capital gains. The strategies are endless.

One of the most controversial ploys is the carried interest rule, which allows hedge fund and
private-equity managers to structure the income they receive for their services
in a form that qualifies for taxation as capital gains. Even some commentators
who are otherwise enthusiastic about lenient taxation of capital gains draw the
line at carried interest. For example, David Frum, who thinks a lower tax rate for capital gains
is good policy, agrees that the rule is “utterly unjustifiable. If you’re
investing with other people’s money,” he says, “What you are earning is income
— and it should be taxed as such.” The 2017 Tax Cuts and Jobs Act, which
slashed the corporate tax rate, was supposed to close the carried interest
loophole, but it ended up making only minor modifications. For the most
part, say tax analysts, the rule lives on.

Tax avoidance strategies that convert ordinary income to
capital gains would be a problem even if they did nothing but generate
inequities and reduce federal revenues, but that is not the whole story. Such
strategies may require more than just waving an accountant’s wand over
something a firm would do anyway. Instead, structuring transactions to take
advantage of specific tax rules often requires changing actual business
practices, such as the choice of financing methods, the timing of investments,
even the choice of one’s whole line of business. Often, the changes would be
unprofitable except for their tax advantages. Although proponents of the
capital gains preference claim it supercharges growth and efficiency,
tax-induced changes in business practices are a significant drag on the real
economy.

Do we need a capital gains preference to correct for
inflation?


A second argument used by supporters is that we need low tax
rates on capital gains to avoid taxing “phantom” gains produced by inflation.
The argument is superficially plausible. When there is inflation, asset owners
may be taxed on nominal gains even when real asset values do not increase.

For example, suppose you buy some shares of stock at $100
and sell them for $120 a couple years later. Inflation has meanwhile pushed up
the cost of living by 10 percent. That leaves you with an inflation-adjusted
pretax gain of just $10. If you pay 37 percent tax as ordinary income on the
$20 nominal gain, your tax rate on the $10 real gain is 74 percent. Cutting the
rate on nominal capital gains to 20 percent reduces the real rate to 40 percent
— not quite enough even to fully level the playing field, but a move in the
right direction, it would seem.

But there are two flaws in that argument.

First, any arbitrary rule, such as a fixed lower tax rate or
an exclusion of a portion of capital gains, can only crudely approximate the
necessary adjustment for inflation. The 20 percent rate that is close to right
in the example we just gave becomes too low if inflation slows (as it has in
recent years). If inflation instead accelerated, it would become too high. Second, the rate that just levels the playing field for a person in one
tax bracket could be too high or too low for those in other brackets.

A more nuanced approach would be to index the basis on which
capital gains are calculated to reflect actual inflation between purchase and
sale. That would avoid the taxation of phantom capital gains, but not a second,
equally serious problem: Other forms of investment income, too, are subject to
phantom taxation when there is inflation.

Suppose, for example, that in a zero-inflation world,
borrowers would offer a 5 percent coupon rate on top-rated corporate bonds. If
the rate of inflation rises to 5 percent, borrowers would be willing to offer a
10 percent nominal coupon rate on the bond, since they know they will be able
to pay future interest and principle in less valuable dollars. The 10 percent
nominal rate leaves your real return and their real interest cost at 5 percent.
So far, so good. But suppose now that you are subject to a 20 percent tax on
your interest income. In the zero-inflation case, your interest income after
tax is 4 percent. In the inflationary case, you have to pay tax on the whole 10
percent nominal rate, leaving you an 8 percent nominal return after taxes. When
you subtract 5 percent inflation, that 8 percent nominal return becomes just 3
percent. In short, even if borrowers adjust nominal interest rates to fully
reflect inflation, inflation increases the effective tax rate on bondholders.

The situation would be similar for income from the common
stock of a firm that has constant real profit, from which it pays a constant
fraction in dividends. Faster inflation would increase the real effective rate
of taxation on the dividends.

A helpful 1990 paper from the Congressional Budget Office explores the problem in
detail. The paper confirms that faster inflation raises the effective tax rate
on investment income, but it points out that the effect is inherently smaller
for capital gains than for dividend or interest income. Attacking the problem
of phantom capital gains in isolation by whatever means — a preferential
capital gains rate, an exclusion, or indexation — only widens the gap between
the way inflation affects capital gains and the way it affects interest and
dividends. Doing so increases the attractiveness of tax avoidance strategies
that involve inefficient business practices.

The ideal solution to distortions caused by inflation would
be to index the entire tax system. Indexation would have to cover not only all
forms of investment income, but also taxation of ordinary income, real estate,
inheritance, and everything else. But trying to remove the effect of inflation
on capital gains taxes separately is likely to make things worse, not better.

Do we need the preference to avoid double taxation of
corporate profits?


“Double taxation” of corporate profits is a third common
argument in defense of lenient tax treatment of capital gains. The idea is that
corporate profits are taxed once at the business level and then again at the
individual level when they are paid out as management bonuses, dividends, or
capital gains.

It is true that a preferential rate on capital gains would
be one way to attack the distortion — one way, but a bad one. A much better way
would be to fix the flaws in corporate taxes that are the source of the problem
rather than apply a Band-Aid to capital gains.

Actually, part of the job was done in the 2017 Tax Cuts and
Jobs Act, which lowered corporate tax rates across the board. A further step
would be to get rid of the numerous loopholes in the corporate tax system that
allow a big chunk of corporate profit to escape taxation altogether while those
unlucky enough not to qualify pay much more.

But the 2017 corporate tax cut left a key part of the job
unfinished. If we want to enjoy the potential efficiency benefits of corporate
tax reform, those taxes should not just be reduced; at the same time they
should be shifted to the individual incomes of the managers and shareholders
who are the ultimate recipients of corporate profits. To do that would require
eliminating the capital gains preference. A regime that had no corporate income
tax and full taxation of profits, whether earned by shareholders as capital
gains, dividends, or in any other form, would eliminate double taxation once
and for all without an unfair redistribution of the overall burden of taxation.

The lock-in effect


The “lock-in” effect is a final problem with capital gains
taxation. As the tax is currently administered, people do not have to pay
capital gains on an asset until it is sold. As a result, the after-tax return
on an appreciating asset increases the longer it is held.

Compare a bond that pays a steady interest income every year
to a stock that increases in value by the same amount each year. Over time, the
effective tax rate on the stock would be lower even if the statutory tax rate
were the same on both interest income and capital gains. The reason is that
bondholders have to pay their tax year by year, while stockholders can defer
payment of the tax until they sell their shares, possibly many years later.

Moreover, if people still have not sold their stock or other
assets when they die, their heirs never have to pay taxes on the capital gains
at all. Instead, the value of the assets is “stepped up” to the market value at
the time of the original purchaser’s death. In the meantime, the original
owners can live quite well by borrowing against the value of the assets. When
they die, their heirs can sell enough shares to pay off the loans, without
paying capital gains taxes either on those shares or the ones they keep.

The lock-in effect, then, creates an artificial incentive
for owners to hold on to stocks or real assets longer than they otherwise
would. In many cases, that means that assets do not move smoothly from the
hands of those who own them to those of new owners who could make better use of
them. Furthermore, the lock-in effect greatly reduces the revenue that the
government realizes from capital gains taxes.

Unfortunately, removing the tax preference and taxing
capital gains at the same rate as ordinary income would, by itself, make the
lock-in problem worse. Assets would move from hand to hand even more slowly
than they do now. As a result, the increase in revenue from lifting the capital
gains preference would be disappointingly small.

Fortunately, there are ways to overcome the lock-in problem.
A recent study from Brookings by Grace Enda and William G. Gale discusses
several possible reforms.

Two of the simplest reforms attack the so-called “Angel of
Death” loophole that allows heirs to fully or partially escape capital gains
taxes. One version would eliminate the valuation step-up at death. Suppose John
Sr. buys an asset for $1,000 in 1990 and dies in 2010 when the asset is worth
$2,000. John Jr., the heir, finally sells the asset in 2020 when it is worth
$3,000. Under the current regime, John Jr. pays no capital gains tax until
2020, and then only on the $1,000 gain that has occurred since the time of
inheritance. Without the step-up, John Jr. would pay tax in 2020 on the full
$2,000 gain that had taken place since the original purchase. An even stronger
version of the same reform would require John Jr. to pay tax on the first
$1,000 of the gain in 2010, at the time of inheritance, and pay the tax on the
remaining $1,000 when the asset is sold in 2020.

A still more far-reaching reform would be to tax capital
gains annually on an accrual or mark-to-market basis.
Suppose that your tax rate is 30 percent, and in year 0, you buy 100 shares of
stock at $50 a share. They rise in price to $100 in Year 1, fall to $75 in Year
2, and rise again to $150 in Year 3, at which point you sell them. Under
mark-to-market taxation, in Year 1 you pay tax of $1,500 on a capital gain of
$5,000; in Year 2, you have a negative tax liability of $750 on a capital loss
of $2,500, which you can carry forward; and in Year 3, you have a capital gain
of $7,500 on which you owe tax of $2,250, $750 of which you cover with the
carried-forward loss. Your total tax over the 3 years is $3,000, the same as it
would be if you were taxed only at the time of sale, but because there is no
deferral of taxes, there is no lock-in effect.

Mark-to-market taxation would be easy to implement for
assets like stocks and bonds that were actively traded, but not so easy for
hard-to-value assets like real estate or private business interests. An
approach called retrospective taxation could be used in such
cases. Under that system, capital gains would be taxed at the time of sale, but
the tax rate would be higher the longer the asset had been hed. The rate of
increase in the tax rate would depend on market interest rates. If it were done
right, the cost of the rising tax rate would exactly balance out the benefit of
deferring taxes until sale. In short, retrospective taxation would eliminate
the lock-in effect without encountering the problem of annual evaluation of
hard-to-value assets.

Any of these reforms, alone or in combination, would
mitigate the lock-in effect. As a result, capital markets would operate more
efficiently, since assets would move more freely into the hands of the owners
who could put them to the best use. It would also increase the revenue gain
from elimination of the capital gains tax preference.

The bottom line


Those who defend the preferential rate on capital gains are
right when they argue that all taxes affect business decisions. But it is
non sequitur to say that because they affect business
decisions, capital gains taxes should be as low as possible. The proper
conclusion, instead, is that we should consider capital gains taxes in the
context of the tax system as a whole:

  • Taxing
    capital gains at lower rates than other forms of investment income does
    little to encourage investment in general. However, it does a lot to
    encourage the structuring of investment in ways that avoid taxes, even if
    they are inherently less efficient.

  • Theoretically,
    an ideal tax system would be fully indexed for inflation, but singling out
    capital gains for special treatment while other forms of capital income
    are not adjusted actually increases the degree to which inflation
    undermines the equity and efficiency of the tax system.

  • A case
    can be made against double taxation of corporate profits, but the proper
    reform would be to tax capital gains and dividends as ordinary income at
    the same time that profit taxes at the corporate level were reduced or eliminated.

  • The
    lock-in effect is real, but the appropriate way to mitigate it would be
    through elimination of the angel-of-death loophole while taxing all
    capital gains on a mark-to-market or retrospective basis.

In short, as we look ahead to the likely need for additional
federal revenues as the U.S. economy fully recovers from the COVID-19 downturn,
a thorough reform of our system for taxing capital gains should be a high
priority.

Based on a previous post at NiskanenCenter.org. Photo courtesy of Pixabay.com.

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