Let's Be Fair about Taxation

When I hear others say "fair share," I know what is coming -- a diatribe against the wealthy followed by recommendations to more heavily tax "millionaires and billionaires."

The specifics usually follow.  I learn that it isn't just millionaires and billionaires who are targeted.  The actual income threshold is $200,000 for individuals and $250,000 for married couples, and it is business and investment income that constitute the real target.  You know: the evil capitalists.

Today, the current top tax rate of 15% for capital gains and dividends is getting a lot of attention because of the recent release of Mitt and Ann Romney's tax returns.  They reported millions of capital gains and dividend income and paid a tax of around 15%.

Let's take a look at fairness in the context of investment income.  We will see a very different picture of their tax situation and the taxes paid by others with investment income.

If an individual purchased stock 20 years ago for $600,000 and sells it today for $1,000,000, we say the investor has a $400,000 gain.  If the top tax rate for capital gains of 15% applies, the tax is $60,000.  The question is, just how much tax should this investor pay?  Is 15% too little if wages and many other types of income are taxed at rates as high as 35%?

Advocates of lower tax rates for capital gains often rely on the need for investment incentives as the primary reason for lower capital gains taxes.  That is a very valid reason, but there are two other even more persuasive reasons that are rarely mentioned in public discussions.

The most compelling reason for low capital gains rates is, in fact, fairness.  Consider the individual with the $400,000 gain.  The investor actually lost money if the inflation rate averaged 2.6% or higher over the 20 years.  That fact doesn't stop the government from taxing the nonexistent $400,000 gain at 15%.  You call that fair?  Isn't it supposed to be a tax on income?

There have been several attempts to incorporate inflation adjustments into the tax law for gains, but none have been adopted because inflation accounting is far more complicated than it might seem.  The compromise answer has been and continues to be to simply tax capital gains at lower rates.  This approach has the advantage of simplicity, but it also has its disadvantages.  Investors who hold a rapidly appreciating asset for just a few years may favorably benefit, while the taxpayer in the example is taxed even though there is no real gain.  The taxpayers who are really punished are the ones whose investments decline in value.  If the stock in the example had been sold for $200,000, the tax law says the loss is $400,000, even though the economic loss in current dollars is much greater.  Even worse, the tax law severely limits the taxpayer's right to deduct the understated $400,000 loss.  Many taxpayers who suffered big losses when the stock market lost over half of its value in 2008 and 2009 will never be able to deduct the full amount of their losses.

A look at historical tax revenues reveals the second reason for lower capital gain tax rates.  The fact is that higher tax rates on capital gains have been shown to produce lower tax revenues.  Obviously, fewer investors are willing to assume risk when tax rates increase.  But there is another very simple reason why revenues decrease.  Investors don't recognize gains if tax rates are high.  This is the so-called lock-in effect.  Well-to-do individuals simply don't sell their appreciated assets.  They may sell assets that haven't appreciated -- no tax there -- or borrow, or engage in other tax-favored transactions.  But they don't pay the high tax rates.  This prevents capital from moving toward  more productive investments, reducing economic efficiency and further reducing tax revenues.

An interesting question is, what would Mitt and Ann Romney's tax have been if the capital gains tax rate were 25%, or even 30%?  Even they couldn't answer that question.  Most of their investments are in a blind trust, which means that a professional manager is making investment decisions on their behalf.  Prudent investment advisers don't subject their clients to high capital gain tax rates.  This is exactly what historical tax revenues indicate happens.  Perhaps their effective tax rate would have been higher, but their actual tax liability likely would have been lower because fewer gains would have been realized.  This unrelenting desire to soak the rich is based on an irrational concept of fairness advocated by the president and other liberals.

What about the 15% maximum tax rate on dividends?  Corporations are subject to a separate 35% federal tax on their incomes before they distribute that income to shareholders.  The 35% tax rate is the highest rate in the world among industrialized countries, a record held by Japan until last year when it reduced its top rate to 30%.  This means that income distributed by U. S. corporations to high-income shareholders is subject to an effective maximum tax rate of 44.75% (35% + 15% X 65%).  As most states tax both corporate and individual income, the combined federal and state tax rate can be well over 50%.

While we are at it, let's also look at interest income.  Today, many interest-earning investments pay 2% or 3%, which, after inflation, leaves little or no real income.  Regardless, this nominal interest income is subject federal taxes as high as 35%.  How can anyone say this is fair?

Today, nearly half of the individuals who file income tax returns pay no income tax at all, not through withholding or at the time of filing.  Many, because of the earned income credit and other provisions, receive "refunds" even though they paid in nothing during the year.  Nearly half of all Americans receive Social Security, food stamps, and benefits from the federal government.  The top 1% -- the target of the Occupy Wall Street movement -- pay 38% of all individual income taxes.  No doubt, if you were to allocate the corporate income tax to the investors who bear the actual corporate tax burden, you would learn that they pay an even greater portion of the total income tax liability.

It is one thing to advocate broadening the tax base, closing loopholes, and simplifying the tax system with a goal of fairness.  But let's be fair when we talk about taxing high-income individuals.

When I hear others say "fair share," I know what is coming -- a diatribe against the wealthy followed by recommendations to more heavily tax "millionaires and billionaires."

The specifics usually follow.  I learn that it isn't just millionaires and billionaires who are targeted.  The actual income threshold is $200,000 for individuals and $250,000 for married couples, and it is business and investment income that constitute the real target.  You know: the evil capitalists.

Today, the current top tax rate of 15% for capital gains and dividends is getting a lot of attention because of the recent release of Mitt and Ann Romney's tax returns.  They reported millions of capital gains and dividend income and paid a tax of around 15%.

Let's take a look at fairness in the context of investment income.  We will see a very different picture of their tax situation and the taxes paid by others with investment income.

If an individual purchased stock 20 years ago for $600,000 and sells it today for $1,000,000, we say the investor has a $400,000 gain.  If the top tax rate for capital gains of 15% applies, the tax is $60,000.  The question is, just how much tax should this investor pay?  Is 15% too little if wages and many other types of income are taxed at rates as high as 35%?

Advocates of lower tax rates for capital gains often rely on the need for investment incentives as the primary reason for lower capital gains taxes.  That is a very valid reason, but there are two other even more persuasive reasons that are rarely mentioned in public discussions.

The most compelling reason for low capital gains rates is, in fact, fairness.  Consider the individual with the $400,000 gain.  The investor actually lost money if the inflation rate averaged 2.6% or higher over the 20 years.  That fact doesn't stop the government from taxing the nonexistent $400,000 gain at 15%.  You call that fair?  Isn't it supposed to be a tax on income?

There have been several attempts to incorporate inflation adjustments into the tax law for gains, but none have been adopted because inflation accounting is far more complicated than it might seem.  The compromise answer has been and continues to be to simply tax capital gains at lower rates.  This approach has the advantage of simplicity, but it also has its disadvantages.  Investors who hold a rapidly appreciating asset for just a few years may favorably benefit, while the taxpayer in the example is taxed even though there is no real gain.  The taxpayers who are really punished are the ones whose investments decline in value.  If the stock in the example had been sold for $200,000, the tax law says the loss is $400,000, even though the economic loss in current dollars is much greater.  Even worse, the tax law severely limits the taxpayer's right to deduct the understated $400,000 loss.  Many taxpayers who suffered big losses when the stock market lost over half of its value in 2008 and 2009 will never be able to deduct the full amount of their losses.

A look at historical tax revenues reveals the second reason for lower capital gain tax rates.  The fact is that higher tax rates on capital gains have been shown to produce lower tax revenues.  Obviously, fewer investors are willing to assume risk when tax rates increase.  But there is another very simple reason why revenues decrease.  Investors don't recognize gains if tax rates are high.  This is the so-called lock-in effect.  Well-to-do individuals simply don't sell their appreciated assets.  They may sell assets that haven't appreciated -- no tax there -- or borrow, or engage in other tax-favored transactions.  But they don't pay the high tax rates.  This prevents capital from moving toward  more productive investments, reducing economic efficiency and further reducing tax revenues.

An interesting question is, what would Mitt and Ann Romney's tax have been if the capital gains tax rate were 25%, or even 30%?  Even they couldn't answer that question.  Most of their investments are in a blind trust, which means that a professional manager is making investment decisions on their behalf.  Prudent investment advisers don't subject their clients to high capital gain tax rates.  This is exactly what historical tax revenues indicate happens.  Perhaps their effective tax rate would have been higher, but their actual tax liability likely would have been lower because fewer gains would have been realized.  This unrelenting desire to soak the rich is based on an irrational concept of fairness advocated by the president and other liberals.

What about the 15% maximum tax rate on dividends?  Corporations are subject to a separate 35% federal tax on their incomes before they distribute that income to shareholders.  The 35% tax rate is the highest rate in the world among industrialized countries, a record held by Japan until last year when it reduced its top rate to 30%.  This means that income distributed by U. S. corporations to high-income shareholders is subject to an effective maximum tax rate of 44.75% (35% + 15% X 65%).  As most states tax both corporate and individual income, the combined federal and state tax rate can be well over 50%.

While we are at it, let's also look at interest income.  Today, many interest-earning investments pay 2% or 3%, which, after inflation, leaves little or no real income.  Regardless, this nominal interest income is subject federal taxes as high as 35%.  How can anyone say this is fair?

Today, nearly half of the individuals who file income tax returns pay no income tax at all, not through withholding or at the time of filing.  Many, because of the earned income credit and other provisions, receive "refunds" even though they paid in nothing during the year.  Nearly half of all Americans receive Social Security, food stamps, and benefits from the federal government.  The top 1% -- the target of the Occupy Wall Street movement -- pay 38% of all individual income taxes.  No doubt, if you were to allocate the corporate income tax to the investors who bear the actual corporate tax burden, you would learn that they pay an even greater portion of the total income tax liability.

It is one thing to advocate broadening the tax base, closing loopholes, and simplifying the tax system with a goal of fairness.  But let's be fair when we talk about taxing high-income individuals.

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