On April 15th, tax day for millions of Americans, Angry Overeducated Catholic posted some, I believe, common sense observations and recommendations on the tax system. One of our erstwhile Angrymen, Angry New Mexican, budding socialist that he is, commented regarding the capital gains tax.
The problem with understanding capital gains is that it is denominated in the same manner as income, that is to say in dollars. In pre-euro days, Britain used ‘pounds’ as a monetary unit and ‘pounds’ as a unit of weight measure without problem — the context usually resolved the ambiguity. In America, thanks to redistributionists and socialists, the context is sufficiently muddied that otherwise clever and analytical people [ANM] are confused.
Capital gains, while expressed in dollars, are entirely different entities than regular income. Funds placed in investment carry additional properties with them — notably risk, for which the investor must be compensated. One of the best analogies for capital gains I have come accross is that of the farmer (investor) and his apple orchard.
The farmer plants an apple tree (e.g. makes a capital investment). Associated with this investment are risks of adverse weather — droughts killing the tree, storms tearing it down, insects devouring the fruit, and some considerable length of time before his investments bear fruit (sorry). As the tree grows, it comes into its first season and produces several bushels of apples. These are the dividends of the investment and can be sold for income. As the tree grows, it becomes more valuable as it produces more and more fruit. If at some time prior to the natural lifespan of the tree, the farmer elects to sell the tree (or the orchard), the apple tree will be appraised on the basis of its condition and how much fruit it produces. If he spent $10 for the original sapling, and received $100 for the mature fruit bearing tree, he has a capital gain of $90.
Taxing this $90 by 40% is equivalent to pruning off live apple bearing limbs and reducing the value of the tree by $36. In order to preserve and increase the income stream (dividends) you want the tree to grow. You want the farmer to take the entire $90 and plant nine more apple trees. Even if he converts his tree into cash, you want to compensate him for the risk of planting the trees in the first place, tying up his money, and perhaps having to replant several trees after the drought, flood, or tornado rips his orchard apart.
And remember, each tree planted needs workers to cultivate the trees, pick and distribute the apples, and generally grow the economy. And if the orchard grows large and requires mechnical harvesting, then the orchard is helping the manufacturing as well as the labor sectors also. This investment behavior needs to be rewarded not dampened by a punative tax system. So AOC is correct when he proposes a capital gains tax of 0%.
The 12 Angry Men Blog 
April 30, 2008 at 10:32 am
APO: The problem with your analogy, is that, as far as I am aware, real life farmers are taxed on apple sales as income, not capital gains. Unlike the hedge fund gurus you so nobly defend, farmers have to pay income taxes like everyone else.
A better analogy is as follows: Bill Gates has lots of money. Unless he chooses to hide it under his bed, he has two basic investment options: debt or equity. In the first column, he chooses to lend money to a bank, corporation or government. Any returns he gets on this investment are considered income. In the second column, he chooses to buy stock by handing his money to a former stockowner. This makes Bill a part-owner of a company. If the company sends Bill a dividend, this is considered income. If Bill sells the stock at a higher price to someone else later, this is considered capital gains. Both options entail risk. Column #2 entails more risk since creditors are closer to the front of the line than owners if the company goes belly-up. Likewise, if the company loses some but not all value, the debt-holder still gets paid, but the owner loses big-time if they decided to sell.
In APO’s gilded-age “paradise”, if Bill Gates invests in equities with no dividends, he never pays taxes again. He assumes all the risk and gets all the rewards.
In real 21st century America, Bill Gates pays taxes on his capital gains. BUT, Bill also can count capital losses against said gains for tax purposes. Meaning that Uncle Sam is taking some of his rewards, but also shouldering some of his risk.
Is there a capital gains tax level where it manifestly discourages investment? Sure. But experience of almost every nation in the world has shown, it’s a hell-of-a-lot larger than 0%.
Sorry, APO, but your firm desire to return America to the untrammelled excesses of the guilded age, does not good policy make:)
April 30, 2008 at 12:05 pm
I’ve got to agree with ANM for once. Capital gains are income, risky income, but then you’re allowed to deduct losses so you’re only taxed on the income you actually receive, just as you should be.
Every other form of income is taxed, why should the fat cats and politicians get a loop hole?
April 30, 2008 at 3:10 pm
ANM…as far as I am aware, real life farmers are taxed on apple sales as income
I don’t believe that I mentioned that dividends were to be taxed as capital gains. Dividends are income and a farmer’s apple sales are in fact dividend income. Actually, I believe that dividends should be considered ordinary income and afforded no special treatment.
AM …you’re allowed to deduct losses so you’re only taxed on the income you actually receive, just as you should be.
Well AM, you’ve obviously never taken any capital gain losses. You can deduct only up to $3000 in losses a year. (caveat —may have changed recently). So if I invested in Enron and got wiped out to the tune of say $300,000, which, say was my nest egg (that is to say, I didn’t have any more money to reinvest to provide gains), then it would take me 100 years of 1040 Sch. D. filings to write down that investment. Clearly, capital gains are NOT treated equally.
ANM…he chooses to lend money to a bank, corporation or government. Any returns he gets on this investment are considered income.
Well actually, lending to a bank is essentially depositing money for which the bank pays interest. Since interest is taxed as ordinary income, it is risk protected (up to $100,000) by the government. (FDIC) Any Gates out there is unlikely to drop one huge chunk in a single bank. Most will ladder their deposits over multiple banks to assure FDIC protection. But the argument is it’s ordinary income because there is no risk. There is no equivalent mechanism to lend money to corporations/governments — these are commercial paper and bonds and fall in column #2 as capital investments and are taxed as capital gains.
ANM…Uncle Sam is taking some of his rewards, but also shouldering some of his risk.
Why ever would you consider a taxing body as ‘shouldering’ some of the risk?
AM …why should the fat cats and politicians get a loop hole?
I seem to recall that 47% of capital gains filed were from household incomes less than $50,000, and 79% were from households with incomes less than $100,000. Your ‘fat cats’ are skinnier than you think. Even Obama has come to realize that he can’t think like this. His proposed 28% cap gain tax is being reworked to 20% (Same as Hillary).
And as for hedge fund managers, whom I believe are on the forefront of fiscal irresponsibility, most of their income is not from cap gains but from bonuses which are treated as ordinary income.
April 30, 2008 at 3:32 pm
APO: Actually you over-simplify matters about corporate bonds. Any income from payments made by the issuer to the holder are taxed as income. Any income made on the difference between the buy and sell price of the bond is taxed as capital gains. Depending on how you approach corporate bond investing your cash gain may be 100% “income” (new issue) or 100% “capital gains” (zero coupon bonds). Why should one gain favorable tax treatment and the other not? Is there really that substantial an economic benefit to incentivising zero-coupon bonds?
As for your capital gains facts, they appear to be incorrect or dated. According to this link, the wealthiest 1% of Americans got 70% of all long-term capital gains, while the poorest 60% of Americans got 2%. Benefits to the market aside, AM is right — lower capital gains rates benefit the fat cats far, far more than folks like you or me.
As for hedge fund managers, you are correct, I did mispeak. It’s actually the private equity bosses that play economic voodoo games to have almost all their income show up as “capital gains” and thus taxed at a lower rate.
April 30, 2008 at 3:47 pm
ANM – by the way. Your last commnent regarding the bond treatment just goes to support AOC’s position that that system is fubar’d. Yes, I was simplifying.
Private equity owners are indeed culpable. But you don’t go after them on the basis of capital gains, you need something else — I just don’t know what.(yet) I was thinking about this a couple of days ago and had a glimmer of a thought. If I can work it out I will post.
My problem with the whole hedge/derivative structure is that it creates something of apparent wealth out of nothing, giving commissions to the purveyors of that something, and then evaporates like the morning dew with only the managers generating a profit.
April 30, 2008 at 3:48 pm
Oh …
My numbers were from today’s Wall Street Journal presumably from 2007 tax returns.
April 30, 2008 at 3:50 pm
Now as I read this, hedge/derivatives reminds me of vacuum polarization. Creates something out of nothing and yet affects the fine structure of the atom while it’s something. You suppose there is a Heisenberg principle operating in finance also?
April 30, 2008 at 4:39 pm
Hey, I already solved this whole issue with my alternate capital gains proposal: tax them at some rate and offer a substantial (say $100,000) personal exemption.
So the first $100,000 you make in capital gains is tax free. This limits capital gains to those who have really substantial investments (probably $1 million or more). Thus, it addresses the “makes all money from capital gains” issue nicely.
Now, I’d argue that the capital gains rate should be set as close to the economically optimal as possible, because I’m pro-growth and pro-prosperity. But if you’re more concerned with squeezing the rich, I suppose you could set it as close to the revenue-maximizing rate as possible.
Note that both rates are probably going to be well under 20%, almost certainly under 25%. So setting capital gains equal to income tax is probably unwise, fiscally.
(For those who don’t know, the revenue-maximizing rate is the rate at which the government rakes in the most. Raise the rate past that point and you take in less. Of course, the optimal rate, the rate which maximizes economic growth, is always under the revenue-maximizing rate. So your choice is really between more money now and more money down the road… )
April 30, 2008 at 4:43 pm
APO: The comparison between the 2005 and 2007 numbers are interesting. I’d be interested in looking at both in more detail. Given the market tanking last yeat, perhaps the little guy was cashing out the stocks he bought long ago (and much cheaper) and got the gains in ’07 while the fat cat decided to hold on. I’ll see if I can pull the raw data from CTJ/ITEP and run some analysis for a follow-up article.
And we’re in complete agreement about the hedge/derivative structure… Heisenberg included:)
April 30, 2008 at 5:01 pm
ANM, as you and APO look at those numbers, make sure you’re comparing apples to apples. From my quick read, it looks like the 2005 numbers are about the total dollars involved, whereas APO’s numbers are about the number of returns filed (and may also be regarding 2005, see this DU piece).
Thus, both sets of numbers might well be right.
But who cares? Why should it matter whether the bulk of capital gains are paid by moderate income folks or rich fat cats? Shouldn’t we be guided by whether a policy is just, fair, and wise? And shouldn’t it be just and fair for everyone?
If we were speaking of taxing the very poor for their capital gains, I’d agree in a heartbeat that that’s different. But whether a household has $50K, $100K, or $1 million, I think we’re above the level where hardship can be claimed.
Mostly, though, we should be guided by whatever course meets our revenue needs and also drives the greatest growth and prosperity, shouldn’t we?
So if 0% capital gains makes some super-rich tax free, but spurs enough growth to put millions more to work earning good money, why should we reject it? Just bushwhack them with the estate tax…