President Biden wants to nearly double the tax on income from capital gains, currently at 20 percent, to 39.6 percent. Add to that the 3.8 percent Obamacare surcharge and you’re up to 43.4 percent. Many states tax capital gains as well and in 13 of them (plus the District of Columbia) the total tax on capital gains would be over 50 percent with the proposed new federal rate. In California it would be a staggering 56.7 percent.
But it gets worse. Unlike the tax on regular income, the capital gains tax is not indexed for inflation. So with long-held assets, much of the gain is illusory. For instance, if you bought an asset in 1971 for $50,000 and sold it this year for $1,000,000, you would owe taxes on a nominal capital gain of $950,000. At 56.7 percent that would leave you with $461,350. But there has been a 554 percent inflation in the last 50 years. So the true cost basis of the asset is $327,008, not $50,000, and the real capital gain is only $672,992. That would make the tax on a Californian’s real gain not 56.7 percent but 80 percent.
There’s a word for taxes at that rate: ‘confiscatory’.
The capital gains tax goes back to 1913, when the modern income tax was enacted following the ratification of the 16th Amendment. The rate was the same as for regular income, but capital gains could be offset not only against capital losses but regular income as well.
In 1921 the Harding administration began taxing capital gains at a special rate of 12.5 percent if held for at least two years, regardless of the tax bracket that the individual was in. The reasoning of Treasury secretary Andrew Mellon — one of the great tax cutters in American history — was that since most capital gains came from corporate stock and the profits of corporations had already been taxed, a capital gains tax at regular rates would be double taxation. Biden’s plan would ignore that reality.
With the coming of the great depression, the Dow Jones Industrial Average declined by more than 90 percent from its 1929 high. It didn’t take the very rich (or rather their tax lawyers and accountants) long to figure out that if they sold stock in which they had large capital losses but immediately bought it back to maintain their position, they could use the capital loss to wipe out taxes on their total income.
In 1934, J.P. Morgan Jr spent nine months cruising the world in the 343-foot-long Corsair IV, the largest yacht ever built in the United States, but owed no income tax that year, thanks to these capital losses.
When that became public, Congress moved quickly to eliminate the loophole. It required that investors wait 30 days before buying back a stock in order to establish a capital loss and allowed only $1,000 of capital losses to be offset against regular income. (The amount that can be offset today is $3,000, but it would be almost $20,000 if the original limit had been indexed to inflation.)
Over the next several decades, the tax rate on capital gains rose and fell, often but not always depending on which party was in power. They were cut under both Presidents Kennedy and Carter.
But government revenues from the tax do not rise and fall in tandem with the rate. The reason is that in one way at least, the capital gains tax is a voluntary tax. It is triggered by the sale of an asset and usually one does not have to sell. The higher the capital gains tax, the more reluctance there is to sell. Lowering the tax has the opposite effect.
Indeed, when Congress lowered the capital gains tax in 1978 from 40 percent to 28 percent, the Treasury estimated that the cut would cost the government $20 billion in tax revenue. Instead, the next year revenues from the tax went up by $20 billion.
So a higher capital gains tax rate has, inevitably, adverse economic effects. As President Kennedy explained, ‘the tax on capital gains directly affects investment decisions, the mobility and flow of risk capital from static to more dynamic situations, the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth of the economy.’
Economists have tried to calculate the capital gains tax rate that would maximize revenues. They differ, of course, as to where that point is, but virtually all economists agree that there is such a point. The staff of the Congressional Joint Committee on Taxation, mostly liberals, puts it at 28 percent. Lawrence B. Lindsay, a former governor of the Federal Reserve and adviser to President George W. Bush, puts it at about 18 percent.
So increasing the federal tax on capital gains to well over 40 percent would inevitably cause the revenues from that tax to collapse not increase.
The left has always favored high taxes on capital gains, arguing that they mainly hit the rich, who can afford to pay them. It is true, almost by definition, that rich people have more assets that can appreciate in value. And more of their incomes come from capital gains rather than salaries or fees. The incomes of the top one-10th of one percent of taxpayers are more than 50 percent from capital gains. The top 1 percent have 38 percent of their income from capital gains.
But those statistics, while true, are extremely deceptive. Say a middle-class family has an annual income that has averaged $100,000 from a small business they started years before. They decide to retire, so they sell the business for $2 million. Because of the one-time capital gain, the family is suddenly in the top one-10th of 1 percent in income. The next year, however, their income drops back down to its old, middle-class level. They were, almost literally, rich for a day.
In theory, since capital is one of the fundamental inputs to an economy, capital gains shouldn’t be taxed at all, in order to encourage its formation. But that, in the current political climate, is a non-starter. However, two reforms would greatly ameliorate the adverse economic effects of the capital gains tax.
First, for reasons of simple fairness, capital gains taxes should be indexed for inflation. Second, there should be no capital gains tax if a capital asset is sold in order to invest in another capital asset. Only if the money is withdrawn from a capital account should it be taxed.
