[kenrexford]

Can anyone explain if my logic is wrong here? My thinking seems right to me, and yet I hear no one ever making this point.

There is a runnig discussion about capital gains taxes. To me, I don't get the debate at all.

Capital gains seem to come in two major forms.

The first is appreciation of an asset. An asset (like gold or a house) grows in value against a different asset -- the dollar. The latter asset actually shrinks, because we print so much. So, the asset might might actually grow in real value. It just looks like it grows because the dollar shrinks. So, the tax on the "gain" is really a tax against holding non-dollar assets.

The second is gain in the value of a stock, a share in a company. But, this seems like double taxing, and NOT for the reason most people claim. If ten people get together and make a company, acting as partners, they might make one million dollars and pay, say, 35% tax each. Thus, the net after-taxes income after taxes is $65K per person.

If the same ten people instead incorporate, then the "corporation" pays about the same 35%, making the net income of the corporation $650,000. This is then split up among the owners for $65,000 each. Same end result. But, as this is now "capital gains," the $65K is taxed another %15, for a net of $55,250. So, it seems like this "capital gains tax" actually results in greater taxes for people who invest through corporations than people who invest directly.

Sure, the corporation might not pay out dividends, such that the asset grows, but the end result should be the same. if the corporation did not pay this tax, then it would grow more.

Am I missing something?

[awm]

Hmm, double posted. My computer is acting weird.

[awm]

On appreciation, the idea is to tax the gain in value on the thing that has appreciated. For example, suppose I buy a bunch of things, then sell them later for a higher price. This is a perfectly legitimate way to make money, but there's no reason it should be taxed less than salary income. Of course, if I held onto the things for a long time between buying and selling, it is true that inflation might cause some illusory increase in value. On the other hand, the capital gains rate is also much lower than the general income tax rate... which probably more than compensates for the effect of inflation (which has been pretty low in recent years).

The gain in value of a stock is actually exactly the same as the above. Just because the thing I bought and sold later was a stock (instead of land, or oil, or baseball cards) doesn't imply that it should be treated any differently.

What you seem to be actually referring to are dividends paid out by a company, which are different from appreciation in the value of the company. There is a stronger argument that dividends are taxed multiple times; unlike money paid out in salaries (or appreciation in the company stock), dividends are taxed as part of corporate profits and then taxed again when received by investors. This is a problem with the way US taxation works (it is different in many other places). Of course, the effective corporate tax rate in the US is a sort of funny thing in any case (some companies pay negative taxes, others pay close to the 35% statutory rate). If ten people form a (US) company they should either form an S Corporation (passing profits directly through to ownership to be taxed at income tax rates) or pay themselves a large salary (which is deductible as a business expense for the company)... not pay out the money in dividends.

[kenrexford]

 awm, on 2012-January-23, 23:17, said:

The gain in value of a stock is actually exactly the same as the above. Just because the thing I bought and sold later was a stock (instead of land, or oil, or baseball cards) doesn't imply that it should be treated any differently.

This does not seem right, at all. Things do not generally gain value as a magic trick. Stock in a company does not gain value on its own. Stock in a company gains value because the company makes money. That money, if paid out as dividends, would be taxed as profits and then as received. If that money is instead reinvested in the company (not paid in dividends), then the money is taxed to the corporation, which decreases the growth of the company.

Suppose, for instance, that the person company had a corporation that made one million dollars. The company has assets, say, of another one million. Great company -- doubled its money in one year!

If the dividends are paid out, then the company is still "worth" one million dollars (investment capital). The dividends are then taxed as paid out.

if the dividends are not paid out, then the company has assets of $2 million, which means that the stock doubles, which means capital gains, which are then taxed.

So, the end result is the same.

Granted, a dollar in my hands is worth a dollar, but a dollar in Warren Buffet's hand is maybe worth two bucks. In other words, the capital investment might be worth more as invested because the company produces so much. But, then the gain is simply taxing future income immediately, and this again all works out, still to double taxing.

[phil_20686]

Well, there are lots of things to consider in capital gains tax.

Firstly, its very broad based, it affects everything from rich individuals to pension funds, to hedge funds. It might be sensible to treat them differently, but doing so in a way that clever lawyers cannot exploit is difficult.

Firstly ill talk about the economics of capital gains:

Firstly, one should appreciate than in an inflationary economy it is basically a wealth tax. That is because the change in nominal value, rather than the change in real value, is what is taxed. So if I decide to hold some stocks/bonds/land/second home as part of my retirement portfolio, planning to liquidate it into cash as I need it in retirement, every year i lose [% inflation]*[% capital gains tax]. Inflation in the 5% range is not uncommon, and let us suppose I set capital gains tax at 20%, then I lose 1% of (the original value of) my portfolio every year to capital gains, purely through inflation (this is not a linear relation though, it obviously asymtopes to the capital gains rate). This type of wealth tax is very damaging, as it is a strong disincentive to save. As a quick calculation, if you were to save $5000 per year (inflation adjusted) for 40 years in some inflation tracking asset, you will end up with 1.4 million in nominal dollars, and you will owe 161000 in capital gains tax when you liquidate it. In the original dollars, I would have paid in 200000, and lost 22000 in tax, or about 11%. If I was given 200000k originally, and held it in an inflation tracking asset for forty years, I would pay about 18% after forty years. For assets that are held for a long time, like in pension funds or self invested savings, the tax asymptopes to the CG rate, and results in needing a high rate of return to make saving worthwhile.

Now this might not seem like a lot, but it is significant at the margin. It means for example, if I bought an asset that pays a dividend, after a few years it is no longer beneficial to sell it, as the effective yield is much higher than the real yield, since I am taking a capital hit if I sell it, and this results in less liquid markets, where lots of players are just sitting on the dividends, which is not generally a good thing. Generally trades are always a good thing as somebody is always seeing a profit, just like in the real world if i were to trade widgets for gadgets at one to one and we were both happy, but then due to taxes I have to trade two widgets for one gadget, I am not happy and I no longer trade, and we are both poorer.

Moreover, on an economy wide perspective, you have to consider the different ways that businesses can raise capital, if you raise capital gains it becomes harder to sell shares, and as a result companies raise more debt instead of equity capital. At the margin this is not generally a good thing, as equity capital allocates the risk among many more players, whereas debt concentrates the risk among the banks and institutions who provide it. This is one reason why the housing bubble bursting was so much more damaging than the dot com bubble bursting, even though the dot com bubble destroyed a lot more wealth.

Capital gains is much in the news recently because it lets rich people invest, and pay capital gains tax on the dividends, and so have an effective tax rate much below the income tax rate. However, its hard to know what the real tax rate is, as that will only become apparent when they liquidate their holdings. However, its clear that it will be below 35%. It is however, tricky to see what the real tax rate is, as there is no really authoritative studies on the incidence of corporate taxes. On the one hand, if global competitive pressures control the price level, then it must fall on the profits, i.e. the owners, however, its unclear how often this is really the case. For example, many staple foods like Pepsi Cola are sold much cheaper abroad than they are at home. If that is the case the tax likely falls on consumers, since the companies act in their share holders interest, and if they can up the price they will inorder to protect share holders from downwards pressure on the stock price. Its hard to know, and likely very complicated.

Finally, there is good reason to beleive that one should promote savings, the only way to do this is to try ones best to insure that delayed consumption really does get you more than consumption now. High levels of savings make an economy more resilient to shocks, but it needs to be broad based savings, not lots of savings by a few middle upper class households. The best way to encourage savings is to make sure that pension funds enjoy a large advantage over holding cash. This puts strong limits on the upper level of CG tax that is efficient, as, at least in the UK, your pension is often paid for out of taxed income, and is taxed again when you receive it, and if it is taxed via capital gains while it is in the pension fund, it becomes very difficult for pension funds to operate profitably, and this is a large loss to society. Instead many investors get into self saving plans which are inherently more risky than pension funds.

Finally, there is the issue that it may just be very difficult to tax the extremely rich, even if you take 50% of their income, they are still rich. Once you get over the 100 million mark, a sensible investment strategy will see you basically always getting richer, unless you are very foolish. Its also not that clear that I am taxing them, in the real world, as if they weren't planning to spend that money, it did not affect the total amount of goods available to everyone else, if you take some of that money and spend it on some of those goods, there is now less goods for everyone else, so you have made everyone poorer in the same way as if you had just printed that money and spent it. Money in circulation is the important thing, if lots of rich people arent spending their money, taxing them doesnt make them poor, it makes everyone else poorer, which is strangely counter intuitive, but appears to be true.

[phil_20686]

 kenrexford, on 2012-January-23, 22:49, said:

If the same ten people instead incorporate, then the "corporation" pays about the same 35%, making the net income of the corporation $650,000. This is then split up among the owners for $65,000 each. Same end result. But, as this is now "capital gains," the $65K is taxed another %15, for a net of $55,250. So, it seems like this "capital gains tax" actually results in greater taxes for people who invest through corporations than people who invest directly.

To directly answer this question, yes you are missing something. You are implicitly assuming that the price that the company charges for its service is independent of the taxes it pays. This may or may not be true. There are certainly examples of industries where global competition on price fixes the price level, and the result is that if you tax the company the company pays it right up until you drive the company out of business/offshore. Consumer electronics, is one good example of this, but there are lots of businesses where this is not the case. One obvious example is the domestic freight industry, both trucks and trains. If you tax them extra, they are only in competition with other companies that are also being taxed, so if they are running at competitive profit margins before, they have no choice but to raise their prices. In this case the corporation tax is paid entirely by the consumer, and does not fall on the owner.

Another way to look at it is to ask what would a company do if its corporate tax was lowered. If it is primarily competing with foreign companies who aren't facing this change in tax, and they were competing anyway, they will either lower their prices to drive up market share, or simply inflate their profit margins to improve share holder returns. If they are primarily competing with domestic companies, then the domestic companies will also have this `windfall' and if you dont lower prices they might do so to drive up their market share. This almost certainly is the case in the domestic retail industry.

Other industries are a mixed bag, its very hard to tell.

[phil_20686]

 awm, on 2012-January-23, 23:17, said:

On appreciation, the idea is to tax the gain in value on the thing that has appreciated. For example, suppose I buy a bunch of things, then sell them later for a higher price. This is a perfectly legitimate way to make money, but there's no reason it should be taxed less than salary income.

The gain in value of a stock is actually exactly the same as the above. Just because the thing I bought and sold later was a stock (instead of land, or oil, or baseball cards) doesn't imply that it should be treated any differently.

There is actually a good reason why it should be taxed less than salary income. When you are providing a service to the economy that is useful, you want to encourage that behavior, ideally by making it more profitable than alternative uses of your time. In this case your `service' is that you are bringing together a seller and a buyer who could not otherwise find each other. This is in effect what the retail industry does, and as a result we generally charge lower taxes for these transactions than we do for employing somebody. E.g. sales tax, is much less than income tax, and in your above example it is actually sales tax (VAT in europe), rather than corporation tax, that you would pay here. You would pay income tax only on the money you paid to yourself from this transaction, and corporation tax only on the profits that you made, after including salaries. This encourages you to keep money in the business and grow your business, since taking money out of the business, either via profits paid to shareholders or via salaries, is much more expensive than investing to grow your business by, say, buying more inventory.

[BunnyGo]

 phil_20686, on 2012-January-24, 09:52, said:

There is actually a good reason why it should be taxed less than salary income. When you are providing a service to the economy that is useful, you want to encourage that behavior, ideally by making it more profitable than alternative uses of your time.

Because working and making a salary are not useful to the economy...

[hrothgar]

 phil_20686, on 2012-January-24, 09:45, said:

Another way to look at it is to ask what would a company do if its corporate tax was lowered. If it is primarily competing with foreign companies who aren't facing this change in tax, and they were competing anyway, they will either lower their prices to drive up market share, or simply inflate their profit margins to improve share holder returns. If they are primarily competing with domestic companies, then the domestic companies will also have this `windfall' and if you dont lower prices they might do so to drive up their market share. This almost certainly is the case in the domestic retail industry.

Kinda hard to make an kind of statements without some kind of information about the price elasticity of demand.
(This is central to real discussions about the incidence of a tax)

[phil_20686]

 BunnyGo, on 2012-January-24, 10:16, said:

Because working and making a salary are not necessarily useful to the economy...

I personally think america could make do with fewer Big Mac's.

[phil_20686]

 hrothgar, on 2012-January-24, 10:58, said:

Kinda hard to make an kind of statements without some kind of information about the price elasticity of demand.
(This is central to real discussions about the incidence of a tax)

Yes, but that information mostly doesn't exist. I think its clear that the incidence of corporation tax will vary based on the company and its competitive environment, which is just another way of saying that not all industries have the same elasticity.

[BunnyGo]

 phil_20686, on 2012-January-24, 13:15, said:

I personally think america could make do with fewer Big Mac's.

And yet dividends and profits from owning McDonald's stock is to be more highly encouraged by the economy than investing in a franchise and actually hiring people and running a store?

Quite frankly, I think you need to read hrothgar's response above, and consider what you are actually saying about this. Starting your own business, hiring employees and paying yourself a salary is taxed at the full rate. But pushing money around in the market and getting paid dividends is taxed less. This is not to say there isn't a societal good towards investing in the market, just that I don't think it's "better" than working or other investments of time and/or money.

This whole concept that capital gains are to be taxed less is very recent, and I don't think it's particularly a good one. The *really* strange part of this is with hedge fund managers who take 2 and 20 of clients money as salary, but get to claim it's capital gains.

[mike777]

Starting your own business is pushing money around in the market.

The argument is should there be tax incentives, a lower marginal tax rate, to encourage people to push their own money around in the market.

Should people have a tax incentive to buy, own and run a McDonalds franchise, or BBO for that matter, that is the question. Should they have a tax incentive to invest in a Green Energy or new drug company that may fail and they can lose all their money?

If you think you are never going to invest in any of this stuff or you think only the super rich do, then I can understand why alot of people would say no.

BTW keep in mind alot of this money that is pushed around in the market is pension fund money. If you want higher taxes on this stuff, ok..
--


I have said before if the goal is to raise revenue through more taxes then raise the gift tax rate and get rid of the exemptions.

[barmar]

 mike777, on 2012-January-24, 13:32, said:

Starting your own business is pushing money around in the market.

The argument is should there be tax incentives, a lower marginal tax rate, to encourage people to push their own money around in the market.

Should people have a tax incentive to buy, own and run a McDonalds franchise, or BBO for that matter, that is the question. Should they have a tax incentive to invest in a Green Energy or new drug company that may fail and they can lose all their money?

Right. Moat entrepreneurs can't afford to fund themselves, they need investors to help them out (we're talking about decent sized businesses, not just opening a store or restaurant, which someone can do with just a bank loan). Tax breaks on capital gains encourage that type of investment, otherwise you might just choose the safety of keeping your money in the bank.

[mike777]

 barmar, on 2012-January-24, 13:47, said:

Right. Moat entrepreneurs can't afford to fund themselves, they need investors to help them out (we're talking about decent sized businesses, not just opening a store or restaurant, which someone can do with just a bank loan). Tax breaks on capital gains encourage that type of investment, otherwise you might just choose the safety of keeping your money in the bank.

right but keep in mind getting a bank loan is yet another tax break on the interest. Again the argument is should there be this tax break for people who borrow money to push around in the market?

[barmar]

 mike777, on 2012-January-24, 13:51, said:

right but keep in mind getting a bank loan is yet another tax break on the interest. Again the argument is should there be this tax break for people who borrow money?

Yes, we want people to start businesses, since they hire people and make stuff or provide services. If they can do it by themselves with a bank loan, we give them a break on the interest. If they need investors, we give the investors a break. Either way, the idea is to encourage putting money into new businesses, since that grows the economy.

[phil_20686]

 BunnyGo, on 2012-January-24, 13:24, said:

And yet dividends and profits from owning McDonald's stock is to be more highly encouraged by the economy than investing in a franchise and actually hiring people and running a store?

Quite frankly, I think you need to read hrothgar's response above, and consider what you are actually saying about this. Starting your own business, hiring employees and paying yourself a salary is taxed at the full rate. But pushing money around in the market and getting paid dividends is taxed less. This is not to say there isn't a societal good towards investing in the market, just that I don't think it's "better" than working or other investments of time and/or money.

This whole concept that capital gains are to be taxed less is very recent, and I don't think it's particularly a good one. The *really* strange part of this is with hedge fund managers who take 2 and 20 of clients money as salary, but get to claim it's capital gains.

I don't know about the US history of capital gains tax, but I know a bit about the UK history. It was only introduced as a tax in 1965, and has been in various guises. For a while it was index linked, which removes inflation from the argument. Capital gains was lowered because index linking became much to complicated for the treasury to work out for financial companies, and the UK moved to taper relief, which means you pay less the longer you hold the asset. It tapered from 40 to 20 %. Then they scrapped that about 2000 and moved to flat rate at 18%.

So your assertion is not obviously true for the UK: The rate has moved from about 15 to 40% since 1965. However, this is in the context of much higher rates of income tax, which were above 60% when CGT was introduced. CGT has always been at least 20% below the top rate of income tax.

I also think you need to think a bit more deeply about your example. For example, if you start your own business, you are likely to at some point need some seed money from a VC firm. The profitability of VC firms is strongly linked to CGT - my father got some VC money from a company called 3i back in the day, and they said that for every 10 investments, 6 failed, 3 did ok, and one was successful enough to pay for all the rest. A high rate of CGT makes VC firms virtually impossible. It also effects start ups, as most businesses are not wildly successful, and if CGT is taking a third of the pay off, that makes starting a new buisness seem like it has a lot less upside.

But all of this is basically a side show. Pensions are where its at, and the real and most important reason to not to have a high rate of CGT. The assets under management by pension funds come to about 70% of GDP for most industrialized countries. Most research suggests that this is probably not enough, but thats another argument. Nevertheless, we are talking about real money. If they trade most positions every few years, then they will pay roughly CGT*inflation in a wealth tax, even if they don't make any money. Inflation is sometimes quite high. In the seventies in the UK inflation averaged 10%. If you have 30% CGT and 10% inflation you are going to drive most pension funds into bankruptcy unless the stock market has a real rate of return (i.e. return above inflation) of at least 8%, which is pretty optimistic. This happens because inflation broadens the base for CGT in nominal terms, and you basically end up taking the CGT rate out of the asset total, rather than the gain.

Now you could argue for special treatment for pension funds, as they got in the UK for many years, but of course, a rich person can just start up a personal pension scheme to take advantage of the tax sheltering properties.

It would be nice if rich individuals paid a bit more tax, but screwing over everyone who has a private pension to achieve it is beyond ridiculous. There is a huge societal gain in people providing adequate pensions for themselves. Pension mechanics are dependent on having asset classes that, after tax, provide a health real rate of return, its good if people use the stock market for this, because it makes use of idle capital. Without a reasonable rate of return people will just buy real estate (driving up house prices), or gold, as basically useless inflation busting assets. The stock market puts capital to work, partly through companies issuing shares, partly through rights issues, and partly through providing information to lenders on their creditworthiness.

[mgoetze]

Hi Ken,

 kenrexford, on 2012-January-23, 22:49, said:

The first is appreciation of an asset. An asset (like gold or a house) grows in value against a different asset -- the dollar. The latter asset actually shrinks, because we print so much. So, the asset might might actually grow in real value. It just looks like it grows because the dollar shrinks. So, the tax on the "gain" is really a tax against holding non-dollar assets.

it sounds a bit like you have committed the standard Economist's Fallacy of assuming that markets are efficient, and thus it doesn't really matter which asset you hold. I can assure that they most certainly are not efficient, and there is good money to be made out of these inefficencies. Doing so, however, is work, and there is no reason why people doing such work should be privileged versus people doing other kinds of work.

At a more fundamental level, in general there is actually real growth in the economy, not just nominal growth. If everyone does an equally good job of managing their assets, those who start with above-average wealth will benefit overproportionately. Now it is easy to make this fair - all it requires is that the concept of families be completely abolished. Strangely, this solution does not appeal to most people.

Given that not all people start with equal conditions, capital gains taxes are an attempt to even out the distribution of this real growth so that everyone benefits equally (or at least more in line with how much actual work they do). There are many practical reasons why they will never succeed completely at this goal but they can at least push things a little bit in this direction.

One of those practical problems is that we do not yet have a world government, and if people feel they are paying too much capital gains tax, they can simply move to Thailand, Singapore, etc. I am aquainted (via Internet) with quite a few people who have actually done this. Another is the combination of inflation with the difficulty of assessing everyone's net value. Due to the latter taxes are usually levied only against realised gains, but this approximation makes it impossible to account fairly for inflation. And then of course there is plain old tax evasion...

[mike777]

"it sounds a bit like you have committed the standard Economist's Fallacy of assuming that markets are efficient, and thus it doesn't really matter which asset you hold"


Actually this is a common mistatement/misunderstanding of what EMH is.

[phil_20686]

I thoguht of something else.

One way to look at Cap Gains, is suppose two brothers each earn 100k a year. One decides to spend all his money, and the other decides to save 50% of his money. Saving in this situation is a public good. Not only because savings = investment = spending on capital goods, but also because later if they should both lose their jobs, spender must curtain his spending, whereas saver can afford to continue spending for a while, which will reduce the severity of a recession. Finally, saver will be able to look after himself when he retires, whereas spender will have to rely on the state.

Morever, in so far as spender will receive benefits from the state in his old age, he will then be paying negative tax, saver on the other hand will continue to pay capital gains tax on his dividends and his investments throughout his life. Is it really fair that we should financially incentive spenders behaviour over savers behaviour, when we really want to encourage savers? Moreover, why should the virtuous brother pay a higher total rate of tax (over his lifetime) than his brother?

There is real moral hazard here. Perhaps the answer is to simply raise the threshold for capital gains tax to quite a high level, say $70,000, in a given year. Then it wouldn't really effect anyone outside of the very rich, and you could pay it at a high level after that. Finally, we could exempt public companies from capital gains tax. While this might seem strange - its actually not, as publicly traded companies, if they make a profit they pass it on through their own dividends, which would be taxed at this high rate if they were owned by the very rich.

This would simultaneously solve the problem of the very rich not paying enough tax, and would help pension funds out of the hole they are in due to the great recession, by significantly improving their expected return on investment.