February, 1989

Fruits of Thought

Capital Gains

Few things are more vital to economic growth and prosperity than a properly functioning tax system. What is necessary is a tax system that is generally perceived as fair by the citizenry, which raises adequate funds for economic growth. One tax, which as presently structured misses out on all these points, is the capital gains tax.

The large amount of entrepreneurial activity in this industry makes this a matter of prime concern. Many people work their entire lives taking very little out of their businesses and then fall victim to the unfairness and confiscatory nature of our current capital gains tax.

For many years, there existed what was referred to as a capital gains tax differential. As part of the last bout of tax reform, this differential was eliminated in conjunction with all rates being lowered, so today both capital gains and other sources of income are all taxed at the same rate.

George Bush, during the recent campaign, advanced the idea that he wished to restore the capital gains differential. He presented a proposal which calls for a reduction of the top tax levied on capital gains to 15% which is significantly below the top rate of 28% (33% in certain circumstances) levied on other forms of income.

Capital gains is a tax in which the revenue realized by government is particularly sensitive to the tax rate. It is a tax that a taxpayer chooses to pay by the act of selling an asset at a profit. If he doesn’t sell an asset he doesn’t have to pay. Thus lowering the tax on capital gains could result in at least no loss of revenue to the government and might even result in increased revenues to the treasury.

Many people who have urged lower capital gains taxes have done so with the explanation that lower rates encourage investment in risky ventures. All different types of investment opportunities should compete in those capital markets on their own terms. If all are taxed fairly, then those projects which offer better risk/reward ratios will get funded.

The opponents of lowering the capital gains tax rate say that in all fairness, all income should be taxed equally; that there is no reason to provide a favorable rate to those who realize capital gains as opposed to those who realize income in another form.

The problem is that the current tax structure does not, in fact, tax all forms of investment equally. The current capital gains tax can be outright confiscatory.

Suppose a young woman purchased a stock for $1,000 fifty years ago. Today, a retired widow, she sells this stock to support herself in her old age, and realizes $1,100 from the sale of this stock. Under current law, she gets socked with a big tax on her profit. Under Bush’s proposal she gets hit with a smaller tax, but still a tax. But note, both under Bush’s proposal and under current law, this widow is being taxed on an illusory profit. There has been so much inflation in the last fifty years that if this woman sells her stock for 10% more than what she paid for it 50 years ago, not only has she made a profit, the reality is that she has suffered a substantial loss!

The virtue of the Bush proposal is that it realizes there is a problem with the current capital gains structure. The problem is that it is an unprincipled response. There is no inherent reason why a 15% tax rate is more right or fairer than 10% or 30%. Thus the Bush proposal, though at least an attempt to deal with the problem, is likely to lead to constant jostling of the capital gains tax rate. Constant change in the tax laws is something that makes it difficult for a business to plan effectively.

Is there another approach that could deal with the capital gains in a fair and effective way? I think so.

The first problem with the capital gains tax is that it can unfairly tax people, by taxing inflated profits that are, in reality, losses. This can be solved by indexing the basis for figuring a capital gain. If one purchases an asset for $100.00 and, after experiencing 5% inflation, sells the asset for $105.00, no tax would be due because no profit had been realized.

The second problem with the capital gains tax is that it impedes the free flow of funds which is so vital to the efficient allocation of capital resources in our economy. In a socialist economy, the state puts together grand plans in which it allocates money to different industries. The government decides that biotechnology is a growth field and steel is a shrinking field. As such, it puts resources in biotech and takes them out of steel. In a capitalistic economy, we depend on the private sector to make these decisions. We depend on individuals and businesses that have their ear close to the marketplace, making the decision of how to allocate our economy’s resources. But just look at the problem capital gains taxation causes:

A man owns a wholesale produce business which is worth one million dollars. Let’s assume that he sees the return on his investment in wholesaling to be 10% per year over the foreseeable future. One of his suppliers offers him an opportunity to develop a high-tech, hydroponic greenhouse to raise certain exotics now imported in the country. The man believes that this business will yield a 12% return on his money. Under our economic system we want this person to fund the higher return industries. But take a look at how the capital tax distorts his decision. He currently earns 10% on his one million dollar investment or $100,000.00 per year. He feels he can make 12% or $120,000.00 per year by selling out and investing in this new venture. But upon studying this new venture, he realizes that if he sells his interest for a million dollars, he will not have a million dollars to invest in the new venture. He started this wholesaling company with nothing, many years ago, and so would end up paying 28% of the million dollar purchase price to the IRS. Additional taxes could be due to the state or city in which he lives. Putting these additional taxes aside and just looking at the federal tax after the government takes away 28% of the million dollars; he is left with only $720,000.00. Our hypothetical wholesaler has to redo his calculations. By staying with this wholesale business, he is able to indefinitely earn 10% on one million dollars, but by selling out and investing in the new higher yielding venture, he can get 12%, but only on the $720,000.00 left after taxes. But 12% of $720,000.00 is only $86,400.00, whereas he is making $100,000.00 a year right now! Suddenly, what made sense economically, becomes senseless because of the distortion of the tax system.

This hurts the individual who doesn’t realize the investment he desires to make. It also hurts our economy because resources are not flowing to the most efficient areas and note, of course, that the government gets no capital gains tax revenue either. The solution to this problem can be found in the way we treat homeowner’s capital gains. When a homeowner sells his home and realizes a gain, tax is normally due on that gain. There are, however, some exceptions. One of the major ones is the rollover provision. If you buy a new home within a prescribed time period, as long as that home costs as much or more than the home you sold, no tax is due until the new home is sold, which can be rolled over, etc. This makes perfect sense as tax policy goes. If someone wants to move to pursue a better job offer, we do not want to hold him back. We want to encourage this kind of vibrant, highly mobile society where people can pursue great opportunities. We need to apply the same type of thinking to capital movement by installing a rollover provision for capital gains. Thus, our wholesaler could reinvest his money in another investment with no tax penalty whatsoever. The time to pay taxes will be when the investor chooses to cash in his chips and start consuming the money. As long as the investor keeps investing in our economy, creating jobs and opportunities for us all, it is a grave mistake to attempt to tax this money.

The final change necessary in the treatment of capital gains is the treatment of capital losses. When the rate differential existed on capital gains, there was some justification for limiting the deductibility of capital losses from non-capital income. This justification evaporated when the differential was eliminated. As long as the tax rate is the same as for other income, capital losses should be fully deductible from all forms of income, as a matter of fairness.

The Democrats have played a game of demagoguery with this issue, constantly trying to paint a reduction in capital gains taxation as some sort of special benefit for “the rich.” And the Republicans have been vulnerable because of their inability to articulate the principle which underlies their policies. By adopting this proposal the Republicans would be sending a message that is principled. They would be saying that the government won’t tax profits that aren’t real, that the government won’t interfere with the free flow of capital, and that the government recognizes that you don’t win every time, so it will allow losses to be stacked up with gains in figuring taxes.

The Democratic party always makes fairness a question of class; thus they paint the Republicans as the party of the rich. The Republican response has to be that fairness is a matter of treating individuals in an even handed way. Knowing that the direct benefits of a tax change helps the wealthy doesn’t make it unfair, anymore than knowing that a change hurts the rich makes it fair.

The Republicans need to enunciate their own conception of fairness.  pb