In Context: Long-term Capital Gains

One of the big arguments going on in Washington these days concerns long-term capital gains taxes. If you are not familiar with the idea of capital gains, a simply example will enlighten you. Imagine you buy one share of stock in a company for $100 and then sell that stock sixteen months later for $150. The long-term capital gain to be taxed is $50. The question politicians are trying to grapple with is what tax rate should be levied against this gain? Politicians on the right side of the political spectrum argue that low taxes on investment gains encourage people to invest. The rationale here is that if taxes are lower, overall returns on investments are higher. Greater returns mean that people are more eager to invest today and reap the benefits sometime in the future. (As opposed to purchasing and consuming goods today.)

High rates of long-term investments are, unarguably, good for a society. And left leaning politicians and economists don’t disagree. They do, however, want to raise the long-term capital gains tax rate (currently 15%) for people in high income tax brackets. For one thing, they point to studies that suggest that the negative correlation between cap. gains tax rates and investment as a percentage of GDP is weak. Many studies suggest this correlation is weak because wealthy individuals have no real option but to invest their money. It is logical to argue, for example, that a multimillionaire is not going to fundamentally change his/her consumption habits just because the cap. gains rate goes from 15% up to, say, 25%. If consumption habits for the rich don't change, investment doesn't change. For middle income earners, on the other hand, high tax rates might very well dissuade them from saving. They might decide that purchasing a wide screen TV today gives them more pleasure than investing and reaping the reward (net of taxes) from saving. [As a side note, income earners who have a marginal tax rate of 10% or 15% pay no long-term capital gains taxes. But short-term capital gains are always taxed at a taxpayer’s marginal rate.]

A point that must be made here is that a separate tax for both corporate profits and capital gains is, in effect, a form of double taxation. Many people find it outrageous that Warren Buffet’s secretary has a higher federal income tax rate than her boss, the third richest man in the world. This misses the big picture, though. The income Warren Buffet makes through his ownership interest In Berkshire Hathaway is taxed at the corporate rate of 35%. (The fact that corporations rarely have this as their effective rate is a whole other issue). After the double taxation, it is pretty safe to assume that Buffet’s overall effective rate is higher than his secretary’s.

The idea of efficiently, and whether it is prudent to take resources away from highly productive members of society and give those resources to a (sometimes) inefficient government sector, is a subject that is complicated and deeply connected to the issue of our country’s massive budget deficits.

Finally, I think you have to take into account fairness when thinking about raising more taxes from wealthy individuals. Is it fair for the rich, who already pay most of the federal taxes in America, to carry more of the burden? If the answer to that question is no, well then you have to cut into programs that are important to the poor and the middle class, two groups that have been devastated by the great recession. It is easy to balance the scale of taxation and capitalism during times of prosperity, but it is much harder to do during times of scarcity.