A Loophole for the Wealthy?

Demystifying capital gains

Are capital gains a way for the wealthy to enrich themselves at everyone else’s expense? In other words, are they a “loophole for the richest 1 percent,” as we hear so frequently?

After all, most of the top income earners don’t draw hourly wages. If they even take salaries, they are token. As Warren Buffet publicly admitted, he makes virtually all his money from profits on investing idle capital, which is taxed at a lower rate than his own secretary’s salary. Federal taxes on earned incomes can reach as high as 39.6 percent. However, before Obama’s 2014 tax increases, even the wealthiest only paid a paltry 15 percent on the profits that their money made for them. How is that fair?

As it turns out, taxing capital gains at a higher rate would not only stymie economic growth and make all of us worse off; even government revenue could suffer from a higher rate.

While all taxes hurt the economy by discouraging productive activity, a capital gains tax specifically targets investment, and capital investment is the lifeblood of a healthy economy.

Let’s look beyond the rhetoric, and see what the real story is.

What are capital gains?

Capital gains are the profits one makes in selling an asset that was acquired sometime previously. Earning capital gains can involve work or be a relatively passive endeavor.

Requires work: Someone buys a foreclosed house in bad condition. He fixes the house up enough to rent. After procuring tenants, he further improves the property: he adds a nice deck with a hot tub. Five years later, he sells the house for a profit, which is a capital gain.

Requires work: My father bought a rusty old 1932 Ford. He spent several years restoring the car to original condition, and it won many awards. He sold the car for a profit, which is termed a capital gain.

Requires work: An experienced turnaround specialist buys a failing company that will soon go bankrupt. Over three years, he reorganizes it, buys new machinery, launches a new marketing program, saves some jobs, and makes the company profitable again. Work done, he sells the company and pockets capital gains.

Passive: In 1985, a woman buys a $30 bottle of wine in France. She holds onto it for 30 years. By then, the vintage is highly sought after. She sells the bottle for $300 and pockets a capital gain.

Passive: A man picks up some BP stock now for a low price, while oil is cheap. Three years later, the oil price has risen, along with the share price of BP. He pockets a capital gain.

Capital loss

The flip side of a capital gain is a capital loss. Things don’t always go up in value. Gangs could move into the neighborhood of the foreclosed house. Despite all the landlord’s investments, the house’s value could go down. Strangely, the ceiling on capital gains taxation is unlimited, but a taxpayer is only allowed to deduct $3,000 per year of capital losses. How is that fair?

But why is the capital gains tax rate lower than the highest income tax rate? Isn’t this a loophole for the rich?

It is lower for two important reasons:

  1. Although the gain is realized in one year, it actually took place over more than one year. The wine did not increase in value just in the year it was sold. It took 30 years to achieve its higher price.
  2. Capital gains are not indexed to inflation. The person may not receive any more “buying power” when he sells the asset, despite receiving more nominal dollars. The $30 that the bottle of wine cost originally may have bought the same number of pounds of hamburger, bars of soap, or anything else that $300 does today. Because of inflation, a capital gain may in fact be illusory. Indexing capital gains to an accurate inflation rate would be a more accurate and just solution.

Why is it important to have a low capital gains tax rate?

First, it should be noted that some countries, including Switzerland, South Korea, Turkey, and many others, have no capital gains tax. Evidently, they consider increasing the base of capital stock a valuable economic goal. Perhaps not coincidentally, the countries with the highest capital gains taxes — Italy, Denmark, and France — have very low to negative growth rates.

Achieving a capital gain is no sure thing. If the entrepreneur stumbles in reorganizing the failing company, for instance, he could lose all his money. On the other hand, paid wages are never lost. A low capital gains tax could be looked at as a reward for taking the risk of improving capital stock rather than taking the no-risk path of wage earning. If capital gains taxes were as high as income taxes, individuals may just decide to work for wages instead of taking gambles rehabilitating capital stock such as dilapidated houses or failing companies.

High capital gains taxes deter capital investments. This is detrimental in any economy. A country with an inventory of well-maintained houses, for example, is better off than a country with an inventory of dilapidated ones.

Another effect of high capital gains taxes is that individuals will hang on to assets they don’t want anymore, rather than pay high taxes on the gain realized by selling them. When George W. Bush and Congress lowered the maximum capital gains tax to 15 percent in 2004, government revenue from this tax shot up instead of going down. People who owned appreciated capital stock sold assets instead of hanging onto them until death, when they would pass tax-free to beneficiaries.

For these reasons and others, it is foolish and counterproductive to tax capital gains at the same rate as income. Of course, it is also unwise and unjust to tax income at different rates, but that is another argument for another time.

Further Reading