Capital Gains

Mr. Hagedorn is Economist and Vice-Presi­dent of the National Association of Manufac­turers. This article is from his column in NAM Reports, June 9, 1969.

At this time the whole Federal income tax system is under scru­tiny, with the possibility that sub­stantial changes will be made in it. In the discussion, the subject of tax treatment of capital gains is being brought up. Frequently, the attitude is expressed (or implied) that capital gains are, after all, simply one kind of income which should be taxed in the same way as any other.

We see this assumption embodied in some of the statistical horror stories, intended to illus­trate how wealthy taxpayers get away with murder. The usual pro­cedure is to show that the tax­payer really pays a much lower rate on his income than the sched­ule of tax rates would suggest he should. In the computation of his "actual" tax rate, capital gains are included in the divisor, on a par with the wages, dividends, and interest received.

The same view appears more ex­plicitly in a statement by Profes­sor Robert Eisner, of Northwest­ern University, recently included in the Congressional Record. After protesting generally against tax "loopholes," Professor Eisner goes on to say: "Most conspicuous and substantial are the huge amounts of income now enjoyed in the form of capital gains." A little later he argues: "For those who take the capital gains route of earning money, taxes are of course mini­mal…."

This raises a question which we will try to analyze in this column. Are capital gains simply another form of income—to be logically included in income totals, and taxed, on the same basis as any other form?

We may note, first, that the De­partment of Commerce, in its com­pilations of the national income, does not include capital gains. This is a matter of well-established sta­tistical practice on which there is no dispute among experts. The reasons for it are obvious. To in­clude in the total of the national income an item resulting solely from the revaluation of existing assets would be to give a com­pletely false picture of the state of the economy. We cannot make each other prosperous by selling each other things which have been around all along, even if we raise the figure on the price tag. There is no real income for the nation in such exchanges.

But this still leaves the ques­tion of whether capital gains may be a real item of individual in­come. Is it possible, in some strange way, that a realized capi­tal gain is an integral part of a person’s income, without being part of the total national income? This question is often dismissed impatiently with the comment that anyone may spend capital gains in just the same way he spends his salary or his dividends. A person, if he chooses, may spend all of his past savings and not only the part he regards as a capital gain. But this doesn’t mean that when we draw down on past savings they become current income.

When this is brought up, the argument usually shifts to another ground. It is contended that a per­son may spend his capital gain, and still leave his savings intact.

This sounds persuasive until we analyze its implications. Suppose your savings are in the form of ten acres of land, for which you originally paid $900 an acre but which are now worth $1,000 an acre. You might figure that you could sell one acre and spend the money on consumption without impairing your original savings. After all, you would still have $9,000 worth of land left. It sounds good but, if the price kept going up and you kept selling land an acre at a time and spending the money, it would be hard to main­tain indefinitely that you weren’t impairing your savings as your landholdings declined toward zero.

It seems clear that when the government taxes capital gains, it is taking a share, not of the indi­vidual’s current income, but of his past savings. The fact that the market might have revalued the assets in which those past savings are embodied doesn’t change that situation.

Of course, political leaders who pride themselves on being "prag­matic" may brush all this aside. Capital gains are there and, since the government needs revenue, why not tax them? A fine theo­retical distinction as to whether they are or are not income may seem beside the point.

We will not comment on this pragmatic view beyond pointing out that it would be hard to com­bine it with moralistic protests of outrage at the present special tax treatment of capital gains. We do feel some qualms at the thought that the government could justifi­ably tax anything that is handy, simply by declaring it to be in­come.

We suppose that some form of the pragmatic argument will con­tinue to prevail and that capital gains will continue to be taxed. We hope, however, that political pragmatism will include some rec­ognition of the practical effects of capital gains taxation on the economy.

The impairment of individuals’ past savings by capital gains taxa­tion is matched by an equal im­pairment of the nation’s supply of capital for use in production. The fact that such impairment, in either sense, is currently made good from other sources doesn’t change the matter.

Presently there are strong voices calling for more severe tax treatment of capital gains, on the ground of equity as among tax­payers. It seems to us a case of an invalid argument being used to support an economy-damaging proposal.