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Dems and Republicans Should Get the Tax Treatment of Capital Gains Right
Raymond Richman, 3/6/2012

Republicans and Democrats in the House of Representatives and the Senate have little understanding of the nature of capital gains and losses and their appropriate treatment in a system that imposes a progressive individual income tax and a corporate income tax and in which proprietorships, partnerships and corporations are subject to different tax treatments. Republicans advocate zero tax on capital gains and believe that corporate dividends are subject to double taxation, once by the corporation and again by the personal income tax. They believe this justifies a zero tax on capital gains and little or no tax on dividends under the personal income tax. Here is a look at the current treatment of capital gains and what we recommend as the appropriate tax treatment.

From 2008 – 2012, long-term capital gains on assets held more than one year were taxed at a zero rate in 10 and 15% income brackets. Those in the 25-35% income tax brackets were taxed at 15%. Short-term capital gains (on assets held less than one year), were taxable at ordinary rates. Democrats argue for higher rates. The president proposed for 2013 a long-term rate of 10% instead of a zero rate in the two lowest income tax brackets and a 20% rate in the higher brackets. Capital losses offset capital gains and are limited to a deduction $3000. Republicans usually argue for a zero rate on capital gains.What is the appropriate treatment?

What is a capital gain or capital loss? A capital gain is an increase (decrease) in the value of a capital asset: stocks, bonds, houses, farms, other real estate, paintings and art objects, antiques, etc.. What causes assets to appreciate in value? In the case of common stocks, the principal source of capital gains, price increases are usually caused by increased earnings per share and, in the case of real estate, higher rents. Capital assets generally increase in prices as a result of inflation and less often as a result of a reduction in interest rates used in calculating the value of capital assets. On assets held for long periods of time, their value often increases as a result of inflation, on the average about 2.5 to 3 percent per year, in which case the resulting capital gain is illusory and should not be subject to tax at all.

In recent years, corporations have often engaged in buying back their own shares in order to create capital gains. The same net revenue divided by a reduced number of shares tends to increase share prices.

Are capital gains income? One of my professors at the University of Chicago, Henry Simons, argued that they were income. His view is the accepted view of most academics. We do not agree.

Capital gains are capital that has increased in value. Like all capital assets, they represent the value of the stream of future income expected to accrue to its owner. If the owner sells the asset and consumes the proceeds he is in effect consuming the future stream of income which justifies treating consumed gains as income and taxing them as ordinary income. But what if the investor reinvests the gain? He is in the same position he was in before he sold the asset. That is why a number of economists argue that capital gains should not be taxed at all if the proceeds are reinvested (“rolled over”).

That was the rule that applied to housing for a long time. If you sold a house and used the proceeds to buy a new one, your capital gains would not be taxed. Unfortunately, Pres. Clinton’s advisors convinced him there should be no capital gains tax on houses. Unless the entire capital gain from the sale of a house was the result of accumulated inflation since it was purchased, the Clinton treatment was and continues to be unjustified.  Capital gains, whatever the nature of the assets, should be treated the same from the standpoint of the principle of equal treatment of equals. The exemption was simply a political ploy to win homeowners’ support in coming elections. It will be difficult to restore the proper treatment because opponents will argue that it would increase taxes on homeowners.  (The same argument will be made when the cut in the social security tax last year and this year is eliminated. Can you hear it? “You’re raising taxes on wage-earners!”  

The preferential treatment of capital gains causes corporate managers to buy back some of the outstanding shares of its stock which is a way of converting ordinary income into capital gains which will be taxed as a lower rate when sold. Corporate managers prefer buy-backs to dividends even though the current rate on dividends is the same as the tax on long-term capital gains, 15 percent. The reason corporate managers prefer buy-backs is because they often receive options to buy shares as an annual bonus. Dividends won’t increase the value of stock options managers receive as a bonus whereas buy-backs will!

Zero and reduced rates of tax on capital gains are not an incentive to invest. If gains are expected the price paid to purchase the asset already reflects the anticipated gain. Growth stocks, for example, tend to have higher P/Es (price earnings ratios) than shares of companies that are not expected to grow. When shares increase in value from the time the shares were purchased, as a result of increased corporate earnings, the increased corporate income is subject to the high rates of the corporate income tax. If capital gains are untaxed or given preferential treatment, the owners are give an incentive to realize the gains rather than hold on to them. If one holds on to the assets, the corporation’s income will be subject to normal corporate income tax rates whereas the capital value of the increased income if realized as a capital gain, will be taxed at a much lower rate. The difference in rates encourages the sale of the asset and its consumption. Preferential treatment thus encourages the consumption of capital, an undesirable economic effect.

The correct treatment of capital gains in our opinion is to tax capital gains as ordinary income unless the gain is reinvested within a reasonable time. In the case of corporate shares, this would mean buying a similar capital asset within a month or two; in the case of houses, within six months or so.  There should be no tax on capital gains that are rolled-over.  The incentive to engage in manipulations to convert ordinary income into the form of capital gains would be eliminated.

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