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What Is the Appropriate Tax Treatment of Capital Gains?
Raymond Richman, 4/11/2015

Capital gains are currently subject to tax when the capital asset is sold or otherwise realized.  Most economists believe that accrued capital gains, that is, unrealized gains, are income but they are confusing capital and income. When one owns an asset whose price has increased in value since it was acquired, he has an accrued but unrealized capital gain. He may realize the gain by selling the asset. To tax accrued but unrealized gains as income while taxing the increased yield which the capital gain capitalizes would be double taxation. It would be taxing the annual yield and its capital value. The value of a capital asset, as every economist should know but often does not, is the capitalized or discounted value of the expected stream of income it is expected to yield its owner. He pays taxes on the yields, the stream of income, as they are earned. To tax accrued gains and the yields as they accrue would be double taxation of the yields because capital value is the value of expected yields. Only realized capital gains can be considered income. Only when a capital asset is sold is the capital gain considered realized and subject to tax.

Holding on to a capital asset which has appreciated in value leaves the owner subject to taxes on its annual yield. Selling a capital asset which has appreciated in value relieves the owner  from paying taxes on its future yields, which will have to be paid by the buyer. No capital value is created by the sale nor has any been destroyed. The case for taxing capital gains as income rests on the fact that in selling the capital asset, the seller is realizing the change in capital value caused by the increase in expected yields during the period of his ownership. He is, in effect, realizing the income that the change in value represents. There is no reason why the capital gain should not be considered income to him. 

But if the asset was held for a number of years, part of the gain may be illusory as a result of inflation. So a case can be made for adjusting the gain by indexing for inflation. Taxing capital gains at a lower rate than ordinary income benefits investors who have held the asset for only a year or two and insufficiently benefits taxpayers who have held the asset for a large number of years. We currently give no reduced rate if the asset sold was held less than a full year.

Many believe that capital gains are the engine of economic growth and that taxing capital gains at lower rates than ordinary income—wages, net rents, interest receipts, and business profits – stimulates investment. Just the opposite is true. Purchasing existing capital assets, for example existing stocks, bonds, real estate, and existing businesses is not investment from a social point of view. They contribute nothing to Gross National Product. Only the production of durable capital assets during a specific year is considered investment. As this is being written, General Electric announced that it is selling its real estate and banking business assets to Wells Fargo and Blackstone Group for $26 billion. So far as GE is concerned it is disinvestment. So far as Wells Fargo is concerned, it is investment. It will not have increased or decreased national output at all. GE announced that it will buy back its own stock in the amount of fifty billion dollars. That will tend to increase the value of remaining shares creating accrued capital gain for its shareholders. It will not show up in the national income accounts either.

Are capital gains income? Realized gains are because they are the capital value of future yields. Selling as asset which has appreciated in value means realizing the present value of the increased yields that caused the asset to appreciate. Realizing the present value of increased yields is equivalent to receiving those future yields which would have been subject to income taxation. The lower rate applicable to realized gains is an incentive to realize them, to disinvest.  The buyer’s savings used to buy the asset could have been invested in a capital asset that produces a product and cause economic growth. Buying an existing asset does not.

A lower rate of income tax on realized capital gains encourages taxpayers to sell assets they own because holding on to the asset subjects them to the higher rates of tax on ordinary income. The buyer’s investment is converted to consumption.

Indexing would increase the complexity of calculating any tax on capital gains. A simpler solution would appear to be to tax only fifty percent of gains on assets held more than ten years instead of one year as under present law. While not as equitable a solution as indexing would be, taxpayers could be given the option of avoiding any capital gain tax at all by reinvesting the proceeds within, say, 60 days, This was the treatment accorded gains from the sale of one’s home until Pres. Clinton eliminated the capital gains tax on the sale of one’s home entirely.

The appropriate treatment of realized capital gains is to treat them as income excepting only some provision that takes into account that some or all of the gain may be illusory.