The Capitol Gains

Most people may have no idea what capital gains are, but they’re darn sure they need to be taxed more. Biden’s rhetoric on that topic is straight from the populist playbook: “Why, it is so unfair that the rich pay lower rates on capital gains when you, dear sir, must pay a much higher percentage on your paycheck!” 

            First, he tells us that “the rich” are not paying their “fair share,” whatever that is supposed to mean. But in fact, the top 1% of earners pay nearly 40% of all income taxes. Their average tax rate is two to three times higher than all other tax-paying groups. They pay more in taxes than do the bottom 90% of all taxpayers combined. Even though their share of total income is 21%, they pay almost double that as a share in taxes (40%). Exactly how much would be enough to qualify as a “fair share”?            

            Capital gains tax rates of 15% and 20% (we’ll ignore the Obamacare NIT 3.8% surtax for now) are said to amount to some kind of “loophole” or “giveaway” to the wealthy. But crucial context is missing here, namely the historical reasoning behind these rates, which are based on two factors: risk, and double taxation.

            Let’s tackle risk first. Wage income is risk-free. As long as an employee does his job he will always receive his paycheck. Employers do not withhold wages or discount them based on the performance of the business that week. They do not lower them if the product that the employee helped to produce fails to sell as expected. Capital gains, however, are derived entirely from investments that are 100% at risk. What would be the incentive to risk one’s savings in useful investments only to have the government (as proposed) take up to 50% (including state taxes)?

            Note that the government itself risks nothing, yet reaps a reward (in the form of capital gains taxes) from every winner while leaving every loser hanging out to dry (if all of your investments lose money the government doesn’t give you a tax refund). From the government’s perspective capital gains taxation is literally a game of “heads I win, tails you lose.”

            The second fact that the “loophole” claim ignores is that capital gains are already diminished due to prior taxation on the source of the invested funds. Wage income is taxed once (until subject to a sales tax, but this only lends support to the idea of abolishing one or the other). However, capital gains come already diminished by previous taxation. Suppose a worker earns $100 in wages. After taxes (federal, state, FICA, etc.) she now has $60. She invests that $60 in some speculative venture (stocks, real estate, etc.). After a few years that $60 investment grows to $120, so she sells it in order to enjoy those gains. But had the original $100 not been taxed she would have been able to invest the full $100 and thereby seen it grow all the way to $200. So the original taxation has already diminished her returns on that investment by $80. 

            To offset this tax burden somewhat (and thereby to encourage investment) the capital gains rate has historically been set lower than taxes on wage rates. In our example, in which a $60 investment turns into $120, a 20% capital gains tax on the $60 gain means $12 in taxes, for an after tax gain of $48. But the Democrats are proposing to DOUBLE the capital gains rate, from 20% to 40%. This would reduce that current system’s $48 gain to a mere $36. 

            Here’s what that means. The entire $60 she invested was at risk of falling to $0. Some investments don’t pan out. Sometimes you lose everything. If people are at risk of losing $60 and stand to gain a mere $36, people will be less likely to engage in such investment in the first place, which decreases everyone’s standard of living. The tax both reduces the investor’s effective return and, to the extent it does not dry up the investment market entirely, tends to shift future investments into far riskier (higher return) ventures to compensate investors for the higher capital gains taxes. A market dominated by primarily riskier ventures is a much more volatile and wasteful one, since higher risk generally means more failures. Junk bonds will become the new standard investment

            If the Democrats were politically savvy and not devoted to ideology above all else they would propose eliminating all taxes on capital gains and setting the corporate tax rate to 0%. We would see an explosion in domestic investment and job creation as companies from all over the globe came to the US to set up shop and expand. This happened to an extent with Trump’s corporate tax cuts, though not as much as we might have hoped. Why? Because no one trusts the US government on taxes anymore. No matter how “permanent” the rates are claimed to be, we all know that just like Lucy with the football, whatever tax regime we have today will likely be different tomorrow. And the Democrats are just proving them right by fiddling with taxes not even three years later.

             Sleepy Uncle Joe is just wrong when he says “fairness” demands that capital gains be taxed the same as wage income. He is either being deliberately deceitful or wholly ignorant. Neither is a good option.