As Occupy Wall Street protesters deliberate over a policy agenda that would combat economic inequality and political favoritism, they will find no target better suited to their mission than the tax break for capital gains. Under current law, the maximum tax rate on profits from the sale of investments held longer than a year is 15 percent. That rate is substantially less than half of the 35 percent applied to ordinary income for the highest earners, who collect an overwhelming share of taxable capital gains. Reforming the tax code to abide by the simple principle that income from investments should be taxed at the same rate as earnings from work would greatly enhance the fairness of the tax system while eliminating myriad economic distortions.
While the nation's economy remains far below its potential capacity, with the unemployment rate stuck above 9 percent, it would be premature to raise any tax rates today. But because it will take time to overcome the powerful political forces defending the special treatment of capital gains, it is by no means too soon to begin the campaign to eliminate the tax break.
As things stand, capital gains rates are scheduled to rise in 2013, with the highest level increasing from 15 percent to 20 percent. But that would still remain substantially below ordinary income tax rates, which are slated to rise to a maximum of 39.6 percent that year (the same as in the Clinton administration). Those scheduled increases are highly tentative, however, given the presidential election next year. A new Republican president, for example, would be sure to push for rescinding those increases and probably for rate reductions as well.
Notwithstanding the political obstacles, the case for eliminating the tax-favored treatment of capital gains is so compelling that there are at least ten reasons to do it:
1. Only the rich would feel the bite. If capital gains were to be taxed as ordinary income, about 72 percent of the additional revenue to the government would come from the 0.3 percent of taxpayers with annual incomes above $1 million, according to an analysis by the Tax Policy Center. Fully 92 percent would be paid by those with incomes above $200,000. Fewer than 10 percent of taxpayers earning below $75,000 would experience any increase at all, and on average the tax increase for that large swath of the population would be below $50.
Most Americans earning under $100,000 a year who own mutual funds, stocks, and bonds hold those assets in retirement and other tax-deferred accounts that are not subject to capital gains taxes. Only the wealthy can afford to max out on the annual contribution limits to those accounts and have their remaining securities transactions exposed to capital gains levies. That's why so few average households would be affected by eliminating the exclusion. This figure deriving from Tax Policy Center data conveys the average share of adjusted gross income attributable to capital gains (light blue) for households at different income levels:
2. Lower levies on capital gains are the main reason why the wealthiest Americans pay a smaller share of their incomes in taxes than those who earn less. The billionaire investor Warren Buffett has repeatedly said that something is wrong with the tax code when he pays a lower share of his income to the government than his receptionist. The reason for that perverse outcome is that such a large share of the income of higher earners is subject to the lower capital gains rate. As the chart below prepared by the Center for American Progress conveys, the effective tax rate (the portion of all a taxpayer's income paid in taxes) for the top 400 households is lower than for those earning between $74,700 and $102,900, and about the same as that owed by people making between $50,00 and $74,700:
3. There is little evidence that tax-favored treatment of capital gains has produced broad economic benefits. Advocates of the capital gains tax break have claimed for decades that the exclusion benefits the economy and all workers by encouraging higher levels of investment and savings, which in turn promote growth and prosperity. But researchers have never been able to demonstrate that such connections actually exist. Capital gains tax rates have gone up and down over the years with little apparent relation to economic performance, aside from fleeting effects on realization of capital gains when rates change.
For example, over the period when the top capital gains tax rate declined from 28 percent in 1987, to 20 percent in 1997, and then 15 percent in 2003 (and 0 percent for individuals in lower tax brackets), household savings rates steadily fell as well, defying the advocates' claims. Arguments that preferential capital gains tax rates boost high-risk investments such as venture capital fail to note that those resources are primarily supplied by institutions not subject to capital gains taxes, such as pension funds, college endowments, foundations, and insurance companies. The National Venture Capital Association reported that only 10 percent of investors in venture capital funds were individuals and families who might owe capital gains taxes.
A study by the nonpartisan Congressional Research Service, The Economic Effects of Capital Gains Taxation, concluded: “Capital gains tax rate reductions are unlikely to have much effect on the long-term level of output or the path to the long-run level of output (e.g. economic growth).” Likewise, leading tax analyst Leonard E. Burman found that capital gains rates have displayed no contemporaneous correlation with real GDP growth over the past forty years. He also tested the possibility of lag times in growth effects and found no statistically meaningful correlation for lags of up to five years.
4. The tax-favored treatment of capital gains is a notorious source of complexity in the tax code, diverting the energies of highly paid accountants and lawyers into wasteful efforts to shelter the incomes of wealthy clients from taxes. The elaborate tax forms known as Schedule D (“Capital Gains and Losses”) and Form 8949 (“Sales and Other Dispositions of Capital Assets”) provide a superficial glimpse at how the differential tax treatment of capital gains can suck up enormous quantities of time and money for the well-heeled and their tax pros. But much more costly and wasteful than the tedious forms are the strategic energies engaged in manipulating income flowing to the wealthy in ways that minimize tax liabilities.
A recent IRS study showed that the primary source of capital gains income has shifted from stocks to “pass-through” entities (gains on assets sold by partnerships, S-corporations, and estates and trusts). In 1999, corporate stock constituted 42 percent of total capital income while pass-through gains amounted to 25 percent; by 2007, those numbers had essentially reversed with pass-through income comprising 40 percent of the total while stocks accounted for 25 percent. Money managers who oversee the assets of private equity partnerships are among those who benefit from beneficial treatment of capital gains.
That transformation has required an enormous investment of brainpower, administrative work, and other energy that has profited individuals engaged in those activities without any discernable payoff to the rest of society. Little of that unproductive work would continue if capital gains were taxed at the same rates as earnings from work.
5. Eliminating the capital gains tax break would generate substantial government revenues that could be used for job-creating public investments. The fiscal cost of taxing long-term capital gains at a low rate amounts to $38.5 billion in fiscal year 2012 and $256.3 billion over the five-year period from fiscal 2012 through 2016, according to the Office of Management and Budget. By way of comparison, all federal grants to the states for education, training, employment, and social services combined amount to about $70 billion for fiscal 2012. So the revenues gained from eliminating the capital gains tax exclusion could add more than 50 percent to the resources available for those jobs and income-security programs.
6. Even without the tax exclusion, capital gains still receive favored treatment compared to other income. Investments that increase in value over time are not subject to taxes until they are sold, while earned income is taxed as it is received. That distinction enables the value of investments to compound untaxed for years, giving assets a significant advantage over work as a form of wealth accrual. Moreover, inherited property, when sold, is taxed only on gains accrued since it was inherited. That provision, which the writer Michael Kinsley has dubbed the “Angel of Death loophole,” is an enormous gift from the government and households with minimal assets to the wealthiest American families, who can pass along their good fortune from generation to generation.
7. The defenders of the capital gains tax exclusion are highly paid lobbyists financed by wealthy beneficiaries, while no countervailing political force is organized to fight on the other side of the issue. For decades, the central priority of the powerful lobbying firm known as the American Council for Capital Formation (ACCF) has been to reduce tax rates on capital gains. Along with the U.S. Chamber of Commerce and dozens of other well-financed groups representing the intererests of corporations and their executives, the ACCF sustains a drumbeat of claims about the economic virtues of the capital gains tax exclusion that bear little resemblance to the findings of serious academic research. Nonetheless, the direct personal stakes to wealthy business leaders of keeping capital gains taxes low keep the lobbyists well financed and energized. Because the rest of the public perceives little personal benefit to be gained from raising those rates, there isn't much of a constituency to fight back. That imbalance in the political system is emblematic of how policies in Washington have perpetuated broad economic inequalities.
8. Most financial advisers and successful investors argue that saving and investment decisions should be driven by assessments of risk and reward rather than tax considerations. Investors gain when they put their money in assets that rise in value and lose when they choose options that sink. Tax rates don't change that basic calculus. An investor who decides to hold onto 100 shares of a $10 stock because he doesn't want to pay 15 cents on a one dollar capital gain will be worse off if the stock drops back to $9. It is true that capital gains taxes can deter the sale of appreciated assets for investors who are uncertain about whether to sell or hold. But the wisdom of that decision will ultimately depend on how the investment performs—not how much the investor ultimately pays in capital gains taxes.
9. President Ronald Reagan, the idol of conservative Republicans, was the only president to sign legislation raising capital gains taxes to the same level as income taxes. Most tax experts consider the historic 1986 Tax Reform Act, which was passed with bipartisan congressional support, to be one of the greatest legislative accomplishments of the past fifty years. It rid the tax code of dozens of special loopholes, including the tax exemption for capital gains, while reducing rates on earned income. Bruce Bartlett, who was a senior economic adviser to Reagan, recently wrote: “In the end, the key compromise that made the 1986 law work was Reagan's willingness to raise the capital gains tax to 28 percent from 20 percent in return for dropping the income tax rate to 28 percent from 50 percent.” Today's conservatives are the strongest opponents of eliminating the tax-favored treatment of capital gains, but it's instructive to remember that even their hero didn't consider the exclusion to be sacrosanct.
10. As a matter of principle, income from investments should not be treated as more beneficial to society than income from work. The labor each worker engages in contributes directly to the economy day in and day out, while buying, holding, and then selling investment securities is a much more passive undertaking that may or may not add to the nation's productive capacity. A man of leisure who collects $75,000 in capital gains income owes less in taxes than working parents holding down multiple jobs who together earn the same amount. It is long past time to restore a modicum of fairness to the tax code and end the tax-favored treatment of capital gains.