Are Capital Gains Taxes Actually Too Low?

| by CEI

By Hans Bader

Capital gains taxes are much too high, rather than too low. They are effectively a tax on savings, since when your investments go up solely due to inflation, you have to pay capital gains tax on them when you sell them, even though you didn’t really get any richer. Thanks to capital gains taxes, you get punished just for living during a period of inflation. As I noted recently in The Washington Times:

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Warren Buffett was wrong to suggest that capital gains taxes are too low (“Calling Buffett’s bluff,” Comment & Analysis, Monday). They are actually much too high, since they force people to pay taxes when they sell a stock based on inflation that occurred after they bought it.

Impoverished investors can be forced to pay capital gains taxes even during huge slumps in the stock market, when inflation masks the slump. Capital “gains” are not indexed for inflation; the seller pays tax not only on the real gain in purchasing power, but also on the illusory gain due to inflation. The liberal economist Alan Blinder, a former Federal Reserve Board member, conceded in 1980 that “most capital gains were not gains of real purchasing power at all, but simply represented the maintenance of principal in an inflationary world.”

Between 1970 and 1980, U.S. stock prices fell by half after being adjusted for inflation. But if you sold stock in 1980, after a decade of getting poorer and poorer you would have had to pay capital gains tax, since inflation made stock prices rise in nominal terms. That inflation penalty – not favoritism toward the rich – is why capital gains have historically been taxed at lower rates than other kinds of income, like Warren Buffett’s salary.

In addition to punishing people for inflation, the capital gains tax comes accompanied by unfair “heads I win, tails you lose” provisions designed to artificially inflate your income. If your investment falls radically in value, and you lose tons of money on selling it for a pittance, you cannot deduct that loss on your taxes for that year, since your tax return limits you to $3,000 annually in net capital losses, even though you are liable for an unlimited amount of capital gains. So if you earn $60,000 in salary, but lose $60,000 on an investment, resulting in a true annual income of $0, you will have to pay taxes that year as if your income was $57,000 ($60,000 minus $3,000 in net capital losses), rather than the true figure of $0. (Theoretically, you may be able to deduct the remaining loss over succeeding years at a rate of $3,000 per year – if you are lucky enough to have no other future losses that count towards the $3,000 limit — but the value of that deduction falls quickly due to inflation and the passage of time.)

As Stephen Moore notes,

Another strange feature of the tax is that individuals are permitted to deduct only a portion of the capital losses they incur, whereas they must pay taxes on all of the gains. When taxpayers undertake risky investments, the government taxes fully any gain they realize if the investment has a positive return. But the government allows only partial tax deduction (of up to three thousand dollars per year) if the venture results in a loss. That introduces a bias in the tax code against risk-taking.

There are other, more trivial double standards as well that harm investors. If you make money on a short-term investment, you will pay ordinary income tax on all of it, regardless of whether or when you subsequently buy replacement stock; but the wash sale rule prevents you from claiming a loss on a sale of stock if you buy replacement stock within 30 days before or after the sale.

Economists have argued that capital gains taxes are a form of double taxation, since they are levied on assets such as stock price whose value has already been reduced by corporate income being taxed at the corporate level, though the corporate income tax, resulting in the same income effectively being taxed twice.