Capital Gain vs. Income

June 17, 1963

The decision of the House Ways and Means Committee to tax long-term capital gains more leniently is a step in the right direction. But it once more raises the question whether there is any economic justification for a capital-gains tax at all.

Economists have long pointed out that capital gains are not income. Capital values are the result of income, the “capitalization” of income. Security values rise and fall with income (and dividend) fluctuations. Corporate income is already taxed twice. First, the whole amount is taxed directly (about 52 percent); then whatever part reaches the stockholders as dividends is taxed again at personal income-tax rates. Price changes cannot be regarded as income legitimately subject to income tax, since the physical asset itself is unchanged. A capital- gains tax on securities is not merely double taxation but triple taxation.

Since 1933 neither Congress nor the Treasury has honestly believed that capital gains are indistinguishable from other forms of income. Otherwise they would have allowed all capital losses to be deducted in full from other forms of income. How can they justify taxing even short-term gains at ordinary income-tax rates as long as they refuse to allow deduction of short-term losses in full not only against short-term gains but against all other forms of “income”? The allowance of a maximum deduction of $1,000 a year of capital losses against income is a token pretense of two-sidedness in a cynical heads-I-win-tails-you-lose tax.

A TRANSFER TAX

The “capital-gains” tax is a sort of haphazard capital levy. It is in reality a transfer tax. It penalizes anybody who transfers from an investment he considers less promising to one he considers more promising—or who is forced to raise cash. With these exceptions, the capital-gains tax is optional; the taxpayer can indefinitely postpone or avoid it by not selling. And when the penalty on selling is as heavy as it now is, he is better off not selling unless he is certain (which he can seldom be) that his eventual loss from holding an asset will be greater than his immediate loss from selling it.

The Ways and Means Committee has provisionally decided to make this tax a little less onerous and to encourage some investors to sell investments with which they are now “locked in.” While still taxing short-term capital gains (on assets held for less than six months) at ordinary income-tax rates, and while still taxing 50 percent of the capital gain on assets held between six months and three years (or at a maximum rate of 25 percent on the whole gain) the committee proposes taxing only 30 percent of the capital gain on assets held longer than three years.

TAPERING OFF

But as long as the committee is willing to go this far, why not carry out the logic of the change? If it keeps its present dual method of approach, it could tax 50 percent of the capital gain on assets held one year more than six months, 40 percent of the gain on assets held two years more, 30 percent of the gain on assets held three years more, 20 percent of the gain on assets held four years more, 10 percent of the gain on assets held five years more, and put no tax on assets held longer than six and a half years. It could accompany this schedule with maximum tax rates, respectively, of 25, 20, 15, 10, 5, and 0 percent of the whole gain.

And if this seems too complicated it could always, like Great Britain and other countries, refrain from taxing long-term capital gains at all.

It is excessive and discriminatory income taxes, in fact, that create the so-called problem of capital gains. When the government levies confiscatory rates up to 91 percent on high incomes, a corporation must pay an executive whose top income gets into higher brackets up to $10 more for every $1 more he can retain in net income. This is prohibitive, so the corporation substitutes a stock-purchase option. Then the government frowns on this as an evasion and a “loophole” and resorts to complicated tax provisions to stop it. But if it levied a proportional income-tax rate to begin with, or at least halted at a top rate of 50 percent, the “stockoption problem” would hardly exist.