That Capital-Gains Tax

April 4, 1955

One good outcome of the Senate stock-market inquiry may be the public education it has provided on the effects of the capital-gains tax.

This is supposed to be a tax on capital gains. But as it is only collected when an asset is sold, it is, in effect, a tax on selling. An investor must pay, say, a tax of 25 percent on his capital gains on his shares in company X—if he sells them. As long as he holds on, he need pay nothing. If he could be sure that his X shares were going to fall, or even that shares in company Y were going to do relatively much better than X shares, he might make the switch in spite of the heavy tax penalty. But as he can almost never have such absolute assurance, he is likely to stay put. This is what is meant when it is said that many investors are “locked” into their investments.

The tax on long-term capital gains therefore raises comparatively little revenue. But by so heavily penalizing sales or exchanges of property, it makes holdings less liquid and the economy less flexible. It discourages people from acting in accordance with fresh knowledge or new conditions. It thereby not only distorts the relative prices of securities and other goods but prevents much capital from flowing into new enterprises or into the lines where it would be most productive. It is locked up where it already happens to be.

A great injustice of the capital-gains tax is that in an era of inflation it is a tax on gains that do not even exist. If a man bought property in 1939 for $10,000 and sells it for $15,000 today, he is taxed on a supposed profit of $5,000. But this “profit” exists only in paper dollars. In terms of what he can buy with the proceeds he actually has a loss. For the cost of living has gone up 92 percent in the meantime, and wholesale prices have risen 120 percent.

Another injustice in the capital-gains tax is that it is levied by the government on the cynical principle of “heads I win, tails you lose.” For the government taxes capital gains without allowing corresponding deductions for losses. True, it allows deduction of capital losses from capital gains. But though it taxes short-term capital gains, for instance, up to any amount just as if they were income, it allows no more than $1,000 deduction of capital loss against income. This negligible pretense of balance does not change the cynical unfairness toward investors with heavier net losses.

Senator Fulbright asks, even today, why even long-term capital gains shouldn’t be taxed as straight income. The question reveals his ignorance of the history of this measure. The government once did treat both capital gains and capital losses for tax purposes exactly like income. And it was appalled at the results. When the stock market fell from 1929 to 1932 Federal revenues collapsed—because taxpayers deducted their capital losses even from their already reduced incomes.

The crucial revelation came on May 23, 1933, when the famous banker J.P. Morgan disclosed before a Senate committee that he had paid no income tax for the two preceding years. The reason was simply that his capital losses had exceeded his income in those years. But the very idea that J.P. Morgan could skip income tax for any reason at all so shocked headline writers and congressmen that it was decided to change the law. An honest change might have been to treat capital gains and losses as the British Government does. By and large it neither taxes gains nor allows losses to be deducted against income. But our own government insisted on eating your cake and having it too. It in effect decided,(with trivial qualifications) to tax its citizens’ net capital gains and ignore their net losses.

It is easier to point to the inequities in the present tax treatment of capital gains, and to the harm it does, than to suggest an acceptable alternative. The truth is that when a country has progressive income-tax rates running up to 91 percent, it is impossible to work out any fully satisfactory solution of the problem of capital gains and losses. But probably the best solution is that adopted in Britain.