Equalizing the rate of tax on income and capital gains

I don’t usually like to recycle old material, but @ModeledBehavior just linked to this 2007 MR post, which remains relevant to current debates.  Here is one excerpt:

My uninformed-by-ever-having-been-a-tax-lawyer sense is that loss offsets for the capital gains tax are worth a great deal to some investors.  Sell your winners to coincide with selling some losers and claim a net gains income of zero or very low.  Let the asset winners ride and they will end up in your bequest and have their taxable values reset upon your death.  If your option values line up the right way, you have enough diversification, and you are not liquidity constrained, it seems that for many people the de facto rate of capital gains taxation is not 15 percent but rather close to zero.  (Maybe not quite zero in expected value terms; it’s tricky because if the losses exceed the gains you can deduct only $3000 of the losses from regular income but on the upside you’re taxed all the way.  On the other hand, you can offset with charitable deductions.)

Let’s say we raised the book rate of tax on capital gains to forty percent.  For some people the net real rate of tax on capital gains could still be zero.  For other people it would be forty percent.

Let’s say we raised the book rate of tax on capital gains to eighty percent.  For some people the net real rate of tax on capital gains could still be zero.  For other people it would be eighty percent.

Under which of these scenarios have we equalized the tax rates on capital gains and labor income?

Comments

Why would you keep the step-up in basis at death? It's one of the weirder tax breaks for the rich in the US tax system.

Perhaps this is a short-term / long-term distinction. Short-term capital gains (held less than one year) are taxable as ordinary income- only long-term gains get favorable tax treatment. So maybe this is a third bucket.

I'm not saying it's right or wrong, but Germany, for example, does not tax long-term gains If I'm not mistaken.

p_a unmasked.

We had carryover basis at death for a while. It was an administrative nightmare, because the person who bought the property was dead, and so not around to answer questions about how much the stuff cost back when. Not a huge problem for publicly traded securities, I suppose, since for those you'd just have to know when they were bought, but no fun for other things.

Yes, this.

I wholly agree with the article, and this is one of the techniques in tax alpha that I provide clients. Alter the step-up basis, though, and it merely changes the incentive structure and administrative costs.

The government's perverse objective is to maximize tax revenues with some politically obligatory deference to economic consequences. It still troubles me to view this in terms of redistribution rather than funding the minimal necessary public goods and services.

There are no completely satisfactory answers, but here are some of them which cumulatively add up to a partial, albeit conflicting explanation:

1. Practicality---Difficulty of ascertaining the basis of assets held for very long periods;

2. The idea that the estate tax is a substitute for capital gains tax (note that assets that are not subject to US federal estate tax, e.g. inherited from an NRA) don't get carryover basis (conflicting with the rationale of 1)---why do we have estate tax?;

3. Death is not a realization event to the decedent and taxing the gain to the heirs would be tantamount to taxing the capital itself;

4. Same problem with respect to "capital gains" generally, "gains" are often not gains due to inflation and it is arguably a double tax.

4. While this is often referred to as a "basis step-up", in fact the beneficiary receives basis equal to the FMV at death (therefore, also potentially a "step-down").

Note that when Bush temporarily eliminated the estate tax (for one year), the step-up rule was also abolished (subject to a limited credit against subsequent capital gains tax). This caused consternation among some large estates such as George Steinbrenner who figured out that while they avoided the estate tax (proper planning could have reduced that substantially anyway), they didn't avoid future CG tax on Yankee shares (purchased at about $10 million). As a result, these assets are typically tied up for quite some time.

As Holmes said, the life of the law is not logic, but experience.

I am frequently amazed at the level of intelligence and experience on this blog. This is as good an example of expert knowledge as you will see on any blog. Lawyers, doctors, financial advisors, researchers - this place has it all.

"4. Same problem with respect to 'capital gains' generally, 'gains' are often not gains due to inflation and it is arguably a double tax."

Actually, even with no inflation, capital gains taxes, along with all taxes on savings and investment (interest, dividends, etc.) are double taxes. In illustrating this point, we can simultaneously answer Tyler's original question, "Under which of these scenarios have we equalized the tax rates on capital gains and labor income?" Suppose we have $100 in wage income, which we can either consume immediately or save for one year earning interest of 10%. Then, absent taxes, we can either consume $100 now or $110 one year from now. Now, suppose we levy a tax on labor income of t_labor = 20%. Then, our choices will be to either consume $80 now or save the $80 and consume $88 one year from now. The labor tax reduced immediate consumption by 20%, so Tyler's question is equivalent to asking what investment tax rate do we need to apply to reduce consumption by 20% for those that choose to delay consumption by one year:

$80 + $8*(1-t_investment) = (1-t_labor)*110 = $88

The obvious solution is that t_investment = 0%. Because the 20% labor tax already reduced the one-year delayed consumption by 20%, any additional tax on investment "income" is a double tax. Hence, the answer to Tyler's question is that we equalize tax rates on capital gains and labor income by setting tax rates on capital gains (and all other savings and investment income) to zero.

Extra Credit: show that when taxes are levied every year, e.g., taxes on interest and dividends, the effective tax rate on an investment held N years approaches 100% exponentially in N. Mankiw showed through a numerical example that the effective tax rate could approach 90% over a finite period, when including corporate taxes and estate taxes [http://www.nytimes.com/2010/10/10/business/economy/10view.html?_r=1&]. For the asymptotic behavior, however, it is unnecessary to include corporate and estate taxes.

Yes, and while this is not exactly the same issue as I've been discussing below with Brian below, it is closely related to the issue as to why indexing capital gains for inflation is justified, although I agree it is only a partial solution to the issues discussed by Landsburg, and probably not the best one. But, which tax policy, much less *any* policy choice is ideal in that it doesn't have offsetting costs and competing objectives? The "perfect solution" is very rare indeed. This is demonstrated by my estate tax post above in which one can clearly see arguments and policy interests that contradict each other. (And, we're discussing here only the policy contradictions on the "micro" level without even considering the effect on the "macro"!)

The issues are related because of the consumption analysis. The consumption analysis revolves around how much one can consume in real terms with his or her after-tax dollars. If I receive $100 of wage income or interest income any inflation effect on consumption with what I'm taxed on is at longest over a one year period because while I'm taxed within that period I'm also able to use that income to consume something within that period. Not so with respect to (nominal) "income" that I do not "realize" (used in the tax technical sense) until a much later date. That is not to say that we should tax interest income (see, Landsburg); it is that the inflation effect is greater regarding capital gains (which can also be an element of your return on a long-term bond but this is normally not an issue because the value of a bond will tend to move more strongly in the *opposite* direction as inflation. In fact, I'd argue that the limit on deduction of capital losses on bonds makes much less sense than for equities).

The labor tax reduced immediate consumption by 20%, so Tyler’s question is equivalent to asking what investment tax rate do we need to apply to reduce consumption by 20% for those that choose to delay consumption by one year.

Except income taxes are not taxes on consumption. The point isn't to reduce consumption by 20% but to capture 20% of income. There the double taxation argument vanishes.

I work a job and earn $100, that's income. I buy stock A for $100 and sell it a year later for $100. No income since I had no profit, although I did delay consumption for a year. I sell it a year later for $200 I have earned $100 in income.

So Joe earns $100 from doing a job, so does Sal. Sal, by buying the stock above, also earns $100 in profit. Are you going to tell us that Joe and Sal have exactly the same incomes? If so then you're not making up a definition of income that defies both common and techincal sense. If not then an income tax would imply that they should be paying different amounts of income tax.

"The point isn’t to reduce consumption by 20% but to capture 20% of income."

Doesn't that depend on how one defines "income"? Or, is income properly unrelated to the ability to consume?

Where did Sal get the $100 to buy the stock, from earlier wages that were already taxed? Then, his profit was already reduced because he was not able to buy as much stock due to the wage taxes. That's why taxing the profit a second time is a double tax.

$200 is twice the ability to consume than $100. What's the problem?

How does one get the ability to consume? Well they can trade labor for it. Or they can trade present ability to consume for some greater amount in the future. In both cases gaining ability to consume is income which is taxed.

If he had brought the stock for $100 and sold it for $100 in the future he would have gained no ability to consume beyond the original $100. No income therefore no taxes.

I think we'd be better off with treating a transfer at death as a realization event and fully taxing accumulated capital gains, than with the estate tax. While the nominal rate is considerably lower, the estate tax is leaky (e.g. GRAT) and has a very narrow base.

It's more a break for the upper middle class. The rich have to worry about paying estate tax when assets get a stepped-up basis. The upper middle class doesn't. (The rest of the population isn't much affected one way or the other, because they don't have much in the way of assets.)

Anyway, it's not weird at all. Some years ago the US tried "carryover basis," i.e., property taking the same basis in the heir's hands as it hand in the decedent's hands. They had to abandon it in part because the administrative problems were too formidable. For example, you inherit stuff from Uncle Alfred that he acquired thirty years ago. You generally wouldn't have a clue what he paid for it or even how he got it.

You can always put down a basis of $0. That's never going to be tax evasion.

"Some years ago the US tried “carryover basis,”

They are still trying it. Carryover basis applies to gifts.

Can someone tell me why capital gains are not indexed to inflation? Why, exactly, should one pay tax on "gains" that don't really exist?

If you go down that road, only interest above inflation should be taxable. Sounds like a mess.

A mess yes, but still a big issue. You are earning 3% in your savings account, inflation is 4%, and yet you are paying taxes on your earnings, while still losing to inflation. Not good.

On the one hand, I agree completely. Paying tax on a loss is terrible. On the other hand, it is a tax on cash, and maybe that is what sneaky lawmakers know they have put in place. No savings for us, thank you, we're Americans.

You are correct Eddie, to the extent that your example is contrived for a real loss. It isn't usual for equities to do poorly net of inflation; the benchmark returns are also nominal.

So there hasn't been any inflation for the past 6 years? Cause my savings account hasn't earned interest about that long...

Lots of things are messy. Figuring out the cost basis of an investment can be messy.

And of course interest should be adjusted for inflation.

As for dividends, there's no reason to tax them at all- just tax the corporation that paid them at an adequate rate, and get rid of those endless loopholes.

The bottom line is, the USA's taxation on various forms of saving is punitive. Which may explain the dismal rate of personal savings.

Why punish people for saving? Where is new investment to come from, if not saving- borrowing from China?

Not really. Interest is taxable at least annually so inflation is not a huge issue (as with wages). Not so capital gains for which the holding period is a minimum of one year. If interest is deferred longer than one year there are imputed interest rules.

Eddie, your math seems to be off. If you earn interest of 3% and inflation is 4% annually, you don't have a current loss with respect to your interest income, although arguably you may be taxed a wee bit too much on that interest. Take a $10,000 bond. Interest income is $300. Are you arguing that you should only have been taxed on $294? (I assume that both interest income and inflation were ratable throughout the year). If it is a bond held one year or more the inflation rate may affect the bond's value, but if you sell it you get a capital gain or loss. If it is a mere savings account, it is not a capital asset but it is not the interest that is being overtaxed so much as the tax system does not allow you a loss on the principal of a non-capital asset---in this case, your US currency which is deemed to be your functional currency.

He's claiming that, although the interest is $300, the $10,000 has lost enough purchasing power that he really lost money.

If widgets cost $100 each at the beginning of the time period he could have bought 100. At the end, they cost $104. He can only buy [slightly less than] 3 with the dividend, and only 96 with the $10,000 principal, so he has the ability to buy one fewer widget than he could have bought at the beginning of the period -- yet he is taxed as if he made a profit.

Indexing bases for capital gains and netting dividends and interest of inflation before taxation is fundamentally correct. It would, however, remove the wealth tax that this phenomenon generates, which the progressives wouldn't like. This way we get to have a wealth tax without admitting that we have a wealth tax.

-dk

DK,

I don't think you completely comprehended what I wrote above:

"If it is a bond held one year or more the inflation rate may affect the bond’s value, but if you sell it you get a capital gain or loss. If it is a mere savings account, it is not a capital asset but it is not the interest that is being overtaxed so much as the tax system does not allow you a loss on the principal of a non-capital asset—in this case, your US currency which is deemed to be your functional currency."

The capital gains system does take into account the loss of purchasing power of bonds. If inflation rises more than expected when the bond was purchased and priced and the bond is then sold, one has a capital loss subject to the same loss deduction rules as other capital assets (inflation expectations are quite implicit in bond pricing). Not so with savings accounts or cash in your wallet because it is your functional currency and it is on demand and that is one reason it is not considered a "capital asset". Not only would it be impractical to allow a loss for cash in your wallet, under your mattress, etc., but the rationale seems also to be that those are assets that can be converted to consume, on demand, widgets and other stuff and therefore there is no reason the tax system should protect you from the loss of purchasing power.

Yeah, really. You're suggesting that since (a) capital gains enjoy a tax advantage in terms of timing, only being taxable upon realization, that they should (b) pick up an additional advantage by being adjusted for inflation. Does not scan at all.

"You’re suggesting that since (a) capital gains enjoy a tax advantage in terms of timing, only being taxable upon realization, that they should (b) pick up an additional advantage by being adjusted for inflation. Does not scan at all."

Did I suggest (b) was because of (a)? Where did I say that?

I would, however, suggest that the penalty of being taxed on phantom gains due to inflation is directly proportionate to the length of deferral.

Are you suggesting that the benefit of deferral is greater than the penalty suffered by being taxed on non-inflation adjusted "gains"? If so, please quantify.

Jones invests 1,000 in a bond with 5% annual coupons. He pays 30% tax. So, in year 1, he earns $50, pays $15 in tax, and has $1,035 at the end of the year. After 10 years, he has $1,410.60.

Mathematically, this is: $1,000 x [1 + 5% x (1-30%)]^10.

Smith invest $1,000 in a non-dividend paying stock whose value grows 5% per year for 10 years. At the end of 10 years, he sells the stock and pays 30% tax on the gain, leaving him with $1,440.23, which is $29.63 more than Jones, even though they earned the same return over the same horizon under the same tax rates.

Mathematically, this is $1,000 x [ 1 + 5% ] ^10 pre-tax ($1,628.29) , less 30% x 628.89 (capital gain tax.)

Non-taxation of inside build-up of unrealized gains is a tax shelter for capital gains investors.

How is it that, on top of this, the capital gains investor requires an adjustment for inflation but not the bond investor?

Brian,

You are overlooking the fact that the bondholder has had access to his interest income over those ten years and the ability to spend it (or reinvest it). The equity owner did not. His purchasing power was greater than the equity owner.

If the bond was greater than 10 years in duration, the bond holder would have a capital gain or loss on disposal of that bond.

Another issue with this example is that the equity investor likely had pre-tax income of more than 5 percent per annum. If the stock value increased by 5 percent per annum, it is likely that the corporation was profitable and its earnings increased. Corporate level tax was paid during those 10 years. If you want to compare apples with apples, you need to take that into account.

The rate of capital gains tax is 15 percent at the federal level, not 30 percent. Dividends are also taxed at 15 percent generally. So, if you want to make a different comparison, it would be a corporation that pays the same dividend as your bond pays interest, but then let's count the corporate level tax on pre-distributed earnings. The bond holder would actually be ahead (and, if you want to look at the complete integrated treatment, someone got a deduction for that bond interest, nobody gets a deduction for a C corporation's distributed dividend). Due to the existence of corporate level tax on non-distributed earnings at a statutory rate of 35 percent, I'm not sure it is correct to say that there is "deferral".

Honestly Vivian. To your first point, the equity holder enjoys an OPTION with respect to tax timing that is denied the bondholder, who has no choice but to record income that is taxed all along. In my example, all coupons are reinvested (apples-to-apples) and, at the end of the day, the bondholder pays more in taxes and has less after-tax wealth. Of course, the bondholder could spend his coupons, but by analogy, the equity investor could also liquidate a portion of her portfolio every year to generate income if she desired.

I am aware of differential capital gains tax rates- my example was intended to illustrate the value of non-taxation of inside build-up related to unrealized gains OVER AND ABOVE the value of any differential between capital gains and ordinary income taxation.

Double taxation, yes I'm familiar with this concept as well. And I understand this is an argument for lower taxation of dividends and capital gains. But we're pretty far from where we started.

My original point, which still stands, is that I don't see the case for special pleading around tax relief due to inflation for capital gains as compared with other forms of passive income.

Brian,

There is no option (not) to pay corporate income tax on the underlying earnings for equities. And, there is no option (not) to pay tax on dividends received. And, for an owner of publicly traded stock, there is no "option" not to receive dividends---that policy is set by someone else. And, bondholders also have an option as to when to realize gains or losses---they can sell their bond at a capital gain or loss. I'm not sure why you think that in this respect bonds are any different than equities. Is it because the tax law requires stated interest but does not (generally) compel dividend distributions?

The original issue was with respect to the tax treatment of inflationary effects on different types of investments. You have posited that deferring or avoiding tax has value; I agree with that, but I don't think you can assign a generic value to that. But "honestly Brian", the issue you raised initially was that recipients of interest are hurt by inflation but get no relief. You then switched that to equity holders are somehow disproportionately advantaged because the alleged deferral value of investing in stock (always?) (more than?) outweighs the negative consequences of ultimately taxing a "gain" caused by inflation and therefore the former justifies the taxing the latter (after setting up the problem, your subsequent "examples" conveniently avoided any discussion of an applicable inflation rate). One can certainly stylize examples where this is the case and you can stylize examples where it is not the case. And, part of the "deferral premium" you are calculating here for equities is the benefit of not paying a tax on a nominal gain that includes implicit inflation in the first place.

I think the best way to at inflation effects is the consumption model and for this I can recommend a number of posts that Steven Landsburg has written that are related.

It's not really all that difficult...it's not like we're keeping records with a quill and inkpot. The IRS maintains and publishes tables for all sorts of tax adjustments...e.g., implicit interest rates to be applied to short, medium and long term loans...and has been doing so for quite some time. The tax code we have could not be as complex as it is without computers...maintenance of inflation indexing would just be another application.

Bottom line: there is not good reason for not indexing income for inflation except that it would reduce federal tax revenue and to replace that lost revenue with something else would politically gore someone else's ox.

Along the same line, is a wage a gain given that it is simply a monetization of human capital? If a person who has human capital worth $1000/hour works instead for $10/hour, isn't "loss" a more accurate label than "gain"?

Very interesting question. The income tax is based on the realization of the value of the human capital. How can you claim a person is "worth" $1000 per hour if there is no market transaction?

Suppose a female lawyer who had earned $1000 per hour left the labor force to become a stay at home mom, arguably worth $10 per hour on the market. What form of tax penalty or benefit should she receive for this?

What actually happens? She loses her incomes less the market value of domestic services, gains the subjective benefit of time with her children. Her marginal and average tax rates go down, and transfer payments might go up. Her skills deteriorate, and her expected lifetime earnings goes down.

Assume she has $100k in student loan debt, the cost basis for her human capital. She gets a small interest deduction which for now we assume is zero.

The market value of her human capital fell but remains fairly high. What is the capital loss and how should it be written off? Does she get a carry forward to future earning years or a carry back to prior years?

The discrete tax year has always troubled me. Accrual accounting and marking to market are supposed to provide time matching. Continuous accounting is too costly. What do we do?

Are celebrities allowed a deduction on their taxes for making charitable appearances? And if so, what rate determines that? Are lawyers doing pro bona work allowed to make a deduction at their normal hourly rate?

One other perverse incentive of the varying official rates of taxation affects small business investment. Returns on an investment in an LLC are viewed as income while returns on an investment in stock is viewed as capital income. Thus non-public small businesses need to return a higher pre-tax basis to be competitive. Can't think of a good policy reason for this.

An LLC is not a type of taxable entity. An LLC can be disregarded, a partnership, an S Corp, or a C Corp. What you say is false.

That's true, but that's not the main problem with bon-supp's complaint. Take out a sheet of paper and figure the effective tax rate on:

1. $100 earned through a C corporation (say, 35% federal) plus the tax on any distributed earnings ($65) to the shareholder (or the capital gain realized by the shareholder reflecting undistributed income);

2. The total tax on $100 earned by an LLC (treated as disregarded) and taxed to the owner as an individual.

Prior to Obama's tax changes, the result clearly favored the disregarded LLC owner. Now, depending on the state, it is likely the LLC owner still comes out ahead, but perhaps not by as much. Note, too, if we are talking about a small business owner, the advantages of the graduated individual rates are often much better.

Given the fact that the system allows the small business taxpayer to *choose* how to be taxed (a luxury most publicly traded companies don't have) non-public small businesses have no good reason to complain. In fact, for reasons stated here, most do not want to be treated as C corporations.

...most do not want to be treated as C corporations.

Agreed, but for that select few that qualified under Sec 1202 (especially 1202(a)(3) or (4)), the C corporation could be enormously tax advantaged. Or NRAs.

Yes, but bon_sup was referring to the tax rate needed for small businesses "to be competitive". So, while he or she is confused on several levels, I take that to mean the rate of tax on operating income and distributed income to shareholders.

Generally, the sale of the business assets of disregarded LLC's would be treated as capital gain just like the sale of stock in a C corporation, with the exception of inventory, depreciation recapture and a few other items. The tax benefit for the sale of the stock of certain small businesses (capped reduction of capital gain by 50 to 100%) would have been a reason to choose C corporation status for a few companies, but that also cuts against the argument that those poor small businesses are disadvantaged somehow by our tax system.

The 80% tax rate on "capital gains" which only negative entropy economists can believe are possible, separates the capitalists from the pillage and plunderers, and pump and dump rent seeking asset price inflation churners.

The pillage and plunderers buy assets that were created in the past and plunder them until they can figure out how to dump them without loss, and with trickery, "profit" that sticks others with all the liabilities they created. For example, take a excessively capitalized firm that can easily ride any economy with profits ranging from 0% ROIC to say 10%. Buy it in a LBO, sell off the capital assets, and contract with the buyer for production at a lower ROIC and much lower labor cost, distribute the cash from the sale as dividends, then IPO based on the super high profits during the boom, and dump the stock. When the exclusive production contracts expire, the supplier starts competing with its own brand, and the lower sales force lower prices for the firm so the debt service from the original LBO becomes an overwhelming burden and the profits collapse and destroy the market cap of the firm, and now bankruptcy is the only option. An 80% tax would take a lot of the profit out of such "creative destruction" of existing capital assets.

And the pump and dump asset churn that Wall Street lives off of would be seriously cut into as people stop churning because they are unwilling to pay 80% tax rates, and investing will be buying to hold forever.

Now the demands on corporate management will not be stock price inflation, but long term profits and long term investments - they would become Warren Buffetts who like shares that cost $50,000 to buy because in a decade they will cost $150,000 to buy, and they hope will cost $1,000,000 when they are deeded to the foundation his kids run to cure some disease, or educate others on how live better..

At the risk of hearing what I suspect may be the ravings of a lunatic, what exactly are "negative entropy economists"?

negative entropy economist means you don't see the CRONY CAPITALIST system, just assuming liberal SOLAR POWER CELLS will fix everything but you forgot about BATTERIES and STORAGE. first you're not even addressing my point, it boggles my mind that people don't see how BRETTON WOODS affects their lives TO THIS DAY even after nixon removed the last layer of the curtain. value doesn't just fall from the sky, it has to come from INTERACTIONS and MUTUALLY BENEFICIAL trade, and dude, IT'S JUST GREEN PIECES OF PAPER, it can't create jobs and cars and med school degrees, actually ok I guess you could print the med school degree on the green piece of paper but that's it. not that any of it matters cuz pretty soon we'll all be marching to the beat of OPUS DEI'S drum, THANKS A LOT OBAMA.

Thanks for clearing that up.

Usually I follow you, but, this kind of thinking/comment really bothers me and I submit that it is not - or may not be relevant to anything. Big Science (BS for short).

"My uninformed-by-ever-having-been-a-tax-lawyer sense is that loss offsets for the capital gains tax are worth a great deal to some investors." Most could care less about your "sense" - maybe you could quantify this - one investor? 5% of investors? What?
"If your option values line up the right way, you have enough diversification, and you are not liquidity constrained, it seems that for many people the de facto rate of capital gains taxation is not 15 percent but rather close to zero." Ifs, ifs, ifs and seems don't work for me. "Many people" means what percentage of investors? Is there any relevance to the real world - I can't tell. If not, what is it - other than conjecture - surely no science.

"Let’s say we raised the book rate of tax on capital gains to forty percent. For some people the net real rate of tax on capital gains could still be zero. For other people it would be forty percent." --- What does some people mean? 2 people?? What does other people mean? 99 %?? How relevant is this?

Sorry, but, to me this is very sloppy thinking. I raelly don't know how people are supposed to deal with commentary like this.

Again, my apologies.

It's hard to quantify, but the ability to control the tax-timing of capital gains definitely has value.

Churning in mutual funds (and by holders of individual stocks) reduces capital gain build up. A quick search found that perhaps 13% to 20% of mutual fund dollars are in index funds. The average turnover rate of managed funds is about 85%.

As to why keep the step up at death, there is the estate tax that goes with it, so it's not exactly as though no tax is paid on gains.

Gifts, generation skipping, endowments, trusts, foundations - lots of ways to reduce effective tax subject to an estate tax. 2012 was a busy year for tax avoidance.

I'm not sure I understand - if you're canceling losses and gains for a 0% tax rate, doesn't that also mean you made 0 money?

If I invest in two things each for $100, and at the end of the year one made $28 (increased in value to $128) and the other decreased to $86, I have a reasonable return of $14 / 7% on the whole, and I'm paying taxes on ...$28-$14 = $14....would someone be willing to use made up numbers for a case where you can make non-zero amounts of money and pay low taxes? Thanks for any help.

That is exactly right. You only pay taxes, if you have enjoyed a net capital gain. If you pay no capital gains taxes, then you have just been wanking it the whole time and your broker is the only one who made any money via his commission or fee, whichever the case may be.

I too am not surprised that people who end even, without net capital gains, would have no net capital gains tax. (If anyone "loses" it is the losers without winners. They have neither gain nor benefit.)

The issue is that labor income is not treated in a similar way. If I have an income I am taxed the same rate because that income is bound within that year. If I have a bunch of future deductible expenses I can't go back and claw back the taxes I paid. The choice of timing of when to realize capital gains and losses allows people to pay less tax because they can sell the assets at any time and net out the difference while postponing future gains to the future. My income cannot be pushed to the future in the same way as to avoid taxes now even if I expect future net losses that are tax deductible.

Capital gains are defined as unearned income. By labor income, I assume you mean what the tax code calls earned income, i.e. income from wages, salaries and profit from a from a sole proprietorship(reported on Schedule C). If you have earned income, then by definition, you cannot have a loss. You can however have a negative income after deductions and even earn a credit on your negative income. Also, if you own a small business which suffers a loss and you also have an earned income you can reduce your earned income by the amount of the loss all the way to zero and even carry forward additonal losses to future earned income periods. The tax code manages earned income handily for the earner.

A deferred tax is a reduced tax.

I don't follow. shouldn't the argument be to close the loophole which allows capital gains to be reduced to zero?

why not have a system where the maximum deduction from realized losses on assets (due to selling them below purchase price) is capped at some nominal level, and then just treat capital gains identically with income earned from labor.

Ben --Suppose that you buy 2 shares of your first stock that goes from $100 to $128 (for a $28 per share gain) per share and 2 shares of the second stock that goes from $100 down to $$86 (for a $14 per share loss). Then you sell both shares of the losing stock for a $28 capital loss and 1 share of the winning stock for a $28 capital gain. For taxes, they cancel out for a $0 gain/loss. Then you keep your remaining share of the winning stock, but since you didn't sell it and realize its capital gain, you owe no taxes on it. Repeat yearly and at the end of your life you may end up with a significant amount of unrealized capital gains. Those can be stepped up to current value by your heirs, and you escape taxes permanently.

Thanks for the clarification. I think the step I missed was the reset in value - this only allows you to easily bequeath money, but not particularly benefit yourself? E.g. if you sell that stock you kept next year, aren't you still paying taxes on the $28 + whatever additional growth it got? But if you die, you've paid little taxes so far, and now you aren't paying any capital gains taxes on your estate?

Liberal Arts, the unsold share is neither here nor there since its value can still fall and fall all the way to zero. Alternatively, you could have said, "Then you keep your remaining share of the winning stock, but since you didn’t sell it, it could fall in value below its cost basis and remain there forever or even fall in value to zero. Repeat yearly and at the end of your life you may end up with a significant amount of unrealized capital losses. Those can be stepped down to current value by your heirs, and they will enjoy your capital losses permanently."

Yes, but that is besides the point. Offsetting the capital gain pushes any taxable gain farther into the future. If your stock goes down, you aren't going to be taxed on it.

Through wash, rinse, repeat, you can reach the end of your life having avoided taxes on a good chunk of your wealth, and then let death tackle the tax collector through gifts, trusts, endowments, and foundations.

Gains and losses are realized, as a practical matter and for tax purposes, at the moment of the sale. If you continue to hold a stock that is valued higher than your cost basis, then that is an unrealized gain and wholly irrelevant for tax purposes or your personal well being. "If your stock goes down, you aren't going to be taxed on it." True, but you have also experienced an outright loss on the investment. Which would you rather have, a taxable profit or an outright loss? "Through wash, rinse, repeat, you can reach the end of your life having avoided taxes on a good chunk of your wealth." True, but you also never realized a tangible gain on your wealth during your lifetime. Your investments will have netted you, personally, zip, but hey you avoided taxation.

You are essentially repeating what I said.

But your last sentence is incorrect. Massive fortunes with tremendous power are amassed through tax avoidance. Saying that investments have yielded zip is gross oversimplification. That wealth can be liquidated, at a cost, at any time. It can be borrowed against. You can hire your child to run a billion dollar foundation. Do you really think Teresa Heinz Kerry has the wits to be a CEO on her own merits?

I repeated the obverse of what you said, to demonstrate that what is true for gains is also true for losses. Name one "massive fortune" that has been amassed through tax avoidance.

Why sell those offsetting stocks at all, then? Aren't you just doing paperwork for no reason at that point?

Maybe you need to turn assets into cash.

You sell what you believe will be dogs in the future or stocks that don't fit your current rebalancing scheme. If you are rebalancing regularly, you are always selling some stocks. The art is picking what to dump.

Two comments. First, Republican proposals to eliminate the estate tax (including the Bush-era law that self-destructed) would incorporate carryover basis. But here's the thing: very few, very few, are subject to the estate tax, whereas most are subject to the income tax. Hence, eliminating the estate tax and incorporating carryover basis would benefit which end of the income distribution? Second, as often said, timing is everything, and that applies to capital gains. Forget the fortuitous (timing) gains on "realized" (the requirement for subjecting gains to the income tax) gains and tax wealth instead, which has the added benefit of reducing inequality and avoiding total societal breakdown.

So you have Person A and Person B who earn the same income, but person A makes a lot of sacrifices and saves all their money thereby increasing their wealth. Then you have person B who saves no money, spends it as soon as they get it and thereby accumulate zero wealth and you are telling me we should take money from Person A and give it to Person B?

Yeah I think there will be riots in the streets if that happened.

In addition, rayward's putative social good is "the benefit of reducing inequality." While this might appear to mean a Robin Hood-esque redistribution of assets from rich to poor, it is in reality a redistribution to government, and reduces inequality principally through making the rich poorer.

It seems to me that the biggest reason for preferential tax treatment of capital gains is to avoid taxing purely nominal gains resulting from inflation. Combine the reduced rate with the benefits of deferring taxes until the investment is sold and you get something like rough justice for capital investors. This reasoning does not justify allowing hedge fund managers to treat trading income as capital gains through "carried interest".

What, is the game to try to equate taxes on labor and capital income while only being allowed to change one rule?

Change the step up rule so that heirs have the same basis as the deceased. If no records are available to establish basis, too bad, basis becomes $0.

Yes. No stepup.

There are all sorts of othergames as well. Stock options to name one. Games that rich people play with retirement accounts ala Mitt Romney and his kids. Or donating appreciated assets to charity with no cap gain but large charitable deduction. And there are more esoteric games that I have read about but are too complex to explain.

Bottomline, this post's argument hardly touches the surface of the abuses avaible to escape taxes using the capital gains tax rules.

You want more jobs? Lower taxes on salary income. Raise taxes on unearrned income and/or wealth. Eliminate the games richpeople play.

Let us not forget the carried interest rules for our poor, overworked hedge fund managers.

This discussion is way too stock market centric. For investments outside the market capital gains are hugely distortive. Consider the investor who is able to make gains outside the market at a 15% clip average annually although it requires frequent selling. If he can buy and hold the market and make 10% what capital gains rate forces this productive individual to abandon his active investing?

It does not matter whether any of the trades are in the stock markets or not. The active trader could be in the stock market and the buy and hold investor could be investing in real estate. The fact that capital gains are payable on sale does give some incentive for buy and hold. Capital gains vs. income treatment encourage the trader to hold any asset at least long enough for it to qualify as a capital gain. Someone who is trading on short time horizons should be taxed on the gains as income.

You're correct, but the point still stands. Why are we incentivizing buy and hold if that isn't the most productive investment for a guy to make.

Do not look at it from the point of view of the individual, look at it from the point of view of society. Society has an interest in encouraging certain long term investments (for example, rental housing). Society may have little or no interest in the activities of your active trader. The active trader will still play even if the tax rate is higher. Therefor it can make sense for society to discriminate in the taxes it collects to maximize the benefit to society. Tax policy is not about "fairness", it is about efficacy.

Didn't Landsburg pretty conclusively prove in his "Getting it Right" post that rate of capital gains taxation that equalizes the taxation of capital income and wage income is in fact zero?

The only rebuttal I've seen that wasn't based on a complete and utter failure to understand the argument was David Friedman's objection that active trading is a form of labor, which would argue for no taxation on corporate income or individual investment income up to the market rate of return, and taxation at ordinary income rates for returns beyond the market rate.

Exactly. That was my numerical example above. I didn't know to credit Landsburg, but I have seen similar analyses in various places. The fact that all savings/investment taxes are double taxes seems to be consistently, conveniently forgotten/ignored in most discussions about the "right" investment tax rate.

I suspect that people favor investment taxes as a (very poor) proxy for a wealth tax. There is, of course, positive correlation between investment income and wealth because wealthy people tend to have more investments. However, investment taxes can hit a relatively less wealthy person with savvy investments while leaving a relatively wealthier person with negative-performing investments untaxed. If we want to tax wealth, we should do so directly rather than trying to jam a poor approximation of a wealth tax into the income tax code. Of course, taxing wealth might also cause problems with people hiding their wealth in hard-to-track assets like collectibles and real assets.

"I suspect that people favor investment taxes as a (very poor) proxy for a wealth tax".

I think that's right, with emphasis on "very poor". That probably explains why they are so reluctant to delve into the difficult subject of what constitutes "income" in an economic sense and why they seem to have a great deal of trouble with the "realization" concept as a trigger for taxing that "income".

I mentioned once here before the innovative solution the Dutch have come up with in respect of this issue. They previously had a wealth tax *and* an income tax on investment income (interest, dividends, etc., but generally not capital gains). They abolished that dual system in favor of this: Net investment assets (less an exempt amount) are *deemed* to produce a 4 percent annual return. The result is then taxed at 30 percent. Of course, this is equivalent to a 1.2 percent wealth tax, but this round about way to arrive at that was probably to create the illusion of an income tax so that the tax would be creditable under tax rules of other jurisdictions (particularly the US, which doesn't allow a credit for wealth taxes, but does for "income taxes" and have ruled, rather dubiously in my view, that this is an "income tax" for purposes of US law). No need for a realization event to tax, no capital gains tax , the tax is not unreasonably high, the exemption gives some progressivity, but it is eventually flat so there are fewer distortions. It's not perfect, but quite a few problems are solved that people have trouble with in the US system. It is a tax on savings and is to some extent duplicative and it is somewhat counter cyclical because it taxes even when wealth is decreasing, etc.

"There is, of course, positive correlation between investment income and wealth because wealthy people tend to have more investments."

There is also a positive correlation between one's propensity to defer consumption and one's wealth.

I would have thought an equalization of OI & CG would require the current limit on deducting capital losses to be removed.

I think it's absurdly picayune to think that offsetting realized gains and losses is a problem of any great magnitude. If that offends you, you must feel the investor having freedom to choose among different investments ot to invest at times of his or her choosing is also problematic. There's no logical reason why the exercise of choice at the end of an investment is any different than the other choices made in respect of it.

let's not encourage anyone to think about taxing UN-realized gains.
Stepped up basis makes sense if you've paid an estate tax.

Not only have people already thought about it, it's been pointed out that at least one country already does so

Taxing nominal gains is nonsense. First we need to index the gains. Second we have to recognize the gains are accrued over the holding period, If this is done then gains should be treated as ordinary income realized at death if not before.

ndex the gains. Second we have to recognize the gains are accrued over the holding period, If this is done then gains should be treated as ordinary income realized at death if not before - See more at: http://marginalrevolution.com/marginalrevolution/2014/01/equalizing-the-rate-of-tax-on-income-and-capital-gains.html#sthash.3JZbGBXZ.dpuf

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