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October 11, 2011
Are Capital Gains Double Taxed?

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By Martin A. Sullivan -- martysullivan@comcast.net

The very rich get most of their income from capital gains. Republicans have tried to sidestep this fact, but you can see it for yourself in the chart on the next page. So any discussion of efforts to increase progressivity -- such as President Obama's so-called Buffett rule -- must include raising the current preferential 15 percent rate. This is anathema to Republicans. Consequently they have counterpunched by asserting that capital gains are double taxed. The hoped-for implication is that the 15 percent preferential rate is justified and that if anything, there should be zero tax on capital gains.

The first thing to understand about the latest installment in the age-old capital gains controversy is that framing the debate in terms of double versus single taxation gets us nowhere. The real question is not about the number of layers of tax. What matters is the overall level of tax. It may be, and in fact often is, that capital gains are subject to a single layer of tax but the effective tax rate is very high. Conversely, it may be, and often is the case, that capital gains are subject to two layers of tax but the overall effective tax rate is very low. You can't explain capital gains taxation in a sound bite.

Overtaxed Capital Gains

There are three ways to argue that capital gains are double taxed (or simply overtaxed). All three are real and cannot be denied by Democrats.

(1) All taxation of saving is a form of double taxation. This observation is nothing new to economists. For example, in 1848 the British philosopher and economist John Stuart Mill wrote: "Unless . . . savings are exempt from tax, the contributors are taxed twice on what they save, and only once on what they spend." Since then, economists have often said things like "income from saving is taxed twice." This is another way of saying an income tax is biased against saving -- a bias not shared by a consumption tax.

It does not mean (except under some circumstances) that when the rate of tax is t percent, consumption is taxed at t percent and saving is taxed at 2 x t. The tax penalty on saving depends on circumstances. For example, if the interest rate is 5 percent and the holding period is 10 years, the effective rate on saving is about 1.33 x t. If the interest rate is higher and/or the holding period is longer, the effective rate is higher. And if tax on investment income is deferred to the end of the holding period -- as it is for capital gains -- the penalty for saving is lower.


Capital Gain as a Percentage of Total AGI for
Top 400 Individual Taxpayers, 1992-2006



Source: IRS, Statistics of Income division, "The 400 Individual Income Tax Returns Reporting the Highest Adjusted Gross Incomes Each Year, 1992-2006," available at http://www.irs.gov/pub/irs-soi/06intop400.pdf.

Note: All pre-2010 income is converted to 2010 dollars.

The problem with this argument as a defense for lower capital gains taxes is that the income tax imposes a tax penalty on all saving -- not just saving in the form of capital gains. In fact, income from interest and dividends suffers more from double tax because it is taxed as it accrues, while capital gains taxes are deferred until realization. The tax penalty on savings is a good argument for switching from income to consumption taxation, but it is not a good argument for relief targeted to capital gains.

(2) Profits giving rise to capital gain on equities have already been subject to corporate tax. There is no good economic justification for the corporate tax. It is unfair and inefficient to tax profits first with the corporate tax and then again with an individual tax either on dividends or capital gains.

Corporate taxes can substantially raise the overall effective tax rate on capital gains (as we shall see in the table). Republicans would like to highlight this fact, but it assumes that the entire burden of the corporate tax falls on shareholders. This would contradict the position Republicans take when they argue for a corporate rate reduction -- that is, most of the burden of the corporate tax falls on workers (in the form of lower wages).

There are two other problems with this argument as a defense for targeted relief of capital gains. First, not all corporate income flows to individuals as capital gains. Dividends from corporations also deserve relief from double tax. In fact, they deserve more of a break. Even though dividends are also taxed at a 15 percent rate, they are tax disadvantaged vis-à-vis capital gains because they are taxed as they accrue. Second, not all capital gain comes from the sale of corporate stock. Capital gains can be realized on the sale of real estate, bonds, art, shares of passthrough businesses (not subject to corporate tax), and C corporations that pay little or no tax.

The problems that arise from the double taxation of corporate profits are a good reason for integrating the individual corporate and income taxes. The most common methods discussed are an exemption for individuals receiving dividends and a shareholder credit on individual taxes for corporate taxes already paid. The double taxation of corporate profits is not a good argument for targeted relief of capital gains.

                       Effective Tax Rates on Investment
              (Real Rate of Return = 5%; Capital Gains Rate = 15%)
 _____________________________________________________________________________

 A. Capital Gains, No Corporate Tax
 _____________________________________________________________________________

 Holding Period    0% Inflation  2.5% Inflation  5% Inflation  7.5% Inflation
 _____________________________________________________________________________

 3 years               14%             21%           28%             34%
 10 years              12%             17%           21%             25%
 25 years               9%             11%           13%             14%
 Until death            0%              0%            0%              0%
 _____________________________________________________________________________

 B. Capital Gains, Corporate Effective Rate of 25% (assuming entire burden is
 on shareholders)
 _____________________________________________________________________________

 Holding Period    0% Inflation  2.5% Inflation  5% Inflation  7.5% Inflation
 _____________________________________________________________________________

 3 years               36%             54%           71%             89%
 10 years              35%             51%           67%             83%
 25 years              33%             47%           61%             71%
 Until death           25%             38%           50%             63%
 _____________________________________________________________________________

 C. Interest and Dividends (35% individual rate and 25% corporate rate)
 _____________________________________________________________________________

 Holding Period    0% Inflation  2.5% Inflation  5% Inflation  7.5% Inflation
 _____________________________________________________________________________

 Dividends              36%            54%           73%             91%
 Interest               35%            53%           70%             88%

(3) Inflationary gains are not real income and should not be subject to tax. The relative stability of the price level over the past three decades has greatly reduced concerns about the highly detrimental effects of inflation on the operation of the income tax. But even at low levels, inflation overstates returns to capital. One manifestation of this problem is the taxation of inflationary gains as if they represented appreciation in real value.

Indexing of capital gains would eliminate inflationary gains. Unfortunately, this would add a lot of complexity to the code, so Congress generally opts for a lower capital gains rate instead of indexing. The problem with special tax relief for capital gains (either in the form of a lower rate or indexation) is that correction for inflation really needs to be made for all aspects of capital income taxation -- not just capital gains. Income in the form of dividends and interest should also be inflation adjusted. And so should deductions for interest. The lack of consistent adjustments for inflation through the income tax provides large opportunities for the worst kinds of tax arbitrage and tax shelters.

Undertaxed Capital Gains

(1) Tax on capital gain is deferred until gains are realized. Deferral of unrealized gain provides a tax benefit. The size of the benefit grows with the holding period and the rate of return on the asset.

How does the benefit of deferral compare with the extra burden caused by the taxation of inflationary gains? The combination of the two can put the effective tax rate on capital gains either above or below the statutory rate. Which effect is stronger depends on the level of inflation and the length of the deferral period. It is interesting to note that time usually heals the wounds of inflation. Over long holding periods (e.g., 25 years), the detrimental effects of inflation are almost always eliminated by deferral, so the effective rate of tax is below the statutory rate. (See the table above.)

(2) Unrealized gains are untaxed if assets are held until death. Except in the wacky tax year of 2010 (when the estate tax was temporarily repealed), heirs get a tax-free step-up in basis of inherited property. So unrealized gains that have accrued between the time of purchase and the time of death are free of individual tax (although they can be subject to the estate tax). Step-up in basis at death eliminates tax on both real and inflationary gains.

(3) Capital gains are taxed at 15 percent. This rate equals the 15 percent rate on dividends but is far below the top statutory rate of 35 percent. If the Bush tax cuts expire on schedule at the end of 2012, the capital gains rate will return to 20 percent. Also at the end of 2012, dividends will lose their special status and be treated like wages and interest -- subject to a top rate of 39.6 percent. On top of all that, the healthcare reform legislation enacted in March 2010 will impose a new Medicare tax on net investment income beginning in 2013 to the extent income exceeds $200,000 for single individuals or $250,000 for married couples filing jointly.

Putting It All Together

Let's first summarize in words. The capital gains rate is 15 percent. The corporate tax (assuming some of the burden falls on shareholders) and inflation can raise the effective rate above the statutory rate. Deferral and tax-free step-up in basis at death reduce the effective tax rate. For assets held for long periods or until death, the benefit of deferral generally offsets the burden of inflation.

The table summarizes with numbers. It calculates the effective tax rate on gains for an asset with a real rate of return of 5 percent under a reasonable range of assumptions about inflation (0, 2.5, 5, and 7.5 percent), about the effective rate of corporate tax (0 and 25 percent), and about holding periods (3, 10, and 25 years and until death).

The effective tax rates calculated in the table illustrate a number of important points. First, there is a remarkably wide range of effective tax rates on investment under a variety of reasonable assumptions. It is impossible to fairly summarize the broad range of outcomes with a slogan or a sound bite -- and that includes the claim that "capital gains are double taxed." The effective tax rate on capital gains can be zero (if the underlying asset is not corporate stock and is held until death). It can also be double the current top individual rate (if the underlying asset is subject to corporate tax and there is moderate inflation). Politicians on both sides of the capital gains debate can easily find examples from real-life situations to support their arguments.

Second, for noncorporate assets earning a modest rate of return, it is nearly impossible for the effective capital gains rate to exceed the top personal rate of 35 percent unless the inflation rate exceeds 7 percent. The annual inflation rate has not exceeded 7 percent since 1981. Between the end of 1981 and the end of 2010, the annual inflation rate has averaged almost exactly 3 percent. Given this low rate of inflation over the last three decades, the only real threat to pushing effective capital gains rates above the top personal rate is a high rate of corporate tax.

Third, inflation has a much more devastating effect on the effective rate on dividends and interest than it does on capital gains. That's because the offsetting benefit of deferral is uniquely available to capital gains. This underscores the need to provide relief from inflation gains to all types of capital income. In fact, capital gains are the form of capital income least in need of indexing.

Conclusion

It is technically correct in some situations but misleading as a generalization to claim that capital gains are double taxed. The effective tax rate on capital gains can be zero, or it can be twice the top individual rate. When high effective capital gains rates do occur, the main culprit is the corporate tax (assuming the burden of the tax falls on shareholders). Instead of providing special relief for capital gains, it would be far better to address this problem by reducing the corporate tax rate or by integrating the corporate and individual income taxes. We have a corporate tax problem, not a capital gains problem. If high levels of inflation return, tax relief for all types of capital income should be considered -- with capital gains receiving the lowest priority.

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