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February 3, 2012
The Peculiar Taxation of Capital Gains Income

Full Text Published by Tax Analysts®

By Roger E. Brinner

In 2012 Tax Notes will celebrate the 40th anniversary of its inaugural issue, published on September 18, 1972. In recognition of that milestone and to show its appreciation for your continued readership, Tax Notes will be republishing select archived articles from each of the past 40 years. Tax Notes hopes that readers will enjoy these valuable contributions from prominent members of the tax community on issues that were and are of central importance to the field. Readers are invited to submit their own recommendations for our retrospective to, along with a short explanation for why the article has been recommended.

This article was originally published on May 26, 1975. Roger E. Brinner, an assistant professor of economics at Harvard University, is now the chief economist at the Parthenon Group LLC. He has served as a senior economist with the White House Council of Economic Advisers and as a visiting fellow with the Federal Reserve.

This article summarizes arguments and results presented in two earlier studies: "Inflation, Deferral and the Neutral Taxation of Capital Gains," Nat'l Tax J. (Dec. 1973); and, with Alicia Munnell, economist at the Federal Reserve Bank of Boston, "Taxation of Capital Gains: Inflation and Other Problems," New Eng. Econ. Rev. (Sept./Oct. 1974).

The article argued that inflation-adjusted gains, including unrealized gains at death, should be taxed in full.

The arguments generally put forward to justify preferential treatment for capital gains are not persuasive. Most of the concerns about capital gains could be resolved by taxing inflation-adjusted gains in full, including unrealized gains on assets passed on at death. This tax treatment should also be accompanied by extensive averaging provisions.

The principal concerns about the treatment of capital gains include:

  • The fact that often a substantial portion of the "gain" really is due to inflation and does not reflect an increase in buying power for the taxpayer. As a result, although the statutory tax rate levied on capital gains is lower than that levied on wage income, the effective tax rate on the former may be even higher during periods of rapid inflation.
  • The postponement effect, which permits holders of capital assets to put off taxation on their gains until the assets are sold whereas a taxpayer who places his capital into a savings account must pay tax annually as interest is earned, placing him at a clear disadvantage vis-à-vis an investor in capital assets.
  • The "lock-in" effect, i.e., the fact that current tax treatment tends to encourage holding on to capital assets longer than sound investment policy would otherwise dictate.
  • The potential for a "bunshing" effect, i.e., if capital assets must be sold in a single tax period, taxable income could be pushed to a level well above average for the taxpaying unit.

The last problem can be handled by use of averaging provisions. The others can be met, in order, by an inflation adjustment for capital gains, an upward adjustment for the postponement benefit and the levying of an income tax when capital gains are passed on at death.

A. Current Treatment

The current tax treatment of the income from capital gains differs from the treatment of wage income in two significant ways. An inflation distortion penalizes and a tax postponement distortion benefits the recipient of gains relative to the recipient of wage income. These distortions can be simply removed by requiring two additional calculations at the time of filing the capital gain income tax form, Schedule D. In the following paragraphs, the nature of the peculiar treatment will be explored and the appropriate tax form adjustments will be described.

B. The Inflation Problem

The effective income tax liability accruing from a capital gain must be very carefully derived. Our tax system focuses on income, not wealth. A wage earner earning $10,000 in a year has $10,000 of current income regardless of what the rate of inflation is. But consider shares of stock which, at the beginning of the year, are worth $100,000 and appreciate by 10 percent to $110,000 at the end of the year. The question is whether this $10,000 increase constitutes income and hence whether a tax liability should have accrued.

If prices have been stable, clearly the stock price appreciation permits the individual to sell $10,000 of the stock and consume the equivalent amount of goods while still preserving his initial wealth of $100,000. However, if the price level has risen by 10 percent, the stock price appreciation has merely maintained the purchasing power of his wealth and, hence, there has been no income.

To better understand the problems involved, consider two individuals who are each deciding what to do with $1,000 of income in December 1974. One individual decides to spend his $1,000 on a washing machine and a refrigerator. The other individual buys shares of XYZ Corporation. During the next twelve months, assume that the prices of all goods in the economy, including those of washing machines and refrigerators, rise 10 percent. Assuming for simplicity that the first person has merely put his appliances in storage, deriving no benefit from their use and losing no real value through wear and tear, should we view the increase in money value of the appliances as income suitable for taxation? Traditional theory and common sense would answer "No" because the individual has derived no benefit from owning the appliances: he is no better off than he was at the beginning of the year and he gained no satisfaction during the year.

1. No income for stock owner. Returning to the second person, the investor in XYZ Corporation, assume that the stock market price of his shares has increased by 10 percent by December 1975 and that he sells the shares for $1,100. Current tax law would require him to pay a tax on the $100 difference between the purchase and sale prices. But, before paying the tax, has the individual received "income" in any meaningful sense? The answer is once again a firm "No." Apply the previous standards: Is the investor better off than in December 1974? No, he can only purchase the same quantity of goods today which he could have purchased in December 1974. Did the investor gain any other benefit from the use of his funds during the year? No. Therefore, just as the appliance purchaser earned no income properly subject to taxation (and would not be taxed under our current law), this share purchaser should be viewed as having earned no properly taxable income.

On the other hand, what if the shares had risen in value to $1,200? Current tax law would impose a tax on a "gain" of $200, but a little thought makes it clear that the shareholder can only buy $100 more goods in December 1975 than in December 1974: his first $1,100 buys him what $1,000 would previously have bought, hence he is better off by, or has properly taxable "income" of, only $100.

Naturally, this extra $100 worth of goods represents a smaller quantity of goods than $100 in 1974. In fact, this $100 is exactly equivalent to $100 in wage income received in 1975 relative to $100 of either type of income in 1974. The purchasing power of each of these incomes is identical and has been identically reduced from the purchasing power of $100 of either type received one year earlier. The inflation adjustment of the capital gain has merely put it on a par with wage income and has not accorded it a special recognition of the more general burden of inflation.

The adjustment of capital gains for inflation requires a straight-forward adjustment of the purchase cost for each asset. The dollar cost should be multiplied by the ratio of the Consumer Price Index (CPI) during the month of the sale to the CPI during the month of purchase. For example, the December 1974 CPI was 155.4. If prices rise by 10 percent during 1975, the December 1975 CPI will be 170.9 and the ratio of the two will be 1.1. (Rounding errors create small differences which are avoidable by using further decimal places.)

The $1,000 purchase cost of the stock in our example should be multiplied by this ratio, yielding an inflation-adjusted purchase cost of $1,100. When subtracted from the hypothetical sale price or $1,200, this produces the correct income measure of the gain, $100. The Internal Revenue Service could easily provide an appropriate table of such ratios each year for use by taxpayers filing Schedule D.

It is important to note that once gains have been adjusted for inflation, a prime argument for the current 50 percent exclusion disappears. The adjusted gains are equivalent to other forms of income and deserve to be fully included in taxable income. This new treatment would at times increase the tax burden on capital gains and at times reduce the burden. Given the likelihood of 5 to 10 percent inflation, and sluggish real economic growth for this decade, this reform might slightly reduce the tax burden on gains in the near future. In any case, it would tend to stabilize the real net return to investors by removing the illusory income from the tax base.

2. Savings account interest. Although this discussion has focused on the issue of capital gain taxation relative to wage taxation, numerous extensions are possible -- and desirable. For example, a savings account produces an "income" which is just as dependent on inflation as the income of the capital gain analysis. It the value of the account, including interest, at the end of the year reflects an increase which only matches the rate of inflation, no properly defined income has been generated and no tax liability should exist. If the increase is less than inflation, a loss should be recognized because the individual is in a worse absolute position. The appropriate treatment can be achieved by reporting the full interest income as usual and reporting a capital loss on Schedule D. The loss equals the average balance multiplied by the previously described inflation adjustment factor minus 1, i.e., the rate of inflation. Savings institutions could easily report the average balance and inflation induced capital loss to each taxpayer, just as they currently report total interest paid.

For example, a hypothetical savings account of $1,000 in 1975 would be associated with a loss equal to $1,000 x (1.1 - 1) = $100, given the inflation rate of the previous examples.

3. What about wage income? Experience with this presentation has led to the realization that many readers remain unconvinced at first that wages do not require an inflation adjustment: "What about the worker whose wages don't rise as fast as the CPI?" Recall the arguments of the earliest paragraphs. The meaningful questions in determining income are:

    "How much more is an individual able to consume as a result of occurrences during the year?" "Is he better off at the end of the year and, has he gained any satisfaction during the year?"

A wage earner who earns $100 during 1974 and $100 during 1975 will certainly be in a worse purchasing power position during 1975 than in 1974, but he will obviously be able to buy more consumer goods during 1975 than if he earns no wage income. This provides an argument for adjusting tax brackets for inflation, but adjusted gross income would still be properly defined as the sum of wages, other current receipts and inflation-adjusted gains. The inflation adjustment is necessary for an equal treatment of the two taxpayers.

The principle is further clarified if the alternative case of the stocks rising in value to $1,200 is considered. If the $200 gain were treated as ordinary income, a tax of $60 would be due and the individual would be left with $1,140: enough for the appliances and only $40 worth of other goods. Although his before tax income is truly the same as the $100 wage earner, he would be left, after-tax, with only $40 rather than $70.

4. The 50 percent exclusion. Of course, current tax law requires only one-half of the gross gain to be included in taxable income. In this particular example, the $200 gross gain would therefore generate $100 of taxable income, coincidentally equal to the inflation-adjusted gain. This highlights the fact that the current treatment is truly correct only if the inflation-adjusted gain is exactly equal to one-half of the gross gain, the current component of taxable income.

This ignores the fact that the combination of a 35 percent tax on large gains and 10 percent minimum tax on the excluded half of gross gains produces a 36.5 percent maximum tax rate on capital gains compared with a 50 percent maximum on wage income. Thus the equivalent of 73 percent of a gross gain may be taxed at rates equivalent to those on additional wage incomes.

The analysis demonstrates that inflation-adjusted gains are equivalent to wages in terms of a commonsense definition of income or taxable capacity. Both still suffer from a common but separable problem of increased tax burdens during inflation due to the progressive structure of the personal income tax. If before-tax income merely keeps pace with inflation, after-tax income will not keep pace because of the rising marginal rates. The effect could be removed if desired by tying the exemptions, deductions, and income brackets to the consumer price index.

C. The Tax Postponement Benefit

This issue is much simpler to describe. Shareholders are able to effectively reinvest part of the income from their investment without first paying taxes on that income if the shares are not actually sold. This derives from the fact that although dividends are immediately taxable, gains, the other component of equity income, are taxed only as they are realized rather than as they accrue. This provides a substantial benefit to the shareholder.

To illustrate this point, compare two taxpayers who have invested $1,000, one in a savings account paying 5 percent per year and the other in corporate stock which will be assumed to also produce a 5 percent yield, all of which will accrue as capital gains. For the purposes of isolating the deferral benefit, it will be assumed that inflation is absent and gains are fully taxable (or the equivalent, that all gains are inflation-adjusted and fully taxable). Assume that both investors are in a 50 percent tax bracket, and that both investors continually reinvest their after-tax proceeds.

Compare their positions at the end of 10 years. The former must pay the 50 percent tax on his gross yield each year and hence his funds accumulate at 2 1/2 percent net, compound rate. His wealth grows to $1,000 x (1.025) [sup(10)] = $1,280. On the other hand, the shareholder's gross yield is effectively reinvested for him by the firm because it is assumed to fully retain its profits. When the shareholder sells his stock after 10 years, it is thus worth $1,000 x (1.05) = $1,629, he has a gain of $1,629 - $1,000 = $629 and owes a tax of $629 x 0.5 = $315. His after-tax wealth is thus $1,629 - $315 = $1,314, $34 more than the owner of the savings account.

The reinvestment of the gross yield allows the shareholder to postpone paying the tax on this yield. The government effectively lends the taxpayer his tax liability each year but does not charge any interest on these loans.

Unfortunately, it is impractical to compute the annual tax liabilities and the associated interest charges for each asset when it is finally sold. Moreover, the alternative of calculating "paper" (accrued but unrealized) gains for each asset on an annual basis is an impossible task. Is this tax postponement problem therefore only theoretically interesting and solvable? No. It is easy to approximate the ideal structure and achieve equity by merely requiring an adjustment of the gain at the time the gain is realized. Furthermore, the procedure is readily blended with the inflation adjustment described in Part I. All gains referred to in the ensuing discussion will be assumed to be appropriately inflation-adjusted.

The postponement benefit adjustment requires that each realized gain be multiplied by an appropriate factor determined by the number of years the asset has been held. The product, a postponement-adjusted gain, is then fully included in tax. For example, the factor for 10 years is 1.109. Therefore, $629 gain to the previous hypothetical shareholder would be adjusted to $629 x 1.109 = $698, producing a tax liability of $698 x 0.5 = $349, and an after-tax wealth of $1,629 - $349 = $1,280. Note that this $1,280 is equal to the $1,280 after-tax wealth of the savings account investor. This is no coincidence -- it is precisely the goal of the methodology used to derive the postponement adjustment factor. The values of the factor for other hypothetical periods are:

    1 year -- 1.000

    2 years -- 1.012

    3 years -- 1.024

    4 years -- 1.036

    5 years -- 1.049

    10 years -- 1.109

    15 years -- 1.169

    25 years -- 1.284

    50 years -- 1.534

D. Capital Gains at Death

1. Constructive realization. Whereas full taxation of real capital gains combined with an interest charge for deferral are desirable changes both to deal with inflation and to increase the mobility of capital, no significant reform is possible without eliminating the loophole that allows gains to escape income tax completely when transferred by bequest. As long as this provision exists, individuals will have an enormous incentive to postpone realization of their gains.

It has been proposed that the accrued gains be taxed at death as if they were realized and this procedure is referred to as "constructive realization." Averaging and allowing the recipients to spread payments over an extended period of time would minimize inequities and forced liquidations. Actually, a constructive realization provision was enacted in Canada in 1971, and has been proposed repeatedly in the United States.

If constructive realization is too dramatic a change then perhaps a more modest scheme requiring the heir to use the original cost as his base when computing gains on future realization might be acceptable. In any case, this avenue of tax avoidance should be closed. This provision is an important part of any thorough capital gains tax reform program.

2. Ways and Means proposal. Finally, it is important to realize that if one accepts the underlying equity principle of this reform, then one must reject the type of solution favored last year by the House Ways and Means Committee. That measure, which died with the comprehensive tax revision bill that never got to the floor, would have reduced the proportion of the gain included in taxable income as the length of time between asset purchase and sale increases. The postponement adjustment principle calls for just the reverse procedure. Moreover, it can be readily proven that the inflation adjustment, while reducing the proportion included in taxable income of any gain held during an inflationary period, also does not provide any support for the Ways and Means. For example, the rising rates of inflation experienced during the seventies provide another strong case for the reverse pattern.

Perhaps it is politically impossible to enact legislation such as suggested here without simultaneously removing the effects of inflation created by a progressive income tax structure. Although, as Part A indicated, this reform merely puts capital income in an equal tax position with wage income, it may not be easy to make any inflation adjustment with respect to the taxation of one type of income without making some inflation adjustment for all types.

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