Our bizarre system of taxing capital
By Scott Sumner
It’s difficult to think of a more bizarre and foolish policy than the practice of taxing capital. Consider:
1. If it were appropriate to pay taxes on capital gains, why wouldn’t it be appropriate to pay negative taxes on capital losses? Economic theories tend to be symmetrical. And yet capital losses do not result in negative taxes, except in certain limited cases. And why only those cases?
2. Economic theory suggests that two people with essentially identical economic outcomes should pay identical taxes. But consider two people who both bought 1000 shares of Apple stock for $50/share at the beginning of the year. One sold the shares on November 9th at $100 and bought them back 5 minutes later at the same price. Both held 1000 Apple shares at year-end. To an economist those two outcomes are essentially identical. But one person must pay a large tax on capital gains, while the other does not. Why?
3. Long-term capital gains are taxed at a lower rate than short-term capital gains. Why?
4. Corporations can expense the cost of debt (interest payments) but not the cost of equity (dividend payments). Why? Is debt morally superior? Are we trying to encourage debt?
5. Economists tend to believe that real variables are what matter, not nominal variables. Yet, while income tax rates are indexed for inflation, taxes on capital income are not. Why not?
6. If you invest in US dollars and the dollars rise in value, you do not have to pay taxes on the gain. For instance, suppose you bought dollars for oil in March, and sold the same dollars for twice as much oil in September. Your dollars increased in value, yet that gain is not taxed. Why not?
7. On the other hand, gains in currencies such as Bitcoin are taxed. You are legally required to keep track of the current market value of any Bitcoin you acquire, and also the date you acquired them, and also the value of those same Bitcoin when you use them to purchase goods and services. That means if you buy a candy bar with Bitcoin, and the Bitcoin are worth more than when you acquired them, you must report that gain to the IRS. Hopefully you’ve held the Bitcoin for more than a year, so that it is not a short-term capital gain on the candy bar purchase. And this must be done for every single transaction.
But all this silliness pales in importance compared to the fundamental flaw in taxing capital income. The IRS assumes that the value of a future dollar is the same as a current dollar, even though that is clearly not the case.
To see how strange this is, consider the following analogy. Suppose you sold 100 ounces of gold for 4000 ounces of silver. Then suppose the IRS claimed you made a 3900 ounce “capital gain” and demanded taxes be paid on that gain. You’d probably say, “Wait a minute, there’s no gain because the market value of one ounce of gold is equal to 40 ounces of silver. So no profit was made on the transaction.” And you’d be absolutely correct. Fortunately, the IRS isn’t that clueless.
Except when it comes to money. Just as one ounce of gold might be worth 40 ounces of silver, one dollar today might be worth $1.05 a year from today. Suppose nominal interest rates are 5%, which reflects 2% inflation and 3% real interest rate. In that case $1.05 a year from today could be purchased for $1 today. If you invest $1 today and your asset rises in value to $1.05 after one year, you haven’t actually made any gain, as the money you receive is equal in value to the money you invested. A future dollar is no more equal to a current dollar than an ounce of gold is equal to an ounce of silver. Except to the IRS.
Some understand this point, but then wrongly argue that taxes should be paid on capital earnings that exceed the average return on capital. If so, then negative taxes should be paid on capital earnings that fall short of the average. However, under that regime the IRS would collect zero net revenue from capital income taxes.
A simpler and fairer solution would be to abolish all taxes on capital, and start over. Think about what the tax system is trying to achieve, and implement a tax system that achieves those goals in the fairest and most efficient way possible. In my view that would be a progressive consumption tax.