August 17, 2007
From the desk of Mindles H. Dreck:How to Tax Capital Gains
How to Tax Capital Gains - WSJ.com
Since the important work by Martin Feldstein and his collaborators in the 1970s, economists have understood that taxing capital gains has a big impact on investors' decisions about when to sell capital assets. Higher tax rates delay sales, causing investors to be "locked in" to their current holdings, unable to balance their portfolios as they would wish. Although more recent research has shown that increases or decreases in the sale of assets are largely timing responses triggered by changes in tax rates rather than permanent shifts in behavior, we must take the lock-in effect seriously, because in fact tax rates are constantly changing. By itself, an increase in the capital gains tax rate worsens the lock-in effect. But this impact can be offset by other desirable changes, such as indexing capital gains for inflation (which would lower the share of capital gains subject to tax) and taxing capital gains at death. (Currently, we do not collect capital gains taxes when someone dies; this makes people want to hold onto appreciated assets throughout their lifetimes.) So-called "constructive realization" (i.e., taxation of capital gains at death) could help solve our current estate tax impasse by substituting capital gains revenues for some of the lost estate taxes. Canada has implemented constructive realization, and dropped estate and inheritance taxation.
This is close to what I've been saying. Many people cite the complications of calculating inflation adjustements and keeping records as if they are reason enough to dismiss the idea. An exclusion for the first $50,000 or so of sales proceeds would render the objection moot, I think (although it would bring an avalanche of tax-inspired installment sales..).
I write about this because it seems like some sort of legislation is inevitable given the 2010 expiration of Bush's tax cuts. But it does seem that all of washington is mired in such low approval ratings that no action is possible right now.
Posted by Mindles H. Dreck at August 17, 2007 10:08 AM | TrackBack | Technorati inbound linksWith their approval ratings so low, you'd think they'd try and do something that would bring them out of their funk.
If I was a Congressman, even if I was a Democratic Congressman, I would not be confident that I had a job come after next year.
People only think about their congressmen when their electoral contract comes up for renewal, sort of the way they think about their landscaper. Till then, the plunge in public esteem for Congressmen hasn't even begun yet.
Canada also experimented with indexing capital gains for inflation but stopped in the late 1980s.
Mexico still indexes capital gains, but there is speculation it may stop.
I wish people would look at taxes as a way to raise money for the government rather than some sort of fairness balance that must happen anytime anyone makes money.
Any discussion of who we "should" tax is based on a false premise. There is no one who "should" be taxed.
To the extent that the capital gains tax on business investment isn't a tax on inflation, it is a tax on job creation.
How about having no capital gains tax at all if the money is put into other stocks immediately?
IE, no tax until you liquidate?
That would solve the lock-in problem and have a pretty low accounting overhead, at least compared to interest rate adjustments.
Inflation rate adjustments for capital gains shouldn't be too hard for anyone who actually has enough money to have taxable gains.
Inflation adjustment seems like a reasonable idea. Government now controls money, an important cause of inflation, so it seems unfair to tax inflation. Why would it be so hard to figure it?
Not taxing reinvested capital gains also seems like a good idea. Anyway, I agree that tax policy should be focussed on raising enough revenue to cover the cost of government. the optimal tax is one that causes the least amount of economic distortion. Poorly designed taxes reduce economic growth, and that makes it harder to raise sufficient revenue.
Then there is the moral hazard of tax exemption. What brought democracy to England first, then the US, and then France was the need for monarchial governments to finance their excesses by taxing unrepresented populations.
The failed bill to make permanent the estate tax repeal actually included "constructive realization" (i.e., ended the step-up at death), but apparently very few people understood that or the consequences. (Alternatively, one could claim that the bill therefore was going to hurt some of the well-prepared megarich at the expense of the ill-prepared, and some in Congress therefore opposed it.)
Many people cite the complications of calculating inflation adjustements and keeping records...
Calculating inflation adjustments can be no more difficult than using the tax table provided in the 1040 instructions. As for keeping records, people do that well enough already in order to know their cost basis in order to calculate the capital gains tax on their net gain.
The advantage that comes from not having to pay taxes until realization certainly affects behavior. But I don't think that giving people more advantages to eliminate distortions is justified. While I would be happy with allowing everyone a certain amount of lifetime gains tax-free to encourage the wider acquisition of capital assets in the population, any continuously available exclusion ends up treating the capital gains of some people different from those of others. The installment sale example already has counter parts. The Clinton residence exclusion comes to mind. It is resulting is some people realizing millions of dollars in capital gains in serial transactions without being taxed while others who stay in their homes and who receive less over their lifetime pay tax on some of it. The old system was a limited, lifetime exclusion for houses only that was fine except for having its value eroded away by inflation. As for inflation adjusting of all assets, the IRS could put official inflation calculators online, which would be also be used by commercial tax software. Put in your original basis and get out your inflation-adjusted basis. The "angel of death" stepped up basis ought to go to. I would apply any unused lifetime exclusion to it but otherwise it ought to be taxed. Because the amount of assets in an estate that were never taxed varies under this rule, it treats also people differently. The unstable estate tax rates do the same. Why should the government take vastly different amounts of someone's estate depending on when they happen to die? We need to try and make tax systems sustainable and consistent over time.
Comments are Closed.