How Capital Gains is a Double Tax
It's not as unfair as it looks
When people refer to the income tax, they are often actually talking about two distinct taxes. One is the tax on labor income, ie the income one receives from wages, tips, bonuses, and so on, and the other tax is the capital gains tax, which is a tax levied on the gains people receive when they sell an asset (that they have owned for over a year). This asset could be anything from stock, to a home, to a Pokemon card that has appreciated in value significantly.
As of now, the Capital Gains tax is quite a bit lower than the income tax, maxing out at a top rate of effectively 23.8% as compared to the income taxes top bracket of 37%. This has made many complain, understandably, that capital income, which disproportionally flows to the richest in society, is being artificially preferenced at the expense of workers. The problem is, this is actually not only wrong but the opposite of true.
Contrary to popular belief, capital income actually faces an effectively higher tax rate than labor income. This is because capital income is *already taxed* on the front end with an income tax. By taxing someone’s income, you reduce the amount they can invest and, by the same measure, the amount of money they make from an investment.
Both wage and consumption taxes are temporally neutral. In other words, they treat people the same whether they consume their income directly after receiving it or in a decade! The only difference is one taxes on the front end and the other on the back end.
The Capital Gains tax violates the principle of temporal neutrality by adding a new layer of taxation that you only face if you decide to save rather than spend your income immediately.
For those who still don’t understand what I’m getting at, which is understandable, given that this concept can be quite unwieldy, consider the following hypothetical.
Imagine a world much like our own where there is a 30% tax on income and a 20% tax on capital gains. In this world, you are trying to determine whether to save a portion of your income for 3 years or spend it now. Now imagine the portion of income you are considering saving is 5,000 dollars.
If you decide to save, you will yield a risk-free return of 3.5% (around what the current yield is on US treasury bonds).Â
In a world without taxation, this would mean you would be left with $5,000 * 103.5% * 103.5% * 103.5% = $5543. A total capital gain of 543 dollars to compensate you for deferring your consumptions and the loss in the purchasing power of money due to inflation.
In a world with a wage tax but without capital gains, this would mean you would be left with $3,500 * 103.5% * 103.5% * 103.5% = $3,880. A total capital gain of 380 dollars. This is, as the very astute may notice, exactly 30% less than 543 dollars. So, just by the tax on wages existing, your capital gain has already been reduced by 30%.
In a world with a capital gains tax, your yield is no longer 3.5% a year; rather, it is only 80% of that due to the 20% tax, leaving you with a return of 2.8%. This means at the end of the day, you will end up with $3500 * 102.8% * 102.8% * 102.8% = $3802. A capital gain of 302 dollars, 20.5% lower than the post-wage tax scenario and a full 44.4% lower than the no-tax scenario.
(this was under the assumption that taxes are paid upon accrual, not realization, but the same principle holds true in either case)
To summarize, in our scenario, when there is a capital gains tax in place, you face a tax rate of 30% if you decide to consume your income immediately and 44.4% if you decide to consume it later. If we expanded the time horizon of savings, this disparity in tax rates would be even more dramatic.
One of the most basic assumptions of economics is that people are generally responsive to prices. In a world where inflation is a fact of life, capital gains not only disproportionally punish saving, it also makes it so that the risk-free return to capital yield may become negative (this can also occur due to monetary policy).
It doesn’t take a genius to point out that the likely result of punishing savings is fewer people choosing to save. This means fewer people investing in bonds and equities. When the demand for these drops, the cost of financing new capital expenditures increases. Businesses will now be forced to pay more interest on the bonds they issue and will raise less money when they issue new shares. All this would suggest that, in the long run, the capital gains tax leads to less business investment in things like R&D, tools, vehicles, factories, and so on.
The degree to which the capital gains tax is practically harmful due to this double taxation element is certainly a contentious topic. Making a determination would require us to have a solid understanding of the elasticity that savings have to taxation and the elasticity businesses have to their cost of capital, and those are both areas where there are widely diverging viewpoints. Some argue that the elasticity to taxation, in this case, is quite low, and since eliminating capital gains taxation will either increase government borrowing or decrease government spending and investment (savings), the total effect on investment it has is negligible if not net positive. Others argue that the elasticity is sufficiently significant so as to make the negative effects of the tax offset its progressivity, which could be replicated by having a slightly higher but more efficient tax with larger government transfers.Â
Diving into the specifics of these arguments will need to be the topic of a blog for another time, along with discussions of the other problematic aspects of the capital gains tax, from the preferential treatment it affords to stock buy-backs to the negative impact of the Lock In Effect. In the meantime, now you can at least say with confidence that the Capital Gains tax is a double tax.
Someone just happened to link to this: I think it's a strange article. You could flip the whole thing by noting that an income tax applies the same rate regardless of when you receive the income. There's this built-in assumption that neutrality with regard to consumption is a relevant tax principle, but that's not clear at all. It's much more clear to me that neutrality with regard to income is important.
Also, you make an accounting mistake by ignoring the paradox of thrift. People choosing to save less does not reduce total savings. Though if you taxed the savings of households and not companies, that would shift savings towards companies of course. More consumption also means a higher return on investment, leading to more investment instead of less. I'm sure you could construct some complex argument that goes against this, but it's not at all as straightforward as you put it.