Eliminate the Capital Gains Tax

The following is a guest post from Marotta Asset Management.

I've decided to run a mock campaign for president again as a forum to talk about public policy. Every four years I look for a candidate who understands economics, only to find politicians instead. My political bias, like many economists, leans toward freedom. The unintended consequences of much of our legislation result in great harm to the economy and to people's livelihood. If elected, I promise to do less harm.

Lots of polls are out there supposedly to help us choose a candidate. I hate them all. They inevitably ask a battery of two dozen questions dealing with issues I don't care about and only vague questions about the ones I do. As a result, these polls are as useful as recommending I vote for a candidate because we like the same flavor of ice cream.

From helping people from all walks of life with their family finances, I've discovered that the most successful people recognize that their financial future mostly depends on actions under their own control. The best way for people to achieve their financial goals is to moderate spending and stay on track with a savings plan.

The issues I consider of primary importance are those that interfere with everyday families becoming self-sufficient. Unfortunately, these are not the issues that voters seem most passionate about. But they should be. Issues such as the capital gains rate determine if we will be able to save toward retirement or not.

Saving and investing just a dollar a day over your working career produces $400,000 at retirement. Saving $2.50 a day produces $1 million at 11% after 45 years. Obviously, most families don't save at all. They are struggling because of the choices they make. Financial planners encounter this problem so often, it's been dubbed "the latte effect." People spend $2.50 a day on lattes rather than becoming millionaires.

Being a good citizen means first and most importantly to produce more than you consume. This will ensure you can take care of yourself. It will also mean you can be charitable and give to the truly needy. You, however, are not the truly needy. Odds are there are people getting by just fine earning half of what you bring home. Don't succumb to envying those who make more than you. At the same time, embrace the virtue of compassion for those who make less.

The previous few generations did not accrue much in savings, but they did have defined pension plans for their retirement. A pension paying $75,000 a year is equivalent to having a $1.7 million portfolio for your retirement. As we all know, however, the days of defined benefit plans are largely over. We need to grow our savings to more than $1 million simply to fund a modest retirement. The government can help us reach that goal by eliminating the capital gains tax.

Every economist worth his PhD agrees that the correct rate for the capital gains tax is zero, zip, nada. Some have even suggested the optimum tax rate for capital gains is negative! Unfortunately, all the 2008 presidential hopefuls (except for me) who would reduce or eliminate the capital gains tax have dropped out of the race.

Certain proposals regarding the capital gains tax are totally unrealistic. Some would like to impose ordinary income tax rates on capital gains; others want to raise the rate to 28%. Many people divide the nation between those who have an adjusted gross income over $75,000 and those who do not. All of the suggestions just described will dissuade Americans from saving and investing, the very activity we should be encouraging.

Under these rules, if your investment assets earn an 8% return, you will be unable to make any progress toward your goals. Five percent of your return will just keep up with inflation, and you will owe 2.24% for a 28% capital gains tax. You would only be left with a 0.76% real return after taxes and inflation. And at ordinary income tax rates, your return would be even more dismal. At these rates, everyone with taxable investments in the market would do better to pull their money out and buy municipal bonds and Treasuries.

Hopefully there isn't a chance these policies would be implemented, but I use a candidate's views on economic matters to judge his or her competence. I find this year's choices particularly discouraging.

We need an incentive to save and invest in order to create an economic environment that encourages the hard work and risk taking that pays everyone's salary. Investment is simply capital, and capital is simply deferred consumption. Why defer consumption if you are penalized for it?

Investment is what builds the factories, businesses and entrepreneurial endeavors that actually make money. Investment stimulates the economy, and as the economy grows, jobs are created and real wealth is produced.

The prospects for our Social Security system look bleak. There won't be enough money to support the number of retirees. Chances are only the worst off will receive anything significant from current funding. Now the political winds are blowing to make saving and investing for your own retirement much more difficult. It seems as though "fair" is being redefined as everyone being impoverished and reliant on the government.

Without incentives, we may as well all go have another latte.

Comments

I agree that the current setup discourages saving and investing. Even with the tax shelter of a 401k, you can't access that money easily and you do have to pay taxes later, which may be even higher than your tax rate now. The ROTH is an excellent idea, but there are so many stipulations about contribtion and income limits that it isn't too effective at encouraging savings. There should be no limit on what you can contribute to a Roth or any income limit. Then you would just pay ordinary income tax and no capital gains tax, and any money you put in you can access at any point with no penalty (just not the interest). Just my 2 cents

[Dave]

I agree with you 100% In fact, you say that it's unrealistic to impose ordinary income tax rates on capital gains, but my understanding is that that's exactly how gains are presently taxed for trades made in less than 1 year.

[Kyle]

Dave, that's correct but if you buy and sell within one year, are you really investing? Not really. And that would exempt practically all retail stores from any sort of income tax so long as they turned over their inventory in less than a year. The point is to encourage long-term productive investment, not short-term speculation. Removing short-term capital gains rates would be foolish.

[Christopher Smith]

A key detail to mention when discussing capital-gain and dividend taxes is that when an investor sells appreciated stock for a profit or receives a dividend payment from a company, that money has already been taxed at the US corporate rate (30%), which is among the highest in the world. Thus, even with the "favorable" 15% rate for investments held long-term, the total tax rate that the investor bears is 40.5%.

[Dave]

Kyle,

I agree with you. I wasn't trying to argue the merits or flaws of short term investing. I was just pointing out that this is the case.

In Canada they are starting something called a TFSA - Tax Free Savings Account. A person can contribute $5000 a year. Although it is not alot of money the money in this account is never subject to taxes,ever. No Capital Gains taxes,Interest taxes or taxes on dividends.Even on withdrawal there is no income taxes.
10,000 (w/spouse) dollars a year the gov't can't get their hands on. I like this idea very much.

[Soren Kierkegaard]

You write: "The best way for people to achieve their financial goals is to moderate spending and stay on track with a savings plan."

Might be good to add: "Focus on earning more . . . much more."

Quitting a "safe" corporate job and going freelance, I've earned my former salary in the first nine weeks of this year!

Saving alone is too slow, too passive.

[Jack Stahl]

The problem with people not saving isn't that they don't have incentive. They do. And they would with income-tax level taxes, too. Rational agents [in the technical sense of the word] will continue to invest because of risk-aversion and lack of other options besides spending.

What is, a problem, though, is that most people are not rational agents. (No one is fully, obviously). Most Americans have a horrible present-time bias. Many are uninformed about realities, how taxes work, just how long they will be alive after retirement etc. 0% capital gains will not get these people to stop spending. Instead, the people that ARE rational agents -- who are already doing fine, if not perfectly efficiently, with current incentives -- will prosper even more and there will be considerably less tax money to help those who are are not doing fine.

Now whether or not that is a good thing is a moral-political position that I don't intend to argue here (though I don't imagine my personal viewpoint is too obfuscated). But it's silly to act like the reason people aren't saving is because they think the capital gains tax is too high.

[Jack Stahl]

One more thing:
What evidence do you have that 'every economist worth his PhD' supports a 0% capital gains tax?

[Jack Stahl]

I google "economist capital gains". The top two hits? Economists from Berkeley and Princeton who (at the risk of oversimplying) support raising capital gains:

http://www.nytimes.com/2007/07/29/business/yourmoney/29view.html?ex=1343448000&en=c45247ad01379f01&ei=5124&partner=permalink&exprod=permalink
http://online.wsj.com/article/SB118723129786699287.html

Again, I don't mean to imply that "raise capital gains" is the extent of either's argument, but it is certainly more that than the other way around, and at the very least both make it clear neither would come close to supporting a 0% rate, as you claim.

[Ryan]

I disagree with having any form of capital gains tax, but with the inevitible happening with Obama (the media darling) likely being our next president, I will refrain from selling anything for the next 4 to 8 years.

Just remember that FMF did not write this post... it was a guest post.

The canadian TFSA... is the money you put in on an after (income) tax basis? If so, it is similar to the Roth IRA. If it's taken out before income taxes than it's a pretty good deal.

[rwh]

Yes, let's cut taxes on those poor folks with large stock portfolios. William F. Buckley would be pleased indeed! The richer you are, the less you pay! Is this a great country or what?

Oh, there's a war on? That's okay. The poor people are fighting that for us aren't they?

[Rob]

1) As far as I know, not ALL the candidates that would eliminate the capital gains tax have "dropped out" of the race. Huckabee is still technically in the race, granted it won't happen, that won't stop a lot of people from writing him in on the ballot in November.

2) RWH, why would you impose a penalty tax on people who worked hard to get where they are? If a person goes through college and possibly further in order to get that high-paying job that enabled them to have a large stock portfolio, they EARNED it with hard work. Let's see you earn something with hard work and then check your position on it being penalized.

[beastlike]

Exactly Rob, good point... It's a free country RWH, go bust your b$tt and invent something and become rich instead of sitting around crying that most those people worked harder than you. No ones stopping you from becoming rich.

Jack Stahl - How about this - Any Economist with common sense would agree that ANY capital gains tax is bad for the economy.

[rwh]

No crying coming from me. I'm sure Paris Hilton has busted her butt her whole life.

The problem with your view is you are not comparing apples to apples. When you can show data that demonstrates those in the top 1, 5, 10 or 20% in TOTAL WEALTH pay a corresponding percentage in taxes then maybe you'll have a case. But I don't think you can.

And all those folks like me who work for a living work pretty darn hard for a very long time.

Nobody said living in a free country is free. Apparently you guys think it should be.

[Ryan]

rwh,

I have a link to show you data you requested:

http://www.google.com/search?hl=en&q=rich+taxes

[FMF]

RWH --

Here's an interesting concept you might like since you want everything to be fair:

Since everyone gets the same benefits of living in a free country (right to use the highways, libraries, etc., national defense, etc.), what if everyone pays the same amount of taxes? Simply take the total costs of running the country divided by the number of people above 18 (or some other age), and that's their tax bill.

I'm sure you'll say it's a regressive tax, but I've always been intrigued by the fact that the benefits of our government, which are enjoyed by all, are paid for by a few.

Food for thought, when you go out to dinner and offer to split the check among friends, how do you divide it up? By income of the people at the table?

[etc]

I agree with rwh. If anything the capital gains rate should match your ordinary income rate. Honestly, why should they be any different?

Since all of the defined benefit plans are dying off, why not give special considerations to taxes on defined contribution plans on withdrawal instead of taxing them as ordinary income? That would more likely help those who would otherwise have a pension.

[rwh]

Ryan:

I went to your link and viewed the first 3 stories. You proved my point, each discussed INCOME tax. None of them addressed WEALTH. It's important to remember that the wealthier you are the easier it is to shield your WEALTH from taxation.

The INCOME tax that very wealthy people pay represents only a sliver of their WEALTH, which tends to escape taxation as it increases, as does income, such as Warren Buffet:

http://gregmankiw.blogspot.com/2007/06/mr-buffetts-tax-bill.html

an exerpt: "Even more striking to me is a fact that Mr Buffett did not emphasize: how low his taxable income is. His income of $46 million represents a mere 0.1 percent of his reported net worth of over $50 billion. That is not an impressive rate of return!

Why is it so low? I can think of at least four possible ways investors like Mr Buffet can keep their taxable income, as opposed to their true income, low:

They hold stocks that pay minimal dividends.
They avoid realizing capital gains.
They hold some of their portfolios in tax-free municipal bonds.
They give appreciated assets to charity, getting a deduction for the current market value without ever having to realize and pay tax on the capital gain."

FMF: Your analogy is flawed. First, fairness doesn't mean everyone pays "the same AMOUNT". That's simply ludicrous. Unless of course, you give the average worker the same AMOUNT of wealth so they can take equal (and fair?) advantage of the items listed in the exerpt above. That's equally ludicrous.

What I infer from some of the commenters that disagree with me is investment income is more important than income earned through a job, or even owning a business, therefore they should be rewarded by having to pay less tax. I can see why some would think that way, investment is obviously the engine that drives growth, however, labor is not some sort of brake on growth, unless there isn't enough of it. Some sectors in our economy (health care) are expected to have reduced growth in the future because of labor shortages. Some regions of our country expect lowered future growth because of stagnant population growth and labor shortages. And of course, reduced growth will eventually lead to reduced investment returns.

I see nothing wrong with treating all forms of income the same.

[FMF]

RWH --

"Fairness doesn't mean everyone pays the same AMOUNT."

Why not? Doesn't everyone get the same rights and benefits from government? Then why shouldn't everyone be on the hook for the same amount?

If you think about it, it's an interesting concept.

[rwh]

I thought about it. It's not that interesting because it doesn't make any sense.

If you think Bill Gates should pay the same AMOUNT in taxes as the kid who sacks his groceries, then either Mr. Gates is going to pay very little or the kid is going to debtor's prison. Either situation is crazy.

I guess we'll have to agree to disagree with that one FMF.

[FMF]

It doesn't make any sense to you because you're fixated on the amount -- not the services received.

Consider it this way:

The government provides all sorts of services, right? Highways, libraries, Social Security, national defense, education, etc. It also offers a lot of rights such as the ability to vote, fredom, etc. Think of all of these collectively as one simple service. Now, how much are these worth?

To answer this, you don't need to know an amount a person makes as the set of services is the same for all of us. You get what I get. I get what Ed gets. Ed gets what Sherry gets. Sherry gets what Bill gets. And so on. Everyone gets the exact same set of services/benefits.

Ok, so if everyone gets the exact same set of services/benefits, how much should each person pay for these? I'm suggesting the answer should be "everyone should pay the exact same amount." Why? Because everyone gets the exact same services/benefits. You can't see where this is at least an interesting concept?

Why doesn't Bill Gates pay $1,000 a gallon for gas and some kid pay 2 cents a gallon? Isn't that "fair"? It is according to your way of thinking.

See what I mean?

[rwh]

No, I don't see what you mean.

First, we all don't get the "same" services. For instance, big campaign contributors get access to politicians who may (or may not) do things while in office that benefit their big contributors, such as changing depreciation schedules, giving property tax breaks or.......lowering capital gains tax rates.

Second, people who can afford to live in more expensive neighborhoods generally get better police and fire protection, have better infrastructure such as streets and roads, and usually have better schools for their kids. Of course, they usually pay higher property taxes, but the point is, they get better GOVERNMENT services because they can afford it. These are the same people who tend to have a greater percentage (and amount) of their income (and personal wealth) from capital gains precisely because they have significantly more assets.

There are lots of examples of this but my main point is people who derive a large percentage (or amount) of their income from capital gains, i.e. wealthy people, are already paying a lower percentage of their income (and a much lower % of their WEALTH) in taxes than a guy like me, who's in a 25% tax bracket. They can choose when to pay their taxes based on when they sell their assets, and can offset some of the gains with losses, which not only further reduces their taxable income but also reduces their "opportunity cost" by giving them additional time for more investment options (and opportunities for more gains). Regular folks get a paycheck every week or two, and the taxes are taken immediately.

And you are incorrect in stating what you think is "my way of thinking". At no time did I say rich people should pay more for the same services or products. I have consistently stated that people should generally have all forms of their income taxed at similar rates.......that's a percent! You seem to be "fixated" on the view that there is some sort of magic number (not a percent, but a real, concrete number that's the same for everyone) that we should pay the government in taxes on our income.

So, you're the one who's fixated on "amount", not me. What is the magic number? $1000/year? $5000/year? And you really would be happy if you and the multimillionaire or billionaire paid the exact same amount? You apparently think that's a fair way to do things. I don't.

So, we'll have to agree to disagree.

[FMF]

I'm not fixated on anything. I'm just open to exploring new ideas/concepts.

Yes, we'll just have to disagree here.

[Kyle]

Wealth should not be taxed.

[Robert M]

I guess this is kinda a moot argument since we're a socialist republic now...Thanks No-Bama!!

Now that the market has lost FIFTY PERCENT OF IT'S VALUE we need radical action to bring about a recovery.

Ideas? I know! Let's SPEND A FEW TRILLION DOLLARS we DON'T HAVE, and then LET'S RAISE TAXES SOME MORE!

Excellent ideas! I would have expected better from someone HARVARD educated, but oh wait, Lawyers don't need to study finance do they!
Glad i went to a state school. The finance majors here know that the only way to restart growth is RADICAL ACTION, in this case the action is totally radical as far as Washington and a Democrat led administration is concerned: Massive tax reductions to encourage investment and growth, coupled with government SPENDING REDUCTION to balance the budget. But, this is the opposite of what happened.

Bailouts are not the answer, no matter who they benefit. Everyone wants government action to pay their mortgage and put them on welfare. People are so desperate they are willing to whore themselves to bureaucracy just to get a handout.
When will they realize that the government is THE REASON we are where we are today, and that they cannot fix the problem.