The Capital Gains Tax Break: Great Idea Or Big Mistake?

Tax Notes contributing editors Robert Goulder and Joseph J. Thorndike debate the merits and necessity of the capital gains preference, all in five minutes.

This transcript has been edited for length and clarity.

Joseph J. Thorndike: Democrats in Washington have been pondering the unthinkable this year, curbing or even eliminating the tax preference for capital gains.

Well, maybe it’s not unthinkable. Democrats have been talking about this for years, decades, even maybe a century, but that’s why it is sort of unthinkable.

The capital gains break is as old as Methuselah in tax terms. It’s been around for a hundred years, with the exception of a crazy moment in the late 1980s, when the greatest tax cutter in recent history (Ronald Reagan) agreed to ditch it.

For today, though, Robert Goulder and I are going to debate the merits of the capital gains preference.

I appear to plead the case for the accused. I will argue that the much-maligned capital gains preference is defensible and plausible. It’s not perfect, but it provides some much needed rough justice. And I have history on my side.

Let’s jump in.

Reason number one is growth. By reducing the tax rate on investment income, you increase the incentive to invest that can produce more economic growth. And, as the old saying goes, if you want more of something, tax it less. I want more growth, so I’ll take lower taxes on investment gains. Thank you very much.

Number two is inflation. When someone sells an asset that has increased in value over time, some of the gain comes from inflation. The capital gains preference helps account for the unfairness of taxing that nominal gain, in addition to the real game. That’s rough justice, sure, but still justice.

Number three is the lock-in effect. People don’t pay tax on capital gains until they realize a gain by selling an asset. The realization requirement encourages people to hold assets when they might otherwise sell them, which can be bad for the economy and inefficient. Taxing capital gains at regular rates would make the problem worse. The rate preference makes it better.

Finally, as I said, the rate preference is a hundred years old. Even the greatest progressive tax reformer of the 20th century, Franklin Roosevelt, made his peace with it — as have generations of voters.

Inertia isn’t an argument, but I think it shifts the burden of proof. If you want to abandon a tried and true element of the tax law, you better have a strong argument.

Robert Goulder: Well, Joe, I think I’ve got a strong argument. In fact, two of them.

Point number one is fundamental fairness. All federal income taxes should be based on the concept of ability-to-pay full stop.

Now, the last time I checked, the folks who were paying capital gains taxes, at least predominantly, were not members of the income demographic who needs a massive tax break. For example, look at Warren Buffett. Does he need a tax break so that he can claim a lower overall effective tax rate than his secretary? Absolutely not. 

I say income is income, irrespective of the source. So, let’s tax it all according to the same progressive tax brackets, in which the rich pay a bit more and other folks pay a little bit less.

By that, I mean we should retain those rules in the tax code that set out the definitions of what constitutes a capital asset and what constitutes a recognition event. Each year when you’re doing your tax return, you would calculate your net capital gain and simply fold that figure into your ordinary income — without special treatment.

As a result, your net capital gain would be taxed according to the same rates as your salary and wages. That’s simple and it’s fair.

Point number two is more nuance. This goes to the integrity of our tax system and the ability of the IRS to effectively administrate it.

I can tell you that about 50 percent of all the bogus tax shelters out there in the world boil down to just one trick: Trying to cloak ordinary income so that it outwardly looks like a return on an investment.

The examples of that are practically infinite, but I would toss out carried interest treatment as the poster child for this kind of practice. Carried interest, in case you don’t know, is a practice where these Wall Street guys are able to mask their huge salaries to resemble a return on an equity investment. It’s an economic fiction. It’s not fair and it’s got to go.

But the thing is, those types of schemes are extremely hard to regulate. Every time the IRS enacts a rule to clamp down on the abuse, the tax bar cleverly figures out a way to work around it.

The ultimate solution is for Congress to eliminate the viability of those types of schemes. You can do that by simply treating capital gains the same as ordinary income. 

Joseph J. Thorndike: Viewers, you’ve heard both sides. Now we want to hear your opinion on the capital gains preference.