How to Tax Capital Gains

From Alan Auerbach:

The recent controversy over the taxation of “carried interest” (the share of profits that managers of private equity funds, hedge funds and the like commonly receive) demonstrates the problems that can arise from taxing capital gains differently from other types of income. While it’s relatively simple to change the way we treat carried interest, it would be far better to undertake an overall reconsideration of the way we tax capital gains.

As President Reagan and others who crafted the Tax Reform Act of 1986 understood, different tax rates on different types of income-producing activities often distort economic decisions and increase the tax system’s complexity. Their solution was a broad-based tax with low and uniform marginal tax rates. The identical rate was applied to capital gains and to wage and salary income. But the reform survived only a few years, and we now confront the old problems magnified by two decades of financial innovation.

We can do better, and here are some guidelines:

  • Increase the capital gains tax rate, but not the “lock-in” effect. 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.

  • Reconsider how best to encourage innovation and risk-taking. Some argue that low capital gains tax rates can spur the formation and development of new enterprises, for the payoffs from successful start-ups flow to their owners largely in the form of capital gains. But many start-ups fail, generating capital losses rather than capital gains, and only a miniscule fraction of the economy’s capital gains are associated with new ventures. A low capital gains tax rate is a very poor way to encourage entrepreneurial activity.

It would be far better to carefully tailor tax provisions to spur innovation, such as the exclusion for capital gains on newly issued small-business equity established in 1993, or the deductibility of losses on certain small-business stock, which is much more generous than the general provision limiting annual loss deductions to $3,000.

  • Don’t raise the cost of capital. Capital gains taxes, like other taxes on capital income, drive a wedge between before- and after-tax returns. Economics teaches us that taxes should be figured into the cost of capital for new investment — and hence influence the amount of investment that occurs. Lowering capital income taxes reduces the cost of capital and spurs investment; raising these taxes increases the cost of capital and discourages investment.

But not all capital income taxes equally influence the cost of capital. Capital gains taxes have a relatively weak impact on the cost of capital because a large share of the tax revenues is associated with income not generated by new investment. Thus only a small portion of the capital gains realized over the next several years will result from today’s investment, so changing the tax rate on the gains won’t influence today’s investment much. By contrast, tax provisions targeted toward new investment, such as the bonus depreciation scheme introduced in 2002, tie tax reductions to new investment and thereby produce a bigger bang for each buck of tax reduction. Offsetting an increase in the capital gains tax rate with a revenue-neutral tax reduction that targets new investment is likely to reduce the cost of capital. It is also likely to be progressive, favoring those at the lower end of the income distribution.

There are, of course, more sweeping tax reform alternatives available. Some proposals would move us from taxing income toward taxing consumption, or toward taxing capital gains as they accrue, rather than only when assets are sold. There are coherent and attractive proposals available to implement either of these approaches. But we need not wait for the next grand tax reform to improve on our current method of taxing capital gains.

WSJ August, 2007

About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar.
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4 Responses to How to Tax Capital Gains

  1. Pingback: Links for 06-29-2013 | Symposium Magazine

  2. Thaomas says:

    In addition to indexing the gains, the should also be taxed as if the gains occurred throughout the holding period and not at the rate applying to the year of realization.

  3. Kaleberg says:

    Given the massive glut in capital and investment money, it makes sense to tax capital gains at a higher rate than earned income. This has led to a low return on investment over the past several decades, and it is this that discourages investment in productive or service providing capacity as opposed to simple gambling – creating risks for the purpose of wagering. The best way to increase the return on investment is to move more money from the capital and investment sector into the consumption sector which is driven by wage income.

  4. Welcome to the tax cap gains at death club, Owen.

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