Capital Gains Should be Taxed at Full Value: A Response to Dan Mitchell

Once a subject left to financiers and members of congress, the Capital Gains Tax has seen a much broader discussion this week. The combination of growing income disparity, Mitt Romney’s release of his income taxes two days ago, and President Obama’s call for more “tax fairness” in his State of the Union address last night has voters considering the societal implications of capital gains tax treatment as never before.

In brief, the Capital Gains Tax is a tax on income gained through the sale of capital assets, ie, income made by investing in a company, or by buying assets such as stocks and bonds at a low price and then selling them at a higher price. This type of income is taxed at a far lower rate than income earned through drawing a paycheck. Currently, if someone earns $100,000 from working at a job, that person falls into the 28% marginal tax bracket. However, if that person makes $100,000 by buying and selling stocks, they only pay a 15% on those earnings. The result has been that those who labor get taxed at one level, while those who sit back and “invest” by placing buy and sell orders with their online broker (and who produce *nothing* for the society) get taxed at far lower levels. This is the main reason why Mitt Romney, who made 20 million dollars last year, paid barely 15% of his total income in taxes, while average Americans making as little as 35,000 end up in the 25% marginal income tax bracket.

As Americans take a hard look at ending this preferential tax practice all together, corporate financiers have begun to circle the wagons to protect one of their most lucrative sources of income. On May 3, 2010, a video narrated by Dan Mitchell was uploaded onto YouTube titled, “Six Reasons Why the Capital Gains Tax Should be Abolished.” Mitchell is a former advisor to the Senate Finance Committee and currently a senior fellow at the Cato Institute, a libertarian think-tank. The video has been uploaded and embedded in right-wing and pro-corporate sites all over the web, including the National Review Online, Freedom & Prosperity.org, Kudlow’s Money & Politics Blog, Townhall.com, For Freedom’s Sake, the Lincoln vs. Cadillac website, and others. The original video can be found here.

In the video, Mitchell lists six reasons why the Capital Gains Tax should be abolished altogether.

This Economist takes the opposite position, and suggests that most capital gains should be taxed at the same rate as earned income. In support of our position, we will list refute Mitchell’s main proposition, which underlies all 6 of his arguments:

“The Capital Gains Tax results in less investment.”

This is the primary argument made by those who oppose the capital gains tax. They argue, with some validity, that the growth and expansion of business relies on investment; if potential investors are taxed for a successful investment, they will be more likely to place their capital somewhere where both risk and taxes are less, including in other nations.

I agree with part of this argument. The error, however, is his assumption that most capital gains actually come from ‘investment’ that assists an actual struggling or embryonic business. The vast majority of capital gains do NOT come from investing in a business; most capital gains come simply from stockholders buying and holding stock from other stockholders.

When someone with capital to invest purchases stock directly from a company issuing the stock, or uses its resources as “venture capital” in a private transaction to help grow a new company, there is direct investment. But when someone simply buys and sells equities on the stock market, not one penny is flowing to the business; rather, it is simply cash trading hands between shareholders. Such a purchase provides ZERO additional dollars to the business. Such “investors” generally do not participate in the corporations decision-making, governance, hiring, or expansion decisions. They use their wealth to purchase stock in an online transaction, follow it for a year, and ignore everything except how their ‘investment’ – which was purchased from another such ‘investor,’ not from the company – is doing. When the time is right, they access their account and hit the sell button…and make instant cash.

They produce nothing. They hire no one. They create nothing. They provide no expansion possibilities for businesses. And they are given preferential tax treatment for this.

The following table provides some indication of the number of these kinds of transactions for 10 random companies from different industry sectors (based on company quarterly filings and Yahoo! Finance compilations). The first figure represents the number of shares of stock issued by the company, over their lifetime, for which they received a payment, or investment, once. The second figure represents the number of shares traded between traders in ONE year, for which for the company received nothing, but which still qualifies as an ‘investment’ for capital gains purposes.

(Click to Embiggen):

In each case, the number of shares traded between traders in a single year far outweighs the amount of investment recorded by the company over that company’s lifetime.

The “problem” of a capital gains tax limiting investment can be fixed very easily: eliminate the ability of sales and purchases between traders to qualify as “capital gains,” while continuing it for actual direct investment. Such a change would incentivize direct investment in a company, make online gambling less lucrative, increase necessary tax revenues, and begin to end the system whereby honest laborers subsidize stock gambling.

Mitchell goes on to make the argument that the capital gains tax makes the United States less competitive in world markets. He argues that numerous nations have no capital gains tax whatsoever, and suggests that American companies and US investors would be likely to relocate or invest elsewhere because of this. Further investigation reveals that his video contains serious errors in this area. For instance, he lists the following nations:

Belgium, the Czech Republic, Mexico, and Portugal – He is simply wrong. Capital Gains are taxed at the Ordinary Tax Rate in Belgium and the Czech Republic. (There is in exception in the Czech Republic when between a parent company and a subsidiary). Mexico capital gains are taxed at 35%; Portugal taxes capital gains at 20%.

Hong Kong – while it is true that Hong Kong does not charge a capital gains tax, they *do* tax corporate executives on the full value of any stocks or stock options they receive as part of their compensation – at full value.

The Netherlands – He is correct in that the Dutch do not impose a capital gains tax based on the actual profit made on the sale of a capital asset; they actually do something far more onerous. They impose an Annual Wealth Tax on all assets, assuming that all assets will increase by 4% in value every year, whether they do or do not, and whether the asset is sold or not. It is, in effect, a presumed annual capital gains tax.

Switzerland – Corporations pay capital gains at the same rate as ordinary income; there are no capital gains taxes for individuals, *if* they are Swiss citizens, rendering Mitchell’s concern that US investors would flee to Switzerland moot.

Tax treatment that values gambling over the creation of goods and services, and that values “wealth making wealth” rather than compensating labor, is indeed class warfare…it is a declaration of war against laborers by the “investor class.” It is time to stop treating gambling as if it was investing, and to recover the wealth that has been steadily accumulating in the hands of the 1% because of our unequal treatment of income, as the following graph so vividly shows: