The Case Against Raising the Capital Gains Tax Rate

Current discussions regarding changes in the capital gains rate drive me nuts.

Obviously, we won’t even consider “fairness”, but mentioning the “Laffer Curve” [big fan, but it doesn't fit here] or “supply-side effects” is also missing the point.

The critical factor is: destruction of the accumulated-gains tax base. There are several other factors, but this is the most important.

For purposes of this discussion, we will assume the stated capital gains rate applies to all, and there are no control benefits gained from majority ownership.

At a 15% capital gains tax rate, stock is valued at 85% of the potential value it would have at a 0% capital gains rate, based on after-tax yield. An increase to 20% would decrease yield to 80%. Such a rate increase would have an immediate adverse effect on the price of stock, and the stock market should fall to 94.1% (80/85) of its prior value [more, if state capital gains taxes are factored in].

The accumulated-gains tax base, which is the basis for calculating the actual tax, is a small subset of total stock value, but it is negatively effected dollar-for-dollar with a fall in the price of the stock.

For example: If stock was purchased for $75,000 and is now $85,000; the capital gain is $10,000 [if sold, tax would be $1,500]. If the capital gains rate is increased to 20%, as above, the value of the stock should fall to $80,000 and the capital gain to $5,000, with both stock and tax base losing $5,000 in value [at the new rate, if sold, tax would only be $1,000]. While the capital gains rate went up by 33.3%, the accumulated-gain tax base lost 50% of its taxable value.

One might argue that a significantly larger accumulated capital gain, as a percentage of total stock value, would result in higher taxes, but they would be wrong. Stocks with large capital gains tend to be long term holdings, and since this is a voluntary tax (you must sell in order to incur the tax) fewer long term holdings would be sold at the higher tax rate.

The ultimate hypothetical test would be at a capital gains tax rate of 100%: The stock market would be destroyed, the ex-rich would have the 100% loss of their purchase price to apply against other income taxes, and the economy would be in shambles.

Luckily, discussions are centered on raising the capital gains tax rate to 20%, which will only destroy the economy a little bit.

Disclosures: Will short everything, if legislative discussions begin.

Comments

[fireball:]

more risk less reward. i already drastically cut risk in these uncertain times. the dollars i invest have been taxed and taxed and taxed. from my view you are correct. if the rate rises i will be very reluctant to do more than piddle around trading if conditions change. i will probably leave most money sidelined.

May 27 08:59 AM

[Alphameister:]

Excellent article, though I'd imagine the existence of tax-sheltered investment accounts would alter your numbers somewhat. Unfortunately, nobody in Washington (at least no Democrat) is able to see beyond intended consequences.

May 27 10:01 AM

[yellowhoard:]

The government obviously wants less investment.

You tax behavior that you want less of.

May 27 10:10 AM

[DavyJ:]

It brings to mind this quote:

"If you don't want a problem with taxes, just ride the stock down. No problem with taxes then!!"
- Bob Brinker

May 27 10:13 AM

[Hot Richard:]

Didn't you guys get the memo that America hates capitalism, wealth, and investing?

America now only loves six packs of cheap beer, manual labor, and living pay check to pay check.

Tough if you need a good surgeon. Try Singapore.

May 27 10:17 AM

[Ned Williams:]

Alphameister:

Thanks for your kind words. While I did assume away the 50% of stock ownership that is tax sheltered, most of those accounts are not actively traded. Day traders, on the other hand, pay a significantly higher rate that will not be affected by a increase in the capital gains rate. The important take-away is that the capital gains rate has some impact on the price of stock, but an even larger impact on the accumulated-gain tax base.

I am struggling with whether to publish something now on my politically viable solution on how to get the capital gains tax abolished, because it's an integral part of the total solution for taxes and entitlements described in my book. The impact on stock prices will be magnified by a concurrent lowering of the corporate tax rate. The solution can stand alone, but it involves a "painless" tax, that is even less painless, when it's part of the integrated solution, since there will be no out-of-pocket expense.

Ned


On May 27 10:01 AM Alphameister wrote:

> Excellent article, though I'd imagine the existence of tax-sheltered
> investment accounts would alter your numbers somewhat. Unfortunately,
> nobody in Washington (at least no Democrat) is able to see beyond
> intended consequences.

May 27 10:33 AM

[Trane250:]

Stocks are usually valued on such things as growth potential, dividend yield, proprietary models of investment houses, personal predilection of the investor, etc., not on after tax capital gains. It's no surprise that you are an adherent of voodoo (sorry, "supply side") economics.

May 27 11:06 AM

[Ned Williams:]

Trane:
Stocks are valued based on known factors, estimations, and emotion. Tax considerations are one of the known factors, which can be forecast with declining certainty into the future. If the tax rate changes, it changes the after-tax yield now and into the future. It is highly unlikely that a change in the known factors will not be reflected in the price of stock.

If the capital gains rate is increased, I will be happy to sell any stock I own to you at pre-announcement prices.

Ned


On May 27 11:06 AM Trane250 wrote:

> Stocks are usually valued on such things as growth potential, dividend
> yield, proprietary models of investment houses, personal predilection
> of the investor, etc., not on after tax capital gains. It's no surprise
> that you are an adherent of voodoo (sorry, "supply side") economics.

May 27 11:19 AM

[Alphameister:]

I have long argued that corporate taxes should be eliminated on the basis that corporations don't pay taxes. Corporations earn roughly the same after-tax rate of return today as they earned prior to the imposition of taxes on corporate profits. Corporate taxes are paid primarily by customers and employees. Particularly when the US inflation rate was running around 5% to 6%, the easiest way to have brought inflation down to tolerable levels would have been to eliminate taxation of corporate income.


On May 27 10:33 AM Ned Williams wrote:

> Alphameister:
>
> Thanks for your kind words. While I did assume away the 50% of stock
> ownership that is tax sheltered, most of those accounts are not actively
> traded. Day traders, on the other hand, pay a significantly higher
> rate that will not be affected by a increase in the capital gains
> rate. The important take-away is that the capital gains rate has
> some impact on the price of stock, but an even larger impact on the
> accumulated-gain tax base.
>
> I am struggling with whether to publish something now on my politically
> viable solution on how to get the capital gains tax abolished, because
> it's an integral part of the total solution for taxes and entitlements
> described in my book. The impact on stock prices will be magnified
> by a concurrent lowering of the corporate tax rate. The solution
> can stand alone, but it involves a "painless" tax, that is even less
> painless, when it's part of the integrated solution, since there
> will be no out-of-pocket expense.
>
> Ned

May 27 12:00 PM

[bricki:]

Which is why tax exempting home owner loans are such a bad idea.

On May 27 10:10 AM yellowhoard wrote:

> The government obviously wants less investment.
>
> You tax behavior that you want less of.

May 27 12:08 PM

[Ned Williams:]

Alphameister:
I agree with your thinking process, but disagree on specifics.
Complete answer is too long for this venue, but I agree that we must eliminate double taxation. That leaves the problem of taxing either corporations or stockholders. Efficiency leans toward the corporation as the easiest collection point, especially when you consider that withheld taxes on salaries will necessarily be collected by corporations.
Embedded taxes are a big issue for FairTax proponents, so the issue is well covered in the Boortz, Linder book, which agrees with you. However, being a totally disagreeable character, I must disagree with you both. If you remove taxes from corporations and place it on investors, the yield on investments must go up to reflect the additional cost, so it will have no impact on how much the corporation must charge for products.
Re inflation, that is a monetary issue. Increased costs do put upward pressure on prices, but the market must decide what it will pay based on its allocation of available capital. Increased prices across the board reflect increased cash available. With fixed available capital [not today's standard], increased prices in one area indicate decreased supply or reduced consumption of something else.

Ned

May 27 01:03 PM

[Ned Williams:]

Yellowhoard:

Love the Midas look.

Shine on!

Ned


On May 27 10:10 AM yellowhoard wrote:

> The government obviously wants less investment.
>
> You tax behavior that you want less of.

May 27 03:02 PM

[Alphameister:]

Who said anything about shifting a tax from corporations to investors? I'm saying the corporate income tax is a cost of doing business and shareholders earn essentially the same return whether or not there is a corporate income tax (as a review of business history will confirm). So I don't accept the "double taxation" issue.

As for inflation, it is indeed primarily a monetary phenomenon, but the relevant equation is MV=PQ. MV remaining the same, eliminating the corporate income tax would lower P (as companies competed away the tax benefit) and also increase Q (quantity of goods and services produced) as better compensated workers could and would increase demand for cheaper goods and services.

Would higher income taxes on increased numbers of better-paid employees make up the shortfall in government revenue? Maybe not completely, at least without a federal sales tax, but they would tend to produce a significant offset.

May 27 06:02 PM

[Ned Williams:]

Alphameister:

Sorry, I misunderstood.
If you got rid of corporate taxes, I assumed you would have to tax investors and raise tax rates, or owners of small companies would pay themselves and high paid execs in dividends to avoid taxes on salary.
It's an interesting idea and I plan to think about it further.
I would say that the embedded taxes in price are primarily salary and payroll taxes, not profits. If they added a federal sales tax or VAT to make up the difference, the after-tax price of the goods would be the same and there would be no increase in quantity purchased.
Finally, it would be politically impossible to get rid of the income tax on those evil corporations, no matter what the economic justification. (Same problem cap gains currently faces.)

Thanks for keeping my brain stimulated.

Ned


On May 27 06:02 PM Alphameister wrote:

> Who said anything about shifting a tax from corporations to investors?
> I'm saying the corporate income tax is a cost of doing business and
> shareholders earn essentially the same return whether or not there
> is a corporate income tax (as a review of business history will confirm).
> So I don't accept the "double taxation" issue.
>
> As for inflation, it is indeed primarily a monetary phenomenon, but
> the relevant equation is MV=PQ. MV remaining the same, eliminating
> the corporate income tax would lower P (as companies competed away
> the tax benefit) and also increase Q (quantity of goods and services
> produced) as better compensated workers could and would increase
> demand for cheaper goods and services.
>
> Would higher income taxes on increased numbers of better-paid employees
> make up the shortfall in government revenue? Maybe not completely,
> at least without a federal sales tax, but they would tend to produce
> a significant offset.

May 27 11:14 PM

[Alphameister:]

I agree completely that politicians are driven by appearances rather than effectiveness, making my proposal politically impossible in its extreme form. I also agree that a VAT would be counterproductive for the reason you cite, but there would still be a signficant benefit unless the VAT largely offset the price benefit derived from eliminating the corporate income tax. I don't favor a VAT.

Thank you, both for an excellent article and for being so open to new ideas.

May 28 11:01 PM