Capital gains taxation and Medicare

I've often lamented the way the capital gains preference works.  First, it distorts taxation by providing a clear preference for capital income over labor income.  The purported rationale for the preference is based in economic theories that, as we have seen repeatedly, assume away most of the real world and satisfy themselves with mathematical formulations of human societies that are often so far removed from actual behavior that they may be little or no use as guidance for policy setting. 

The  capital gains preference justification has several veins.  They include:

1) the idea that savings and investment should be preferred, so that those funds will help to "grow" the economy by funding businesses, creating jobs, etc. 

2) the idea that capital is more "elastic" than labor and thus taxes on capital are more distortive

3) the idea that capital income is realized at a point in time but reflects increased value accumulated over a long period of time, so that part of the realized amount is actually inflation rather than increase in real wealth, and

4) the concern that if capital gains are taxed, investors will "lock in" their investments to avoid tax rather than selling, suffering a tax "hit" and re-allocating their resources appropriately according to the changing economy.

There are others, but these are perhaps predominant. 

While there is some merit in each of these basic ideas, there are also significant counterarguments, alternative concepts that might lead to very different conclusions about whether it is appropriate to have a preference for capital gains (lower or no taxation) compared to labor income (higher and certain taxation). 

For example, if one values a more egalitarian society where all members of the society have adequate opportunities to develop human capital, provide a decent life for themselves, and grow as individuals (a fundamental premise of democratic egalitarianism as espoused here), the preference for capital income, on efficiency grounds, is seen to be lacking.    It emphasizes efficiency over everything else (like fairness).  And it relies on a market-based theory that has been found lacking in accurately describing human behavior.  Further, it is not clear that taxing labor and not-taxing capital leads to better economic growth.  The academic literature that looks at the periods of broad-based economic growth seems to suggest that broad-based growth is ultimately better, and that broad-based growth depends on not disadvantaging labor vis a vis capital.

Capital is generally more elastic--most people with capital assets have lots of assets, while most people who labor for their income need to labor for their income.  And capital is certainly more fungible than labor--at least to the owner of capital income versus the owner of labor income.  But of course one problem that has shot into prominence in this fiscal crisis is the fact that owners of capital view labor as fungible.  Need more money.  Fire people.  Want more to pay your top executives.  Cut jobs at the lower end.  Wanna distribute dividends.  Fire people.  The route to higher profits for owners is to push labor to perform even more productively or substitute machines for people or both.  That doesn't necessarily lead to a good society.  Over time, the results may be that the society transitions from one type of economy to another, but the transition period is catastrophic for the cut laborers, many of whom cannot find any real replacement jobs.  Not clear, in other words, whether these factors should weigh in favor of favoring capital.  Yes, someone with capital can take it out of one investment and put it in another, and tax on one and not the other could distort the decision.  Maybe we need to deal with that, as far as our taxation of capital income goes, by being more careful to avoid rules that set up category distinctions.  Maybe we need to mark-t0-market all financial investments. 

The inflation argument has some heft, but it carries too far.  Remember that there are ways to monetize assets without being taxed on them (called loans).  And that the rules that exist now are extraordinarily favorable--monetize with a loan, die, leave to an heir who gets stepped up basis, the heir sells some (pays off the loan) with no gain, then retains plenty for another generation to do the same.....  And of course, labor income is taxed through a withholding regime that collects the tax immediately while capital income gets maybe a 15-month (at least) delay since it is not taxed under withholding.  And capital income can be selected--the timing and the amount are often in the hands of the holder of the financial assets (I'll sell the loss asset now; I'll hold the gain asset longer, etc.). 

The lock in effect may be real, but one suspects it is overstated as well.  Day trading certainly hasn't been deterred by the tax hit.  And it is interesting that an objection to the estate tax  seems to contradict the concern about lock in.  Estate holders don't like it that the estate tax may force them to sell wildly appreciated assets (sometimes;  some portion of the assets).  But if lock-in is real, then this generational forced sale of some of an estate's assets would be a good, not a bad effect, of the estate tax.

So I, among others, have recommended that one way we can help pay for health care costs is to apply the payroll taxes (Medicare and Social Security) to capital gains and other income from capital (i.e., dividends, etc.) and not just to labor income.  Looks like that idea has finally begun to see some daylight.  Orszag, the White House Budget guru, has noted it as one thing "in play" to pay for health reform (instead of taxes on high-end insurance plans).  See Orszag Says Capital Gains Medicare Tax 'in Play' on Health Bill, Bloomberg.com, Nov. 12, 2009. 

Here again Obama's silly pledge not to raise taxes on anyone earning less than $250,000 (a quarter of a million annually) comes into play.  The proposal only applies Medicare taxes to non-wage income for US couples earning above that amount.  Id.  But at least it does require "the very wealthiest Americans who have enjoyed tax cut after tax cut over the past eight years to pay their fair share."  Id. (quoting USAction program director Alan Charney).

Comments

[Mike]

Linda,

How about an article on the taxation of the sale of body parts...i.e. blood, sperm, eggs, organs?
What are the tax laws pertaining to these sales? Capital gains, self employment income, other ordinary income. What are allowable deductions to offset this type of income?

[Raza]

Thanks for the great post, Linda. I would agree with you on M2M.

[Charles C.]

A very nice educational and social commentary. I really enjoyed and appreciate it. Would like to understand more broadly the idea of mark to market on all capital assets.

[LindaMBeale]

Hi Charles
Mark to market would require assets to be evaluated at year end and "marked" up or down to market. The corresponding gain or loss would be taken into account for tax purposes. Currently, securities dealers (and some others) mark their positions to market and are taxed on a "constructive sale" basis.

The most difficult issue in marking to market is valuation for items that are not actively traded.

[Stephen V.]

Really appreciate this post Linda.
Too much to say on this particular oddity of tax policy, I bite my tongue.

On MTM: there has been a very strong push toward seeming transparency (why NOT show assets @ today's DECLINING values?) which revelation can then have the effect of causing a decline in the firm's stock price.
But I also came across an interesting take from an accountant's point of view.
Not marking-to-market just means that a historical approach is taken--human judgment is used. The public is told (in footnotes, I don't know?) that Firm XYZ tends to hold its equities long term, and values will have time to recover. Not to mention the historical values of the equities themselves. MTM is great for a bankruptcy / liquidation scenario.
Very interesting topic.

[Zack]

If one is concerned about the incentives of capital gains tax on investment behavior, then the important point is not the absolute rate, but rather that the rate be flat ( not progressive ) and that capital losses be subsidized at the same marginal rate that gains are taxed. Doing otherwise creates an artifical disincentive to putting capital at risk and an artifical incentive to putting capital in safer investments.

The current system seems quite ad hoc and inconsistent in this regard. Losses are deductable but only from other gains and only if those gains occur in the same or later year as the loss. This system is also regressive in that wealthy people tend already to see flat marginal rates and are likely to have other gains against which losses may be offset.

A middle class individual who makes a large bet on a speculative company will be taxed at a high marginal rate if the investment pays off, but will get no benefit from the loss if the investment fails.

[LindaMBeale]

Not sure that I agree, mainly because I think that the Chicago School economic analysis of incentives is extraordinarily weak, in reality, at predicting what people will do. There are significant benefits to progressive rates, and there are strong reasons for needing anti-abuse loss disallowance rules for income that is easily manipulated.

[Tax Problems CPA]

It is all a zero sum game. Capital gains should not be taxed and you should not be able to claim capital losses.

The most efficient way to pay for health care is to place a sin tax on the type of food that is known to cause health issues.

http://www.edisonaccounting.com/irs-problems-backtaxes-home.php