Don’t Increase the Federal Tax on Long-Term Capital Gains

What is a capital gain? A capital gain is the profit enjoyed when assets such as real estate, stock, bonds, etc., are purchased and later sold at a profit. There are two types of capital gains: short-term and long-term. Short-term capital gains are those that are realized within a year or less of the acquisition of the asset. These gains are taxed by the federal government at the same rates as ordinary income.

Long-term capital gains are those realized when an asset is sold at a profit after being held for a period exceeding one year. Under present tax law, the maximum federal tax on long-term capital gains is 15 percent. The rationale for this lower tax rate is that it encourages people to make investments that are long term – investments that may involve considerable risk (think stock market and real estate). In addition to the federal tax, most states impose a state tax on capital gains. Frequently, states apply the same tax rates to both short-term and long-term capital gains as they do to other income.

An example of a long-term capital gain would be an investor who purchases a rental property, thereby providing housing for those who cannot afford or may not want to purchase a home. Like other long-term investments, purchasing real estate involves significant risks, such as vacancies, tenants not paying rent, real estate taxes climbing rapidly, etc. The lower federal tax rate on long-term capital gains encourages investors to take these risks. When the investor sells the real estate, if she/he has held it for more than one year and makes a profit on the sale (an unlikely prospect in this economy), then any profit is taxed as a long-term capital gain.

At the onset it needs to be noted that most taxable long-term capital gains are enjoyed by upper-income/wealthier taxpayers. Thus, one might argue that increasing the tax rate on long-term capital gains would be a good way to obtain added tax revenues – especially from upper-income/wealthy investors. As demonstrated below, that argument is seriously flawed.

Example of a Long-Term Capital Gain

Suppose you purchased stock for $10,000, the price of the stock increases at an average rate of 9 percent a year and now, 10 years after the purchase, your stock is worth $23,674. Assume you sell at the end of the 10 years for the $23,674, enjoying a long-term capital gain of $13,674 ($23,674 – $10,000 = $13,674). Applying the 15-percent federal tax rate to this long-term capital gain produces a tax bill of $2,051 (.15 x $13,674 = $2,051). The after-tax dollar amount of your wealth increased to $21,623 ($23,674 – $2,051 = $21,623). But did your real wealth increase by $11,623. No, it did not!

Contrary to popular thought, the increase in the dollar value of an investment is not (I repeat not) the operative factor in analyzing long-term investments. Rather, when considering long-term investments, investors want to know how much their purchasing power will increase as a result of making the investment. In this example there was a 10-year time period between the purchase and sale of the stock. The decrease in purchasing power during that 10-year period resulting from inflation must be considered.

Suppose the rate of inflation during the 10-year period averaged 3.1 percent per year (the average inflation rate from 1926 to 2006). Determining the purchasing power of your $21,623 10 years after your initial $10,000 investment requires that you discount the $21,623 for 10 years at the 3.1-percent average annual inflation rate. This calculation can be accomplished easily using a financial calculator.

The result of this present value calculation indicates the following: The $21,623 you received 10 years after you made your $10,000 investment has a purchasing power of only $15,934. That is, after applying the 15-percent long-term capital gains tax, your purchasing power increased by only $5,934 ($15,934 – $10,000 = $5,934). This increase represents a real (inflation-adjusted) after-tax average annual return of only 4.77 percent. If your state income tax was included in the calculation, the real return would be even less.

To summarize, you started with an investment that grew at 9 percent a year for 10 years. But, after paying taxes on your capital gain and adjusting for inflation, your real return was only 4.77 percent. An after-tax real return (i.e., a real increase in your purchasing power) of only 4.77 percent a year is not very much considering the risk you take when you purchase stock, bonds, real estate, etc. Of course, if the capital gains tax rate is increased to 20 percent, your real after-tax return will be even less.

Taxing the Rich

Don’t let the title of this column mislead you. Although the upper 5 percent of taxpayers pay roughly 60 percent of federal income taxes, and the top 20 percent pay about two-thirds of all federal taxes (income, Social Security, Medicare, estate, etc.), I am not necessarily opposed to asking those with very high incomes to pay more. I share the opinion of many that scores of corporate chieftains are grossly overpaid, along with entertainers and professional athletes. But, as explained below, increasing the tax on long-term capital gains is simply the wrong approach to trying to obtain more tax from the wealthy.

Long-term capital gains differ from other sources of income. With respect to taxation, until a long-term capital gain is actually realized, tax liability is not incurred. Consider the example above. If you had not sold the stock in year 10 and continued to hold the stock, you would not have incurred any capital gains tax (federal or state). The fact that a tax liability is not incurred until the asset is sold is very important.

Federal and State Government Tax Revenues Will Fall

Suppose Sen. Obama is elected president and the Democrats hold large majorities in both the Senate and the House. The Democrats will have roughly 20 months from November 4, 2008, to significantly reverse the direction of the economy (currently sinking into a deeper recession) and reduce unemployment (that is also increasing).

Sen. Obama has promised change and Americans want change – immediate change. We are a very impatient people. If the recession drags on, the country will blame Obama and the Democrats in Congress. Then, it is very likely that Republican candidates will replace many Democrats in Congress after the 2010 elections. Investors realize this possibility.

So, suppose the Democrats increase the federal tax on long-term capital gains to 20 percent as Sen. Obama has proposed. Many investors will simply hold on to their appreciated investments hoping the Republicans will return to power shortly and reduce the tax rate on capital gains back to 15 percent. In the meantime, many investors will postpone taking long-term capital gains. So, federal and state government tax revenues will decrease. Instead of generating more tax revenues, the proposed increase in the capital gains tax rate will have just the opposite effect.

Suppose the Republicans do not return to power in 2010 or even 2012 and the increase in the capital gains tax remains “permanent.” Wealthy investors have other alternatives for avoiding the capital gains tax. For example, they can donate appreciated assets to charity. This avoids the capital gains taxes (federal and state) and, in many instances, the investor will be able to include the value of the donated asset (on the date it was donated) as an itemized deduction on her/his federal tax return. So, by donating appreciated assets to charity (or by establishing charitable trusts – think Bill and Melinda Gates and thousands of others), investors can avoid the capital gains taxes and concurrently reduce their income tax. And, the federal and state governments won’t receive any tax revenues.

Thinking About Retiring Some Day?

At present, the low 15-percent maximum tax rate on long-term capital gains provides an incentive for investors to consider long-term investments in risky assets (stock, real estate). That is, the lower tax rate tends to create demand for stock, thereby buoying up the stock market (albeit that is not obvious in today’s chaotic markets). Why might you care about this “buoying up” the stock market?

You care because, like many millions of other workers who would like to retire before they are 90, you have stock in your individual retirement accounts and 401(k) plans. You want stock prices to increase – and especially at present when stock prices have been beaten down so terribly. You don’t want to remove any existing incentive for investors to purchase stock unless, of course, you would like to work until you are 90!

What about those employed by state and local governments (school teachers and the millions of other municipal, county and state employees) as well as those employed by companies that offer pension plans {in addition to 401(k) plans}? None of your pensions are guaranteed! That’s right, none!

The ability of state governments and corporations to pay pension benefits depends on how much they have in their pension funds and are likely to have in the future. Since pension funds include stock in their portfolios, if the stock markets remain depressed for a long time, the amounts in those pension funds may be insufficient to pay pensioners their promised benefits. If pension fund assets decline, the first change would likely be the elimination of any cost-of-living increases in pension benefits. If employer plans provide retirees with health care benefits, the co-pays and deductibles are likely to increase dramatically. Not pleasant thoughts! All of America needs to see a stock market recovery.

What about Economic Growth?

Increasing the tax on long-term capital gains will reduce economic growth. This reduction will result for two reasons. First, consumer spending is the primary driving force behind economic growth. In part, consumer spending is affected by the “wealth effect.” Simply put, this means that when consumers feel wealthier they spend more, and when they feel poorer, they spend less. So, if the stock markets improve and the values of consumers’ individual retirement accounts and 401(k) plans increase, consumers are likely to spend more. Increased spending will lead to an increase in the rate of economic growth (and federal and state tax revenues). The same can be said for the housing market. Once the housing market stabilizes (likely by mid or end of 2009) and property values start to appreciate, consumers will be more comfortable spending.

Second, an increase in capital gains taxes will result in decreased federal and state tax revenues. This, in turn, will further limit spending in most states and will pressure the federal government to reduce spending. Such limits and reductions in government spending are problematic during recessions. The reason is that government spending is another major driving force behind economic growth.

Should Taxes be Increased?

Although politically popular at present, I most strongly recommend against increasing the tax on long-term capital gains. Furthermore, I am very reluctant to support any tax increases while we are in a nasty recession. History has taught us a very bitter lesson. One of the underlying causes of the Great Depression was the federal government’s increase in taxes.