TIME: Almanac 1990/1990 Time Magazine Compact Almanac, The (1991)(Time).iso/time/110689/p108

Text File | 1990-09-22 | 7KB | 116 lines

ESSAY, Page 108

A Capitalist's Guide to Capital Gains

By Michael Kinsley


   Let's not even talk about fairness. Almost no one disputes that
most of the benefit of the proposed tax break forcapital gains --
profits from the sale of investment assetssuch as stocks and real
estate -- would go to people withincomes of more than $200,000 a
year, or that the averageperson in that pleasant category would
save $25,000 a yearin taxes. The dispute is whether this break
(which haspassed the House and is currently stalled in the Senate)
would be so good for the economy that we would all prosperfrom it,
making resistance on fairness grounds foolish.

    True? The answer to that is another question: Do you believe
in free-market capitalism? Do you think the best recipe for
prosperity is minimum Government interference in the economy?
Devotees of the capital-gains break usually claim to be
enthusiastic free-marketeers. Let us take them at their word. Does
the capital-gains break make sense from a free-market point of
view?

    The ideal free-market tax system would be no taxes at all.
Taxes discourage productive activity: working, saving, investing.
Even President Bush, though, seems to recognize that we can't
borrow the entire federal budget. So taxes are necessary. In real
life, the ideal free-market tax system is one where taxes affect
people's economic decisions as little as possible. That is, a tax
system that leaves the world looking as much as possible like one
with no taxes at all.

    Such a tax system has two features. First, rates as low as
possible. At this late date in the supply-side revolution, you
don't need any more sermons about the evil effects of high tax
rates. But there is a second, equally important feature. Tax rates
should be the same on alternative forms of economic activity. If
plumbers are taxed more than electricians, there will be fewer
plumbers and more electricians than the free market would dictate.
If a tax break goes to timber but not to steel, investment flows
out of the steel industry and into the timber industry. In either
case, the Government is overriding the free market and dictating
the shape of the economy just as surely as if it did so directly.
Except that doing so directly is called "socialism" (or at least
"industrial policy"), whereas doing the same thing through tax
breaks is called "a pro-business attitude."

    There is nothing magical or unique about capital gains. A
special break for this particular form of investment profit
distorts the free market in two ways. First, it prejudices the
economy in favor of certain kinds of investment. Those who say we
need to encourage entrepreneurs or long-term investors with this
break (which actually would reserve few of its benefits for those
charmed circles) are saying the Government can outguess the market
about which investments will pay off. If a risky or long-term
investment makes more sense than keeping money in a savings
account, the market will reward it without any special incentives.
Or at least, you'd better believe it will, if you want to call
yourself a free-marketeer.

    Second, billions of dollars (not to mention vast reservoirs of
human ingenuity) can be wasted turning disfavored forms of income
into favored forms. The essential function of the tax-shelter
industry was converting ordinary income into capital gains, before
the gains break was eliminated in the 1986 tax reform.

    Although they are now ostensibly taxed at the same rate as
other income, capital gains already get favored treatment in two
ways. First, they are only taxed when an investment is sold, unlike
interest and dividends, which are taxed every year. An ideal
free-market tax system would leave an investor indifferent between,
say, a savings account paying 10% a year and a stock expected to
rise 10% a year. But tax-free compounding means that, for a
top-bracket taxpayer the after-tax profit on the stock will be 45%
bigger after 20 years.

    Second, most capital gains are never taxed at all! There is no
tax when the owner dies before the asset is sold. The profit on
inherited property is measured only from the moment it was
inherited. This is a huge loophole, costing the Government more
than $5 billion a year in lost revenue.

    Our current tax system discriminates against capital gains in
one way: it ignores inflation. If a stock has doubled during a time
when the general price level has also doubled, the real profit is
zero, but you'll pay a capital-gains tax anyway when you sell. Of
course, the same is true of interest -- an 8% return on a
money-market fund at a time of 5% inflation is really only 3% --
but no one is proposing to do anything about that. Furthermore, no
one is proposing to limit the deduction for interest paid. In a
world with no taxes, it would not make sense to borrow at 10% for
an investment that will pay only 8%. If the tax system adjusts
profits for inflation but not borrowing costs, such a topsy-turvy
investment can suddenly become a brilliant tax shelter. If you
believe in the free market, that makes no sense.

    One other factor makes capital gains different from other forms
of income: you can generally choose when to take them. In a world
with no taxes, an investor would trade one investment for another
whenever he or she thought the new one would be more profitable.
In the real world, people hold on to investments they would
otherwise trade in order to avoid paying the tax. That makes the
economy less efficient. A tax break for capital gains would reduce
this so-called lock-in effect.(Although, please note, this is
exactly the opposite of one argument usually heard for a
capital-gains break -- that we need to encourage long-term
investment.) What would reduce the lock-in effect even more,
however -- without adding to the favorable treatment capital gains
already enjoy -- would be to tax capital gains at death. People
would then know that their gains could not escape tax forever.

    From a free-market perspective, then, there is no justification
for a special tax break for capital gains. If advocates of a
capital-gains break wish to concede that they are socialists
engaged in large-scale Government intervention in the economy, we
can start again from the top on that basis. Of course, if we're
talking socialism, it will be a lot harder to avoid the fairness
issue.