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20 April 05.
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There are two kinds of people in this world: those who benefit from
the capital gains tax discount, and those who have no idea what capital
gains are. With a setup like that, it is not surprising that the first
group has won out in the legislature.
For those of you in the second group,
capital gains are profits from capital. If you bought the stock or the
house for $100,000 and sold it for $150,000, then you made $50,000 from
the rise in value of your capital.
As a general rule, the wealthier you are, the more likely
you are to be living off of capital gains instead of income
from work. This isn't just stereotypes about capitalists in
top hats--you can find the same results by taking a few ratios
from this IRS spreadsheet, which breaks down how people in different income brackets
made their money. [All data from 2002.]
I took the ratio of long term capital gains (column AC) to wages/salaries
(col E), and Figure One shows the result. For the vast majority of humans,
the average comes out to about 15%: for every dollar of capital gains,
they're making six or seven dollars in wage/salary. But for those in
the million plus range, the average quickly rises: for those making ten
million per year and up, they're pulling down $2.50 in capital gains for
every dollar in salary (we'll assume they're not getting an hourly wage).
Percent of income from capital
<b>Figure One:</b>
yes, the wealthy really are capitalists. The graph goes from $0 to $10
million, so you will find yourself in the clump at the far left.
[To give a bit more detail, here's a little table of the figures. The
first figure is the minimum of the income range (i.e., the first line is
people making $1-$4,999), and the second is (long term capital gains)
divided by (wages and salaries). I'm giving you the table because
the chart clumps almost all of these brackets into a little blob at
the left--and thus gives a very clear picture of where we five-digit
earners stand in the grand scheme of things--but there's something
of an interesting side story in that blob in the corner. For very
low incomes (less than $20,000 or so), the amount of capital gains is
actually higher than for moderate incomes ($20,000 - $75,000). So we
have a few people, possibly people who are kids or otherwise not in the
mainstream labor market, who are making a large portion of their money
from capital trading, but those who we would consider to be middle class
are really much more focused on working than on capital gains. Once we
hit six digits, there's a steady increase in the focus on income via
capital gains.
| bracket |
cap gains/wages |
|
| 1 |
51.03% |
|
| 5,000 |
34.66% |
|
| 10,000 |
22.72% |
|
| 15,000 |
19.66% |
|
| 20,000 |
20.96% |
|
| 25,000 |
15.22% |
|
| 30,000 |
13.69% |
|
| 40,000 |
12.38% |
|
| 50,000 |
13.27% |
|
| 75,000 |
12.52% |
|
| 100,000 |
19.25% |
|
| 200,000 |
33.14% |
|
| 500,000 |
48.97% |
|
| 1,000,000 |
67.35% |
|
| 1,500,000 |
76.67% |
|
| 2,000,000 |
93.60% |
|
| 5,000,000 |
116.38% |
|
| 10,000,000 |
241.65% |
|
So the moral here is that the top-hat stereotype more or less holds out:
the wealthy get a larger proportion of their income from capital gains
than the middle class do, who make most of their money by working.]
For most of us, to the extent that we have
an ethical belief about taxation, it's that the wealthier should pay more
in taxes, both in relative and absolute terms. This is based either on
the gut ethics of it, or the formal Benthamic argument that the marginal
utility from income is decreasing. For wages/salaries, the tax system
takes this into account: you pay a lower tax rate if you earn less. If
you make under about $7,000 you pay a tax rate of 0%, while people making
more than $319,000 in taxable income are theoretically paying a 35%
tax rate (ignoring adjustments and exemptions and thousands of pages
in forms). The lingo for a system where the tax rate rises with income
is a progressive tax system, and most people generally approve
of having a progressive system--or at least a neutral system,
where everybody pays the same rate.
Now back to capital gains. The tax rate on long term capital gains
is generally 15%. Coincidentally, 15% is also the tax rate for those
earning under $29,000/year. [Again, lots of details, lots of brackets
and rules. Capital gains taxes cap out at 28%, which is about the tax
rate on income in the $100,000/year
range.]
To summarize, thanks to the discount in capital gains taxes, the guy
making $10 million/year pays a lower tax rate on his/her/its
income than you do.
Those making over a million/year reported total
long term capital gains of $127.6 billion. The difference between a 15%
and a 35% rate on that amount of bank would be $25 billion. If we include
those with six-digit incomes, then this would be around $46 billion. I
don't know if $46 billion seems like a lot or a little to you; in 2003,
the US government took in $1.8 trillion, so $46 billion would have been
an expansion in government income of 2.5%.
Which brings us to the resounding question: why is is that long term
capital gains are taxed at a lower rate, thus giving the top-hat set an
easy loophole that allows them to pay a lower tax rate than you do?
The official story is usually about long term lock-in of capital. You
pay taxes when gains are realized. If you hold stock for a decade, and it
rises in value by $10,000/year, then you pay zero in taxes on that--it's
paper value, not cash in hand, so it's not yet taxed. Now say in the
tenth year you sell the stock, so your cash rises to fully $100,000 over
the original price you'd paid. In the year that you realize your gains,
you have to pay taxes on all hundred thou at once. That's a lot in one
clump, which gives you something of an incentive to just leave the money
there; that is, the cash is locked in, which is generally suboptimal
for the economy, which benefits from money moving freely. [This story
is why most of the discounts are on long-term gains held over a year,
but long-term gains outnumber short-term gains by ten-to-one, so either
this incentive is working really well or short-term gains aren't all
that interesting to investors to begin with.]
This is something of a fallacy: if you sell only some of the stock so
you realize only $10,000 in profits--one year's returns--then you'd
only pay one year's worth of taxes. It looks like a lot when you pay it
all at once, but that doesn't mean that you're actually somehow paying
more in taxes. As far as only that $10,000 is concerned, paying all your
taxes at the end of ten years is the same as an imaginary pay-as-you-go
system where you're putting down taxes for unrealized gains every year. A
single dollar in profits is no more locked in than before (especially
for divisible assets like stock).
But this rationalization, along with a `we need to give people incentives
to save' story, is a consistently given justification for letting the
wealthy pay a lower tax rate than you. Frankly, it's a weak justification,
so we need to look to other stories for why this persists.
One is the opening paragraph: the only people who lobby about capital
gains tax rates are the people who profit from them. A concentrated few
are saving billions of dollars a year on this, and the rest of America
has no idea what any of this is about [which is why you should forward
this essay to everybody you know].
The other story is that people are sort of myopic. The people in the
middle class in the above table are still realizing some amount of capital
gains, and they're saving a few bucks on their returns because they're
paying 15% instead of 25% on those gains. For our middle-class hero to
lobby against the capital gains tax would be to ask the government to
impose marginally higher taxes on herself. But this is indeed myopia,
because if she could somehow get capital gains taxed as normal income,
then government revenue would expand on the order of $50 billion, which
may or may not mean that the overall tax rates could be adjusted down
in the long run, so our middle-class hero may wind up paying less in
taxes. Alternatively, the government may print less money, meaning that
her savings won't dwindle by inflation as much, or she may just get more
services out of that additional $50 billion.
I'm a bit reluctant to call the capital gains tax discount a loophole,
because that word implies that it is a detail of the law that you need to
hire a creative tax lawyer to piece together. Instead, it is a fundamental
piece of the system, covering well over half of the average millionaire's
income, which guarantees that they pay a lower tax rate than you do.
(*)
The rates I'm giving may be misleading for those unfamiliar with
the rate structure. First, you pay zero dollars on income up to the
standard deduction/exemptions, meaning that your first $7,000 or so is
untaxed. Then you pay a 10% rate, which means that if you make $7,010,
you'd pay $1 in taxes: 10% of that $10 above the cutoff. Similarly
at the next bracket, which starts at $7,150 in taxable income: If
you make $15,000, you'll pay 0% on the first $7,000, then 10% on the
next $7,150 (or $715), and then 15% on the remaining $850 peeking out
over the bracket's cutoff, for a total tax of $843. So you're in the
15% bracket, but you're only paying 6% of your income in taxes. For
this essay, I decided to not to deal with all this, and just state
that you're paying the tax rate indicated by the last dollar earned.
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