Capital Gains Misinformation

Here's a series on what I believe is a combination of misinformation and deception surrounding the justification for lower rates on capital gains realizations. As I'm sure many of you know, there's a fervent debate about whether capital income should be taxed as ordinary (wage) income, well below ordinary income (as they are today) or possibly not even taxed at all.

I'll start with some basic terminology:

Capital Income -- Income from capital gains, interest and dividends. Capital income is categorized as 'unearned income' (or passive income) by the IRS.

Note: The terms "capital gains" and "capital income" are sometimes used interchangeably when they actually shouldn't be. Often when people say "capital gains," they really mean "capital income." It's probably because capital gains just gets more attention than the other two (interest and dividends). In addition, current policy (2012) states that interest is taxed as ordinary income (i.e., at marginal/statutory rates) while capital gains and dividends are taxed at 15% (or 0% for the bottom two income brackets). To complicate things even further, only long-term capital gains (assets held longer than one year) and qualified dividends (ordinary dividends that meet specific requirements) are taxed at that lower rate. So, not all components of capital income are taxed the same which is why we have to be careful when discussing taxation on capital income.

Wage Income (a.k.a., ordinary income) -- Income from labor and services. Wage income is categorized as 'earned income' (or active income) by the IRS.

There are several reasons often cited by "low rates for capital income" advocates. They are:

1. Double taxation
2. Inflation and the savings disincentive
3. Greater risk-greater reward
4. The importance of investment

I'll tackle each one of these in separate posts. The first post will focus on double taxation.

The topic of double taxation drives me a bit crazy because we know there are plenty of smart people out there who understand this basic concept but they continue to play what I believe are word games with the intent to deceive others. The best answer always resides in the moral philosophy or principle behind the purpose. So, as my good friend, Rick at Creekside Partners, best described to me regarding taxes:

"Taxes are transfers of money from one party to another, for value added/received. Our economy (and system of governance) is based in part on the presumption that, when money changes hands, it is for a reason: Value added, and value received."

The example that everyone uses -- i.e., dividends distributed to shareholders have already been taxed at the corporate level -- involves two distinctly different entities. This is not double taxation because taxes should occur at every point of transfer.

Now, even if you refuse to subscribe to the above philosophy and still insist that double taxation exists for capital income, then you have to make the same claim for wage income. Why? Because your after-tax dollars from wage income are also taxed again when you:

buy general commodities (commonly known as a "sales tax")
buy gasoline (average of 60 cents per gallon in the U.S.)
buy alcohol or tobacco (they call these "sin taxes")
register your car (they call these "fees")
drive on a toll road/bridge (they call these "tolls")
try to build or remodel something on your own property (they call these "permits")
try to start a business (they call this a "license")
I could go on...

Lastly, there are actually situations where the gov't takes a double hit on their end -- e.g., employer-provided healthcare premiums are exempt and they're also deducted as a business expense. This costs the gov't well over $100B/year.

When you really think about it, this "double taxation" claim is rather silly. But I'll admit the first time I heard it (without researching it), I also fell for it. Unfortunately, in the end, many people will believe only what they want to believe. The truth is less of a priority with them.

Why am I doing this blog? Because the lack of knowledge on public and private finance among the average American is astounding to me. More importantly, I'm disappointed with their general lack of desire to better understand the subject given how critical it is to our success as a country. As Bankers Anonymous states, "I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society." Trust me, I'm still learning too. This is an opportunity for me to teach and discuss/debate what I know and to learn much more myself.

Next up: Inflation and the savings disincentive