Friday, December 28, 2012
Part 3: Greater Risk-Greater Reward
If you didn't catch Part 2 then read it here.
Another common claim for lower rates on capital income is the argument that the risk associated with capital income is greater than the risk associated with wage income.
First off, risk is obviously relative to the person experiencing it. I'll use myself as an example because 1) most of my net worth is invested in the stock and bond markets so I obviously care about capital income and 2) my wage income comes from a job that has been and still is in very high demand within this country. Point being: I probably have one of the most risk-free jobs in the nation.
Having said that, I can tell you that I have far greater stress from risk associated with my job (wage income) than I do from my investments (capital income). Here's why:
- If I don't perform technically well at my job then there's a significant risk that I will be let go for performance reasons -- we lose people in similar positions for similar reasons within my company all of the time.
- If I don't "click" with my boss then I run the risk of getting forced out -- I actually had this issue last year.
- If my sales rep and I don't meet our quota, for whatever reason (e.g., my accounts just have a bad year), then I run the risk of being let go for performance reasons.
- If my company merges with another company, something that happens a lot in my industry, then I run the risk of getting laid off due to a reduction-in-force (RIF).
If I'm let go, forced out, laid off, or whatever, then I have to address how I'm going to get and pay for health insurance for my family and that's highly stressful. Clearly, I could go on and provide more examples of risk through wage income.
Bottom line, the risk I feel based on my dependence on wage income is far greater than the risk I feel based on any potential losses I might experience with my investments. Now, you might say that someone who receives most of their annual earnings from capital will feel differently. Sure, they probably would. Keep in mind, I lost ~40% of my net worth in 2008 so I fully understand the risk and pain of losing money on your investments. However, if you were to ask me, "Where would you apply preferential tax treatment (wage income vs capital income) if the decision had to be based solely on risk?" then I'd say, "wage income."
So, why is their risk more important than my risk? More importantly, why does their risk justify preferential tax treatment and mine doesn't? If your answer is: Because capital is more important to the economy than wages, then hold that thought and wait for my next blog post.
Next up: The Importance of Investment
Part 2: Inflation and the Savings Disincentive
If you didn't catch Part 1 then read it here. I've recently updated it.
Again, let's start with some basic terminology:
Nominal vs Real -- There's a concept in finance theory that says the value of money today will not be equal to the same amount of money in the future due to factors like inflation. The nominal value is the amount unadjusted for inflation while the real value is the amount adjusted for inflation.
Inflation Index -- A tool used to measure the rate on inflation in an economy (e.g., CPI).
One of the common complaints about taxes on capital income is that the profit on a capital gain or the interest income on an investment are decreased due to inflation. As a result, an investor is paying tax on inflation (a.k.a., an "inflation tax"). There can even be situations where inflation grows at a greater rate than the nominal gain or nominal interest on the investment. In this case, the investor will still pay a tax on the capital gain profit (or interest income), when, in fact, the real gain (or real income) was a loss (or negative). This distortion is due to the fact that capital income is not indexed for inflation. This lack of inflation indexing is one of the reasons why people often say "inflation discourages savings and investment." Again, I find this statement a bit disingenuous since it's similar to saying, "Since inflation is going to reduce my after-tax gain or income on my investment, I'd rather make nothing, or even possibly lose money, by not saving and investing at all."
In addition, as Rick Ashburn from Creekside Partners reminds me, there's a paradox regarding saving that is important to understand: What works when examining a single household (think in terms of a single economic agent), doesn't necessarily work for the economy as a whole. The simple example is that any given economic agent can save most of their earnings and retire early. However, that doesn't work for the entire economy due to the need for consumption. So, the "save a lot and retire young" proverb can never be a societal goal. I mention this because the average American tends to think along the lines of what makes sense only from a microeconomic perspective and often overlooks the importance of what makes sense from a macroeconomic perspective.
Now, most features of the federal income tax system for wages are indexed for inflation, which means we can't necessarily say that taxes on wage income suffer from the same issue. However, many states do not index their income tax systems for wages. Therefore, it's important to understand that indexing for inflation is not something we do consistently for all taxes on wage income. Lastly, the lack of indexing can work in our favor too. A good example is a person with a fixed-mortgage payment will see that payment decline as a share of his income as inflation pushes up his wages.
So, does the lack of indexing for inflation justify lower rates for capital income? Of course it doesn't. We shouldn't fix a dynamic issue with a static solution. If we're genuinely interested in addressing the fundamental issue then I believe we should fix the problem by indexing for inflation, not by lowering rates on capital gains and interest to make up for the distortion.
Next up: Greater Risk-Greater Reward
Again, let's start with some basic terminology:
Nominal vs Real -- There's a concept in finance theory that says the value of money today will not be equal to the same amount of money in the future due to factors like inflation. The nominal value is the amount unadjusted for inflation while the real value is the amount adjusted for inflation.
Inflation Index -- A tool used to measure the rate on inflation in an economy (e.g., CPI).
One of the common complaints about taxes on capital income is that the profit on a capital gain or the interest income on an investment are decreased due to inflation. As a result, an investor is paying tax on inflation (a.k.a., an "inflation tax"). There can even be situations where inflation grows at a greater rate than the nominal gain or nominal interest on the investment. In this case, the investor will still pay a tax on the capital gain profit (or interest income), when, in fact, the real gain (or real income) was a loss (or negative). This distortion is due to the fact that capital income is not indexed for inflation. This lack of inflation indexing is one of the reasons why people often say "inflation discourages savings and investment." Again, I find this statement a bit disingenuous since it's similar to saying, "Since inflation is going to reduce my after-tax gain or income on my investment, I'd rather make nothing, or even possibly lose money, by not saving and investing at all."
In addition, as Rick Ashburn from Creekside Partners reminds me, there's a paradox regarding saving that is important to understand: What works when examining a single household (think in terms of a single economic agent), doesn't necessarily work for the economy as a whole. The simple example is that any given economic agent can save most of their earnings and retire early. However, that doesn't work for the entire economy due to the need for consumption. So, the "save a lot and retire young" proverb can never be a societal goal. I mention this because the average American tends to think along the lines of what makes sense only from a microeconomic perspective and often overlooks the importance of what makes sense from a macroeconomic perspective.
Now, most features of the federal income tax system for wages are indexed for inflation, which means we can't necessarily say that taxes on wage income suffer from the same issue. However, many states do not index their income tax systems for wages. Therefore, it's important to understand that indexing for inflation is not something we do consistently for all taxes on wage income. Lastly, the lack of indexing can work in our favor too. A good example is a person with a fixed-mortgage payment will see that payment decline as a share of his income as inflation pushes up his wages.
So, does the lack of indexing for inflation justify lower rates for capital income? Of course it doesn't. We shouldn't fix a dynamic issue with a static solution. If we're genuinely interested in addressing the fundamental issue then I believe we should fix the problem by indexing for inflation, not by lowering rates on capital gains and interest to make up for the distortion.
Next up: Greater Risk-Greater Reward
Wednesday, December 19, 2012
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
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
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