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What if long term capital gains were taxed as ordinary income?

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Stock MarketThe Bush tax cuts were a hot topic these last few weeks between the deal making (extending cuts for all in return and estate tax relief for extended unemployment benefits) and the political dancing, but ultimately something had to be done. While much has been made of the tax brackets themselves, one of the other things that went along with it was the long term capital gains tax rate. They were set to increase from 0% and 15% to 10% and 20%, respectively.

So here’s the question at hand, what if we no longer had favorable long term capital gains rates (and dividend tax rates) and instead all investment gains were taxed as ordinary income? In other words, what if there was no such thing as long term capital gains? What if everything were taxed as short term?

Less Stock Market Investing

Investors have a lot of options when it comes to where they want to put their money. Many of them put it in the stock market because long term capital gains are lower than their marginal tax rate. While it’s hard to say how many people invest because long term capital gains rates are much lower, we can probably all agree that the number is greater than zero. That means if that incentive were removed, some people who consider other options.

Dividend stocks would be less appealing: One reason why they look to dividends is because it’s taxed so little relative to ordinary income. When you tax it at the same rate as other income, the big incentive is gone and they might consider something else. Here’s what you look for in a dividend stock – stability, yield, and yield growth (obviously a simplification). Many dividend investors purchase these stocks because they want the cash flow. They see the dividend as a stream of passive income that will grow over time.

Why Other Investments?

Another reasons investors will shift their money into other investments is because of how gains are reported. When you sell a stock or receive a dividend, you usually do it through a broker and that broker will send you a tax form detailing your activity for the year along with your gains and losses. You must declare that on your tax return because the IRS already knows about it.

Now consider a rental property where you rent it out to a family. They pay you rent each month and you deposit it into your bank account. At the end of the year, no one sends the IRS anything. If you didn’t claim it on your return, it’s near impossible for the government to catch you. (this is an imperfect example because rents are already taxed as ordinary income but it’s an example everyone can understand easily) There are plenty of similar examples, where you can sell an asset at a higher price than what you paid for it, where the difference isn’t reported.

Who Does This Hurt?

I don’t think it hurts people in the higher income tax brackets because they will have plenty of investment options. I think it hurts the lower brackets, people who have their retirements invested in index funds or retirees invested in dividend stocks. Fewer people entering the stock market, because it’s less attractive, means some component of its growth will slow, which hurts people whose futures are directly tied to the market (retirement savings).

I think there are plenty of other places to set your revenue boosting sights before capital gains (that said, I think increasing them to 20% or some smaller amount can help boost revenue while mitigating the effects of a higher capital gains rate). If you want people to invest, you have to make it attractive.

What do you think?

(Photo: thewalkingirony)

{ 17 comments, please add your thoughts now! }

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17 Responses to “What if long term capital gains were taxed as ordinary income?”

  1. DIY Investor says:

    The big negative in my opinion is that it would increase short-term trading.

  2. There’d be a lot more speculation in the markets and momentum chasing, and less buy and hold.

  3. Not directly responsive, but I believe capital gains taxes on stock market investments is an absurdity.

    The whole premise behind giving a tax break to those who invest capital is becasue that capital is given to business to help them grow. It’s for capital directly used to create: new business, new plants, new anything that provides jobs.

    When I buy stock that you sell, it helps no one. It offers capital to no business. It provides zero growth. The only stock market investment that truly deserves reduced capital gains taxes occurs when a company makes an initial (IPO) or secondary public offering. That means the money goes directly to the business – not to someone who is selling his/her shares.

    Bottom line: IMHO there should seldom be a capital gains tax break. And that goes for selling one’s home at an profit.

    There is no politician alive who has the courage to tell it like it is and abolish the capital gains tax break in its current format.

    • NateUVM says:

      What if no one wanted to buy the stock at the given price? Aren’t you, by purchasing that stock, supporting the value of the issuing company? Aren’t you, therefore, providing value to that company by supporting the price of the stock?

      If you weren’t willing to purchase the stock, then, assuming you represent the market, the price of the stock falls and the company is hurt.

    • Bob says:

      Actually hats not the “whole premise” behind the reduced gains rate. It was done to increase revenue actually. People don’t sell when taxes are of high. the other reasons it makes sense are because the company itself pays taxes and as an owner of the stock, the shareholder has already paid taxes. If the corporation didn’t pay any tax, the balance sheet would be more attractive, and the stock would trade higher. Taxing gains is double taxation.

  4. Ryan Benigno says:

    We know what happens when the government encourages investments in particular asset classes – the housing bust is the latest example. Tax policy should not be used as a tool for steering investment decisions.

  5. billsnider says:

    Don’t forget about trading fees. They lower your overall ROI. So if they were taxed at a higher rate, for sure less people would invest and trade. The question is how much?

    Bill Snider

  6. Allie says:

    Middle income families after funding 401ks, SEP’s and IRA’s have no other income for investing. If they did perhaps they would invest outside of deferred income. Most have children, homes, college etc and can not do this. The capitol gain rates only benefit those that would invest anyway.

    • spyoptic says:

      Perhaps this is the case for some middle income families, but in general, not having enough money to invest is rarely ever true. Tell me you’ve never seen a middle income family drive a BMW or have a 70″ TV..
      My parents are part of the 1%, but my dad drives a honda civic. People just have priorities on what they spend their money on, and investing isn’t usually high on the list for middle income families.

  7. Excellent, provocative post and ditto to Mark Wolfinger’s comment. The emotional argument is that rich people have capital gains, poor people have salary, thus taxing the former at a lower rate than the latter is somehow unfair.

    I believe at least one country (Ireland) doesn’t tax capital gains at all.

  8. zapeta says:

    I feel like increasing taxes on capital gains would do a lot of harm, much more than the extra taxes would be worth. I doubt the rates will be changed significantly because the rich would be the ones that lose the most and they have the most money to lobby to resist the change.

  9. Eddie says:

    I’d guess the opposite-little effect on the lower income brackets, big changes in the higher. Exceptions abound, but for the most part taxable stock investing is the realm of those with a lot of cash. Most lower-income individuals only participate through tax-sheltered options like the 401k or IRA.

  10. steve says:

    Biggest effect would be on those earning large salaries based on stock options. These people usually hold shares long term and when they receive their options to buy they can turn around and sell these shares immediately to earn income. The trick is that when they have to pay taxes on this income they can claim that they sold long term shares instead of the shares they just bought. That’s why so many CEO’s often pay a smaller percentage of their income in taxes than most of us. These very wealthy CEO’s pay 10% instead 35%!!

  11. Tony says:

    If Capital gains and dividends were taxed as ordinary income. The bonuses of top executives and Wall Street banksters would bring a lot of tax money in and pay for some of this debt. The other side of the coin is they might not take those hugh bonuses and leave the money in the companies that they are invested in, only taking what they needed. This would make my retirment account worth more, because the wealth would not be taken off the top. This would also be fair because the average American is paying taxes on his retirement account when he withdraws, at the ordinary income tax rate. The irony of all this swiss cheese tax laws is that instead of paying taxes at 15% on our retierment which are invested in mostly long term stocks and bonds and getting the benefit like the top investors we are subjected to a higher income tax laws.
    All this money going into the stock market from our retirment accounts is a guarentee for the broakers and bankers to reap hugh bonuses and pay the minimum of taxes on those bonuses

  12. John says:

    The argument in favor of a lower tax rate on capital gains is more robust when (1) there is significant inflation and (2) the hold time of the investment is 5, 10 or 20 years. Think of the result if you invest $100,000 in a home then sell the home 20 years later for $500,000. But in that 20 year period, home prices have gone up and if you want to purchase a similar size home it would cost you $500,000. So, you have to pay state and federal tax on the $400,000 of “profit” of perhaps 40% ($160,000 of tax), leaving you with $500,000 – $160,000 = $340,000 to buy your next home. The strongest argument for a lower tax on capital gains is that inflation reduces the real return on a particular investment. Making $10,000 in 4 days is a different return on making $10,000 in 4 years, indexing investments based on inflation one method of dealing with this issue, charging a different tax rate is a highly simplified method of dealing with this issue. I would suggest a graduated tax rate based on the number of years an capital investment is held whereby the tax rate drops 3% (say from 28% to 25%) each year for 5 to 7 years (depending on how low of a minimum tax rate on long held capital assets you are willing to accept). Just my 2 cents on a complicated tax issue.

  13. John says:

    The argument in favor of a lower tax rate on capital gains is more robust when (1) there is significant inflation and (2) the hold time of the investment is 5, 10 or 20 years. Think of the result if you invest $100,000 in a home then sell the home 20 years later for $500,000. But in that 20 year period, home prices have gone up and if you want to purchase a similar size home it will cost you $500,000. So, you have to pay state and federal tax on the $400,000 of “profit” a tax of perhaps 40% ($160,000 of tax), leaving you with $500,000 – $160,000 = $340,000 to buy your next home. The strongest argument for a lower tax on capital gains is that inflation reduces the real return on a particular investment. Making $10,000 in 4 days is very different than making $10,000 in 4 years; indexing investments based on inflation would be one method of dealing with this issue. Our current system of charging a different tax rate on gains on capital assets held for more than a year is a highly simplified method of dealing with this issue. I would suggest a graduated tax rate based on the number of years a capital investment is held whereby the tax rate drops 3% (say from 28% to 25%) each year for 5 to 7 years (depending on how low of a minimum tax rate on long held capital assets you are willing to accept). Just my 2 cents on a complicated tax issue.

  14. ulTRAX says:

    Fewer people entering the stock market, because it’s less attractive, means some component of its growth will slow, which hurts people whose futures are directly tied to the market (retirement savings).

    Since when is it the roll of government to subsidize, thus encourage, the crap shoot on Wall St?


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