Capital gains are monies derived from increased value or earnings of capital assets, but only upon realization of the profits. Capital assets are defined by the IRS as pretty much, “everything you own.” When an investment increases in value, that value is taxed at a specific rate called the capital gains tax. There are multiple reasons that capital gains are treated differently than income. Also, with an increasing national debt, this tax is often volleyed around as a cure for everything from low revenue to wealth inequality. What effect does an increased or decreased capital gains tax have on investment and the economy as a whole?
Capital Gains vs. Ordinary Income
The main reason that capital gains are taxed at a different rate than ordinary income is to encourage investment. Also, because the money used to purchase the assets (stocks, bonds, real estate) has already been taxed when it was initially earned, some people feel that there is an inherent unfairness in taxing earnings off a capital investment that was paid for with taxed money. Now, there is a case to be made that it is not the initial investment that is taxed, but the earnings, so therefore the double taxation argument would not apply. Also, capital losses can be deducted on investment losses. This would mean that if you are wealthy enough to afford investments, you can get a tax break whether you win or lose. That can seem lopsided since there are few breaks for lower-income people who lose money in the course of life.
It is important to remember that private investment is a vital part of the American economy. If people do not invest their money, then there will be less capital for new business construction and expansion, which leads to fewer jobs and lower economic growth. In order to incentivize investment, a lowered capital gains tax rate is encouraged by many on both the right and left. What seems to be left out of the conversation, whether purposely or not, is the fact that not all investment income is the same. There is investment that builds business and increases retirement funds, and then there is investment that brings little value to society as a whole. Speculators and day traders make money off of money. They produce nothing, yet they get taxed at a lower rate than people living in near poverty. There is something unsettling about that and some feel that that differentiation needs to be made in setting the rate.
The Real Conversation
Taxation is a tool that can be used by the government to encourage or discourage certain behaviors within the economy. The capital gains tax is the perfect example of this. Should we only lower the rate during times of economic contraction to stimulate growth through investment, and then return rates to a higher level to increase the revenue brought in to the government when we are focused on reducing the debt?
A good portion of Americans can discuss this topic reasonably and come to middle ground solutions that make sense. That does not seem to translate well to Washington, DC. Special interest groups lobby to keep these rates low, and they have been very successful. As usual in America, every side of this argument has some merit, but the answer lies in the middle, although, the middle does not always seem to be a very popular or productive place to be these days.
This piece was composed by Ty Witherspoon, a freelancer based in Buffalo, NY; he writes for State Tax Advisors, a firm which can assist with sales tax compliance.
© 2013, Jen Carrigan. All rights reserved.