December 1st, 2011
Econintersect: A major contribution to wealth accumulation is capital gains. Someone starts a business in his garage and puts in every waking hour, puts back every penny available out of earnings and after 30 years has a corporation employing thousands of people and worth more than a billion dollars. When he finally sells the company and pays $150 million in federal long-term capital gains taxes and $70 million in state taxes, he retires to paradise with an after-tax “nest egg” of more than $800 million. Many feel this is the epitome of the American dream.
Then there is another way such wealth is accumulated. Another individual, who has accumulated several million dollars through investing activities, starts a hedge fund and manages to attract $2 billion in investors’ dollars to add to his few million in an investing venture. The hedge fund establishes long-term call option positions in a group of stocks with the payment of $40 million in premiums and the manager puts his money, say $4 million, into the same venture. Over the next 13 months the stocks more than quadruple in value and the hedge fund books a gain of $2.5 billion (and the manager makes $250 million on his own money). The manager also takes the standard 20% of the fund gain, so he has a total gain of $750 million from this part of his business. He does this sort of thing two or three times and he also has a total long-term capital gain of $1 billion or more and is in the same wealth position as the business builder discussed previously. There are some (probably less than for the first individual who built the company) who also would consider this an example of the American dream.
Note: The hedge fund calculation is an approximation is two regards:
- The 12-month holding period to achieve long-term capital gains tax rate is not necessary for some hedge fund manager “carried interest” income, which qualifies some types of income for the low rate.
- Tax accounting rules force a split in the assignment of open option interest partially to short- and partially to long-term status at the end of each tax year.
A Forbes article by Robert Lezner, posted at Yahoo.com, discusses the way in which the preferred tax treatment of capital gains has contributed to income disparity (and by extension) to wealth disparity in the U.S. Lezner wrote:
Capital gains are the key ingredient of income disparity in the US-- and the force behind the winner takes all mantra of our economic system. If you want even out earning power in the U.S, you have to raise the 15% capital gains tax.
Income and wealth disparities become even more absurd if we look at the top 0.1% of the nation's earners-- rather than the more common 1%. The top 0.1%-- about 315,000 individuals out of 315 million-- are making about half of all capital gains on the sale of shares or property after 1 year; and these capital gains make up 60% of the income made by the Forbes 400.
According to the Congressional Budget Office more than 80% of the increase in income inequality was the result of an increase in the share of household income from capital gains. Lezner argues that this aspect of the tax code is one that needs to be changed. He wrote:
I commend you to the late Justice Louis Brandeis warning to the nation that " We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can't have both." We have to make up our minds to restore a higher, fairer capital gains tax to the wealthiest investor class-- or ultimately face increased social unrest.
Econintersect would point out that there is more than one type of wealth creation and income disparity. The two examples at the beginning of this article discuss two distinctly different situations:
- One is a reward to a person who built a business life for thousands of people and developed a structure that can build wealth for many others on a continuing basis over many years. This person has left a legacy to society.
- The other is a reward to a person who built nothing of lasting value but ended up with a similar reward in a much shorter time, much as would be the case with the purchase of a winning super-lottery ticket or winning at a very high stakes casino table. Yes he did create a couple of windfall gains for a few thousand clients, but what structure of lasting economic value resulted? Econintersect sees no lasting legacy for society.
Should both types of gains have similar tax treatment? Econintersect believes they should not and has some suggestions in the following editorial comment.
Editor’s note: There are some suggestions that could address the income distribution distortions that have occurred without doing something as drastic as moving the capital gains rates to become the same as ordinary income. Here is a (partial) list:
- Make the holding period discount progressive, such as holding periods less than 12 months taxed same as ordinary income (done today); reduce rates by 1% for each subsequent year of holding period down to the lowest rate of 15% (for incomes with marginal rates 15% or higher). For someone in the highest marginal bracket, this requires 20-year holding period for the lowest rate.
- Make the long-term capital gains rate progressive, such as the first $50,000 each year taxed at 15% and increasing the rate by 1% for each $10,000 until the marginal tax bracket rate for ordinary income is reached. This means that, for anyone in the marginal ordinary income bracket of 35%, long-term capital gains above $250,000 each year would be taxed as ordinary income.
What is the logic in such suggestions? It would place a higher value on uses of capital to produce continuing income over extended periods of time than on uses that produce quicker windfalls. It would value the ongoing “production facility” over the quick payoff “casino”.
What is an argument against such changes in capital gains tax treatment? It restricts the options of capital in a way that could create less capital mobility and possibly make it less available to new ventures when that would be appropriate.
It is this editor’s opinion that the failures of the current tax structure to create sustainable socio-economic operations weaken the opposition argument and strengthen the supporting logic above.
Rewards of wealth should go to those who give to society and should be taxed away from those who take from society. If tax codes present perverse incentives, perversion is what results.
Source: Forbes, posted at Yahoo.com