Mitt Romney has been criticized for the fact that he pays a lower percentage of income than most middle class Americans, even though the actual dollar amount is much higher, in the millions. The billionaire Warren Buffet has likewise criticized the capital gains tax rate saying that his secretary pays a higher rate of taxes than he does–although he decided not to volunteer more funds to the government than required. What the discussion on the capital gains tax rate mostly involves is emotion, and what it lacks is rational analysis.
Do we want people to invest? If we want more jobs we do. Investment fuels new companies which means new jobs, and it fuels innovation and experimentation for companies that already exist, which also means new jobs. Does anyone disagree that America needs more jobs? No? Good.
How do we make sure people continue to invest? By making sure that if their investment pays off, they get to keep the rewards of the risk they took. It is so convenient to never talk about the people who’s investments fail, or companies who never make it off the ground, yet this is the reality of the market. People are taking a risk by investing, and in order to take that risk people need a sufficient reward. When 15% of the profit a person makes on an investment is taken in taxes, people still invest a good amount of money, literally fueling the expanse of the economy. If the rate was 0% people would invest even more in the economy, because the reward would be even higher. And if the capital gains tax goes up to 24%, fewer people will invest in job creating industries, because the potential payoff is lower.
The risk of investing is high, and therefore people will not engage in this risk if the payoff is the same or similar to other, less risky financial decisions. Why invest in the stock market when you can make a similar return on a virtually no risk investment in a high interest bank account? So this is not a matter of fairness, this is a matter of economic progress. If you are truly in favor of creating more jobs in America, you cannot be in favor of a higher capital gains tax.
Thomas Sowell discusses the largely misunderstood capital gains tax in a recent article. He points out that most people earn a salary and they know how much they will earn in a one year time. Capital gains however, are not necessarily earned in a one year period. If someone holds onto an investment for 10 years before getting a return of $100,000 than this money was not earned over one year, it was earned over ten years. Apart from the fact that there was no guarantee going into the investment that it would ever pay off (in fact the entire investment could have been lost), it would not be fair to tax this income at a higher rate because it was not income from one year, it was income over ten years. People who make $10,000 per year should not be taxed at a higher rate, and this is the reality of the situation. Not everyone making money on capital gains is a billionaire, or millionaire–in fact during college I made a few thousand dollars on short term capital gains, however I still needed to take out loans to pay for school. The elderly and retired also often rely on capital gains and dividends to pay their bills, so the whole idea that a low capital gains tax only benefits the wealthy is false.
Sowell uses the following examples to illustrate his point about the extreme risk of investing:
McDonald’s teetered on the edge of bankruptcy more than once in its early years. Desperate expedients were resorted to by the people who ran McDonald’s, in order to just keep their noses above the water, while hoping for better days.
At one time, you could have bought half interest in McDonald’s for $25,000 — and there were no takers. Anyone who would have risked $25,000 at that time would be a billionaire today. But there was no guarantee at the time that they wouldn’t be just throwing 25 grand down a rat hole.
Where a capital gain can be documented — when a builder spends ten years creating a housing development, for example — then whatever that builder earns in the tenth year is a capital gain, not ordinary income. There is no guarantee in advance that the builder will ever recover his expenses, much less make a profit…
If a country wants investors to invest, it cannot tax their resulting capital gains the same as the incomes of people whose incomes were guaranteed in advance when they took the job.
It is not just a question of “fairness” to investors. Ultimately, it is investors who guarantee other people’s incomes in a market economy, even though the investors’ own incomes are by no means guaranteed. Reducing investors’ incentives to take risks is reducing the jobs their investments are likely to create.
Business income is different from employees’ income in another way. The profit that a business makes is first taxed as profit and the remainder is then taxed again as the incomes of people who receive dividends.
The biggest losers from politicians who jack up tax rates are likely to be people who are looking for jobs that will not be there, because investments will not be there to create the jobs. (Full Article).