On Capital Gains Taxes

Oct 26, 2011 by

Capital gains taxes in the United States are a perplexing thing, as they force people to treat profit differently depending on the time that it took them to earn it. In short, the tax code favors people whom make a profit through investing slowly over those whom make a profit through investing quickly, even if the profit is of the same magnitude.

Imagine two investors in Sandwich Corporation, Jimmy and John. Both buy $1,000 of the stock on January 1st, 2020, at $10 a share. The price of the stock quickly doubles over the course of a week, and then remains flat at $20 per share. The sandwich industry is not very innovative, so this particular stock does not move much. On December 1st, 2020, Jimmy decides to sell all his shares. John sells his shares as well, but waits until February 1st, 2021. If both make $100,000 a year, outside of their sandwich investing activities, do they pay the same tax on the sale of the shares?

Surprisingly, the answer is that they do not. The Federal government taxes investments that were made over the course of less than one year differently than it taxes investments that were made over the course of more than one year. Jimmy, whom invested only for 11 months, must pay his normal marginal tax rate on his profit, while John must pay the lower long-term capital gains tax rate on his profit. As single men earning $100,000 in 2011, Jimmy and John both face a 28% marginal tax rate. Jimmy had a short-term gain of $1,000, so he must pay $280 of taxes on that gain. Meanwhile, because John held the stock for over a year, he must pay long-term capital gains tax of 15%, which in his case is $150.

2011-2012

 

2013 onward

Ordinary Income Tax Rate

Short-term Capital Gains Tax Rate

Long-term Capital Gains Tax Rate

 

Ordinary Income Tax Rate

Short-term Capital Gains Tax Rate

Long-term Capital Gains Tax Rate

 

 

10%

10%

0%

 

15%

15%

10%

15%

15%

0%

 

25%

25%

15%

 

28%

28%

20%

28%

28%

15%

 

31%

31%

20%

33%

33%

15%

 

36%

36%

20%

35%

35%

15%

 

39.6%

39.6%

20%

The problem with capital gains taxes is that they encourage people to maintain particular investments. Imagine Jimmy has set aside $1,000 to keep in his brokerage account for investment purposes. Under the capital gains rules, Jimmy has a financial incentive to hold investments for longer than a year. Although all of the money is being reinvested rather than withdrawn, the government treats each separate purchase and sale as a separate investment, rather than part of an overall investment strategy. As the volatility of the market increases, holding some long-term investments may not be as prudent a strategy as it once was. The capital gains tax laws encourage people to make an artificial distinction between assets they have held for under and over a year, and may encourage investment in assets long past their prime. 

The gap between short-term and long-term capital gains taxes is shrinking in 2013. Bringing the taxes to parity will eliminate some of the distortions caused by the tax code. However, so long as short-term capital gains are taxed at the ordinary income tax rate, there will be the further distortion of there being a greater penalty on churning stocks for higher income investors. Investment income differs from “earned” income, in that it already has been subject to at least two taxes – personal income tax at the time the investor earned the money to invest, and corporate income tax on the profits of the underlying investment. Eliminating capital gains taxes and replacing them with corporate tax revenue would make sense, as it would stop this form of double-taxation, and would get rid of a factor distorting investment decisions. As they are currently implemented, capital gains taxes make the market less efficient, as they are a form of friction which discourages trading.

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