TIME: Almanac 1993/TIME Almanac 1993.iso/time/110689/p108

Text File | 1992-09-23 | 6.4 KB | 126 lines

                                                                                ESSAY, Page 108

A Capitalist's Guide to Capital Gains


By Michael Kinsley


   Let's not even talk about fairness. Almost no one disputes
that most of the benefit of the proposed tax break forcapital
gains -- profits from the sale of investment assetssuch as
stocks and real estate -- would go to people withincomes of more
than $200,000 a year, or that the averageperson in that pleasant
category would save $25,000 a yearin taxes. The dispute is
whether this break (which haspassed the House and is currently
stalled in the Senate) would be so good for the economy that we
would all prosperfrom it, making resistance on fairness grounds
foolish.

    True? The answer to that is another question: Do you
believe in free-market capitalism? Do you think the best recipe
for prosperity is minimum Government interference in the
economy? Devotees of the capital-gains break usually claim to
be enthusiastic free-marketeers. Let us take them at their word.
Does the capital-gains break make sense from a free-market point
of view?

    The ideal free-market tax system would be no taxes at all.
Taxes discourage productive activity: working, saving,
investing. Even President Bush, though, seems to recognize that
we can't borrow the entire federal budget. So taxes are
necessary. In real life, the ideal free-market tax system is one
where taxes affect people's economic decisions as little as
possible. That is, a tax system that leaves the world looking
as much as possible like one with no taxes at all.

    Such a tax system has two features. First, rates as low as
possible. At this late date in the supply-side revolution, you
don't need any more sermons about the evil effects of high tax
rates. But there is a second, equally important feature. Tax
rates should be the same on alternative forms of economic
activity. If plumbers are taxed more than electricians, there
will be fewer plumbers and more electricians than the free
market would dictate. If a tax break goes to timber but not to
steel, investment flows out of the steel industry and into the
timber industry. In either case, the Government is overriding
the free market and dictating the shape of the economy just as
surely as if it did so directly. Except that doing so directly
is called "socialism" (or at least "industrial policy"), whereas
doing the same thing through tax breaks is called "a
pro-business attitude."

    There is nothing magical or unique about capital gains. A
special break for this particular form of investment profit
distorts the free market in two ways. First, it prejudices the
economy in favor of certain kinds of investment. Those who say
we need to encourage entrepreneurs or long-term investors with
this break (which actually would reserve few of its benefits for
those charmed circles) are saying the Government can outguess
the market about which investments will pay off. If a risky or
long-term investment makes more sense than keeping money in a
savings account, the market will reward it without any special
incentives. Or at least, you'd better believe it will, if you
want to call yourself a free-marketeer.

    Second, billions of dollars (not to mention vast reservoirs
of human ingenuity) can be wasted turning disfavored forms of
income into favored forms. The essential function of the
tax-shelter industry was converting ordinary income into capital
gains, before the gains break was eliminated in the 1986 tax
reform.

    Although they are now ostensibly taxed at the same rate as
other income, capital gains already get favored treatment in
two ways. First, they are only taxed when an investment is sold,
unlike interest and dividends, which are taxed every year. An
ideal free-market tax system would leave an investor indifferent
between, say, a savings account paying 10% a year and a stock
expected to rise 10% a year. But tax-free compounding means
that, for a top-bracket taxpayer the after-tax profit on the
stock will be 45% bigger after 20 years.

    Second, most capital gains are never taxed at all! There is
no tax when the owner dies before the asset is sold. The profit
on inherited property is measured only from the moment it was
inherited. This is a huge loophole, costing the Government more
than $5 billion a year in lost revenue.

    Our current tax system discriminates against capital gains
in one way: it ignores inflation. If a stock has doubled during
a time when the general price level has also doubled, the real
profit is zero, but you'll pay a capital-gains tax anyway when
you sell. Of course, the same is true of interest -- an 8%
return on a money-market fund at a time of 5% inflation is
really only 3% -- but no one is proposing to do anything about
that. Furthermore, no one is proposing to limit the deduction
for interest paid. In a world with no taxes, it would not make
sense to borrow at 10% for an investment that will pay only 8%.
If the tax system adjusts profits for inflation but not
borrowing costs, such a topsy-turvy investment can suddenly
become a brilliant tax shelter. If you believe in the free
market, that makes no sense.

    One other factor makes capital gains different from other
forms of income: you can generally choose when to take them. In
a world with no taxes, an investor would trade one investment
for another whenever he or she thought the new one would be more
profitable. In the real world, people hold on to investments
they would otherwise trade in order to avoid paying the tax.
That makes the economy less efficient. A tax break for capital
gains would reduce this so-called lock-in effect.(Although,
please note, this is exactly the opposite of one argument
usually heard for a capital-gains break -- that we need to
encourage long-term investment.) What would reduce the lock-in
effect even more, however -- without adding to the favorable
treatment capital gains already enjoy -- would be to tax capital
gains at death. People would then know that their gains could
not escape tax forever.

    From a free-market perspective, then, there is no
justification for a special tax break for capital gains. If
advocates of a capital-gains break wish to concede that they are
socialists engaged in large-scale Government intervention in the
economy, we can start again from the top on that basis. Of
course, if we're talking socialism, it will be a lot harder to
avoid the fairness issue.