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All posts by Dan Whalen,
Providence, RI (resume)

Thursday, November 24, 2011

Capital Gains Taxes

      Let’s say that on the day after tax day you invest $100 in a start up restaurant down the block.  Over the course of the year, the restaurant takes off, and a stake in it becomes a real hot commodity. 

      364 days after your original buy-in, the day before tax day, you manage to sell your stake to a friend for $200.  That's a $100 dollar profit.

      Now here’s the question.  Is that $100 part of your “income,” in the exact same sense that your paychecks are?  Or is it something else? 

      What about the interest you earn on your bank account?  Or what if your parents are lucky enough to sell their house for more money than they ever put into it? 

      Sure, these things are all money you get to spend however you see fit.  But was it paid, or worked for it in the same way as your regular paychecks were?

Capital Gains

      The colloquial use of the word “income” typically signifies any money that you have literally “incoming” to you.  Anything that you get to spend.  But the technical/legal/accounting definitions are more complex.

      It’s an over simplification, but for the most part you can think of any money your employer pays you directly as “income.” 

      But if you then take that pay and find a way of multiplying and growing it, without working with it directly (e.g. entrusting it to someone or something else), well, that’s something entirely different.  That’s a “capital gain.

Some common capital gains:
- Profits made on the sale of a house or piece of real estate
- Profits made on the sales of any non-inventory asset that appreciates in value, like gold, silver, or  heck, even collectors' items
- Profits made from selling stocks, bonds, or any other stake in a company

      Basically, a capital gain is just any maneuver that grows the money you have into more money.  You’re not working with your money.  You’re letting it work for you.

      Capital gains are not considered a part of an individual’s regular income.  They’re handled as their own separate, isolated financial event.  They are taxed without consideration of a person’s other economic behaviors, much like taxes on purchases (sales tax), or excise taxes or a property tax.

      For the most part, any time a person makes a capital gain, 15% of it is surrendered directly to the government.  This is the famous “capital gain tax.”

      Why do we tax capital gains in their own unique space?  And why at that particular rate?  The logic behind it is pretty similar to the logic behind those “economic stimulus” packages that you keep hearing about. 

      The theory goes like this: the lower the taxes people are charged on profits made from investing, the higher the potential gains from investing will be (since less of investor profit has to be surrendered as taxes). 

      This in turn, should give people an incentive to invest more of their own money in our economy, our industries and our entrepreneurs than they would otherwise.  This greases the wheels of our economy and keeps the whole production moving along.  Hopefully. 

      Capital gains are taxed differently because we see them as being special.  They're something we want to encourage to happen, so we try to limit the financial penalty of creating one.

      On paper, the capital gains tax is not something that applies specifically to the wealthy or the middle class or any one group.  But in practice it is much more relevant to the lives of the wealthy than it is to the rest of ours.  There’s a couple of reasons why the rich are making so much of their money capital gains:

1.  They are just better situated to “play the market.”

      Investing in upcoming firms, growing cities or new technologies can afford huge gains…and is incredibly risky.  But those with a few million already in their bank account can stand to lose a few thousand here and there.  As long as they profit in the long run, they’ll do fine.

      Those of us with more to fall back on naturally stand to lose less of our total wealth by taking risk.  Those of us with comparatively less stand to lose a lot. 

      Betting the whole farm isn’t that wild a move when you hold the title to a dozen others.  Just the nature of investment will scare off a lot of middle and lower income people from participating.

2.  The wealthy sometimes can’t really avoid investing.

      Ok, so I want you to picture your life as a gazillionaire.  See yourself with exorbitant amounts of money.  Scrooge McDuck money.  Like condor egg omelets for breakfast and then off to your personal athletics field for a rousing game of unicorn polo with your entourage of robot pals money.

      Now, you might try your best to just spend as much of that money as possible.  But man, if you were a true gazillionaire, imagine how hard it would be to get rid of ALL your wealth?  At a certain point, if you’re very very very rich, you simply cannot spend all of your annual income every year.

I have empirical evidence:
  


      There’s simply a terminal velocity where an individual can’t keep all their cash flowing out at the rate that it’s flowing in.  And even if they could pull it off, they would be flat broke at the end of the year anyway, right?  Who would want that for themselves?

      Bill Gates weirdly owns 6% of John Deere.  Why doesn’t he sink that money into Microsoft?  Well, even Microsoft's coffers can have an amount that is "too much."  They can't make practical use of all of Gates' money! They wouldn’t know what to do with all of it!  (Also I’m sure Gates has his personal wealth in firms all over the world…you know, just in case.)

      If you’re not going to spend your money, you’d have to invest it.  What else is there that you can do with it?  Ok, yes, you could just save it.  But that brings me to my next point:

3.  In just saving money, when you have opportunities to invest it, you would actually be losing money.
     
      Let’s say you have a job that right now pays $10 an hour.  Then one day, you get two identical job offers.  Same duties, same distance from your house, identical benefits…they’re the same jobs completely. 

      One firm pays $11 an hour.  The other pays $12.  If you take the job at the $11 an hour place, and leave your $10 an hour gig, you’re making a $1 an hour gain (i.e. 11 is 1 more than 10), right?

      WRONG.  Your really making a $1 an hour loss, since you sacrificed the opportunity to make $12 an hour to go make $11.  Seriously dude, why would you do that?

      If I can make a million dollars in a year from investing, and I instead just leave that cash lying idle in a saving account for a year, that’s a million dollar loss I’ve suffered.  Who would do that to themselves?

      So by just saving their money, a person who can afford to invest would be incurring a personal loss, as the many opportunities to multiply their money pass them by.  Some might go this route, I guess.  But just as most of us prefer jobs that pay more, most of us also prefer to park our money where it pays best to do so. 

      If a particular bank paid out more interest on accounts than any other in town, would you be surprised if suddenly everyone started moving their money there?  The same holds true for any other investment entity.

4.  Those scary big “incomes” we hear about all the time are not the product of paychecks.  No one gets paid billions by their employers.  If someone has billions to their name they almost must have made it through capital gains.

      Those astronomical incomes you hear about being pulled down by the Gates, the Zuckerburgs, the Jobes of the world, they aren’t paychecks.  They are the payout of investments that they have made in their own businesses and in the ventures of othersEven the dudes who work in technology, law, medicine, software - as opposed to banking and finance - are making their crazy big money this way.  They're sinking their personal income into investment assets. 

      Warren Buffet is rumored to have pulled down $63 million last year.  Do you think that that means that Berkshire Hathaway just cut him a check for $5 million every month?  Of course not.  Most of that “income” was not wages.  It was the earnings that he made from investing here and around the world.

      The more likely scenario is Buffet earned just a few million as salary and the rest was made as capital gains.  Or at least I hope so.  If Berkshire Hathaway is paying a $63 million dollar salary to just one employee…I wouldn't expect them to be around for long...

      So where am I going with all this?  The big conclusion (and I think it’s kind of an obvious one) is that the majority of the money that gets invested in an economy – in stocks, in real estate, in money market mutual funds, whatever – will always come from the wealthier folks.  

      Its’ kind of a tautological statement, really.  If you’re investing a lot of your money as opposed to spending or saving it, you must have more money than you need just to get by.  You have a lot of disposable cash.  And that is the definition of “rich.”

      By accident, by design, by default and by intention, wealthier folks are "earning" much more of their legendary incomes as capital gains than they do as straight-up, everyday paychecks. 

Implications

      Ok, so now, what’s the big controversy surrounding the capital gains taxes? 

      We've seen how a large portion of the money we hear about the super wealthy making is not "wages" in the common sense of the word.  It's more likely to be capital gains.  And that's true no matter how they made their wealth. 

      Here's the issue with that: with these capital gains being taxed at such a light rate, a wealthier investor's total tax rates are diminished, since a big chunk of their money is taxed at that lower rate. 

      This is why some feel the capital gains tax "skews" the tax burden of the wealthy.  Since most of their money is made from capital gains, which are taxed at a lower rate, their effective rates of taxation are much lower than what you would anticipate.

      As an example, imagine a guy who managed to “make” $10 million in a year.  If that sum was 100% earned salary, and taxed entirely as "income," at say 30%, the guy would fork over $3 million in income tax every year.

      BUT if in truth, only $2 million of that $10 million figure was money paid to him as wages from an employer, and the rest was all capital gains, his tax bill would be way lower! 

      Subjecting just $2 million to the income tax gives us an initial $600,000 tax bill.  Add in the 15% capital gains tax to the remaining $8 million (which is $1.2 million) and you get a grand tax bill of only $1.8!  (that is (2*.3)+(8*.15)=1.8) 

      Compare that to the $3 million he would have paid if the entire $10 million was legally considered “income.”  

      It's a driving force behind why those making top dollar in the US have a stated income tax rate of 35%, but in reality tend to pay more to the tune of 25% or so of what they make in taxes.

      In a weird way, it kind of all boils down to semantics.  When we hear someone “made” $10 million in a year, we think that means he has a $10 million “income.”  But when tax day comes around, he really doesn’t.  Likely only a fraction of that figure is “income” (paychecks, salaries or wages).  Most of it probably is capital gains.

      Remember the original concept behind a low capital gains tax?  To encourage investment in the economy?

      So the thinking is that a low capital gains tax turns Warren Buffet into a one man economic stimulus packages machine.  The higher returns of investing (i.e. only losing 15% of the profits to taxes), drives him to pump more and more of his personal wealth into the economy.  We only take 15% of the money he makes in doing so as a reward for him sharing his money with the rest of us.

      BUT!  Does he really need that incentive?  Remember, there was already an incentive to invest in the first place…the original return on the asset!  The capital gain itself is already a monetary reward for investing! 

      So what if he only ends up receiving $50, $20 or $5 of a $100 capital gain, as opposed to the $85 he'd receive now? (that is: 100-(100*.15)=85).  As long as the capital gains tax is less than 100%, you can make a net profit from any investment that grows!

      Buffet himself in the now famous open letter appearing in the New York Times, argued that the super rich like him don’t need strong incentives to invest.  He says he’d keep on doing what he’s always done no matter what his taxes are.  The real driver of his decision to invest is whether or not he thinks the investment will grow.  If he can pull money out of thin air, he’s going to do so even if it were only a few pennies at a time.

      On the other hand, maybe the only-kinda-rich truly DO need a strong incentive not to bogart their cash.  Those just on the fence about investing might be enticed to share if the rewards were just a little greater. 

      In this case, it’s intuitive that a low capital gains tax could spur investment.  Risking $100 to make $150 seems reckless.  Risking $100 for $185 seems tempting.

      But also keep in mind, we have no idea how effective lowering capital gains is at stimulating the economy in the first place!

      There’s no one out there that can demonstrate exactly how much economic activity is created or lost by capital gains taxation.  That is to say, a 1% drop in the capital gains tax creates a lord-only-knows-how-much percent increase in GDP.  And a 5% increase in capital gains will increase unemployment by it’s-anyone’s-guess percent. 

      We just don’t know if or how the whole concept works.  Somewhere along the way we decided that it seems like it should, and everyone went along with it. 

      Lowering capital gains may ultimately have a net economic effect no different than throwing money out of an airplane flying over a populated city.  Or it might make all the difference in the world.  That’s the thing about measuring the economic impact of any particular policy.  The economy is so complex, and so interconnected, that separating the effect of just one thing from all the others rigorously is virtually impossible. 

5 comments:

  1. What does the rent from an "investment property" come under? Is that considered a capital gain / investment? Is it income? Does it change the way property taxes on said property are assessed if it is used for income (even without significant remodeling into apartments)? Is it investment or is it property...

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  2. "We just don’t know if or how the whole concept works. Somewhere along the way we decided that it seems like it should, and everyone went along with it."

    That just seems to be the problem with most of these economic issues in the political sphere. We have little real evidence to argue one way or another and it doesn't seem clear that models are complex enough to give an answer of how doing A will influence B. Rhetoric and assumptions based on first principles seem like poor tools for these issues. What questions do we know the answers to? What real knowledge do we have?

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  3. SMR - Rents from anything will never be capital gains. A capital gain is only realized when an asset is sold off. Although that's not to say that the rents from the property won't be taxed in some other weird way. And in the end that would really depend on the state/municipality, the particular property and its use as well as anything else.

    If your main source of income and principal occupation is being a landlord, then yes, rent receipts are your "income." But a lot of your taxes related to the renting will be corporate/business taxes. If your "in the business" of renting out apartments, then the property is treated more like a business than a residence. Makes sense if you think about it...if renting out living space is the profession I'm in, than the spaces I have available are used for the creation of my "product," the same way a pizzeria uses ovens to make its product or a factory uses machinery to make theirs. They should all be taxed the same.

    Now, IN GENERAL, if you have another full time job and you just rent out say one house, that's still treated kind of like having a "business on the side" and viewed like any other business. And those rents will be part of your income. BUT there are a ton of weird tax deductions for THAT sort of thing...and I think there's no capital gains taxes at all if you sell a property that you are renting as an income supplement in less than three years of opening it up for rent. I also know the rules are different if you live in the house your renting out for part of the year, or if you rent out just one floor and live in the other.

    But this is getting way past my level. Specific questions about this are more appropriate for an accountant. If its something your thinking about doing PLEASE DON'T TAKE FINANCIAL ADVISE FROM ME. I'm not a professional in this field. But do check out this link, there's some good info in there: http://turbotax.intuit.com/tax-tools/tax-tips/Rental-Property/Real-Estate-Tax-and-Rental-Property/INF12039.html

    Dave Bapst - the big issue that economics has in going from academic to policy is in "scaling up." You get a lot of good explanatory power on the granular level (trying to explain the behavior of an individual or a firm, for example), but when you step back and try to look at "the whole economy," things get fuzzy.

    A big part of that is due to the fact that economists can't run experiments. They can't take two countries, make them identical in everyway except one or two economic facets, leave for 10 years, then come back and measure the differences between. (Now that I say it out loud, I think that that might be a good thing)

    The best you can do is look for some "accidental experiments." Situations where two economies start off identical in all ways but one or two, then go along for a few years and wind up in different positions. Those aren't impossible to find when comparing two cities in the same state or two states in the same country. But finding two comparable economies on a national scale is hard.

    In a weird way, it can be like a field you're familiar with: geology/geophysics. There are very good rules on the micro level. There's very good understanding on the micro level. But we still can't tell the date, time and location of the world's next earthquake or make an exact schedule for the rate of climate change or know the precise locations of each tectonic plate 100,000 years from today. Its the "scale up" that's the challenge

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  5. This is a very informative read. People must definitely understand what capital gain tax is and not just the capital that they gain. Capital gain tax is very important because it is literally the portion of what we earn that we give to the government as part of our responsibility to national development.

    *Audrey Sizemore

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