As the previous installment of Huddleston Tax Weekly made clear, our tax code draws a distinction between ordinary income and capital gains. In general, ordinary income is income derived throughout the course of running a business or trade; capital gains result from the sale of a “capital asset” (which is defined by the code). It is important for people to understand how their behavior will be classified because these classifications carry particular tax implications. In conjunction with criteria from the tax code, our common law also provides additional guidelines for classifying a given source of income.
The capital gains tax has long been the focus of controversy: many argue that its current low rate disproportionately benefits wealthy citizens and that it should be increased, while others contend that a lower rate actually stimulates more economic growth and that such growth benefits citizens of all socioeconomic levels. The evidence in favor of the latter position is considerable and should strike most objective observers as persuasive. The capital gains tax rate has fluctuated widely over the past several decades, and there is an unmistakable positive correlation between low rates and greater revenues generated from capital gains. This association may appear counterintuitive upon first glance, but a bit more scrutiny makes it very easy to understand: when the tax rate is high, people simply hold on to their assets and avoid paying the tax at a high rate; when the rate is low, people sell more frequently and this results in greater total revenues for the government.
Low rates also appear to influence stock market prices. The tax cuts in the 1980s, the late 1990s, and in 2003 all coincided with significant stock market gains. What’s more, there is also an association between reduced rates and business development as measured by initial public offerings (IPOs), money raised from IPOs and the money committed to venture capital firms. Investors are less willing to commit funds when capital gains tax rates are high; this agrees with common sense given that higher rates will result in smaller returns on investment.
Though lower capital gains tax rates do appear to provide greater benefits to the economy as a whole, there is no denying that such rates disproportionately benefit higher income levels. The clear majority of gains from capital asset sales are made by those with incomes above $200,000. Going forward, it appears that the debate on capital gains tax rates will be framed by this question: can our society accept the positive impact of lower rates even though lower rates tend to benefit wealthy individuals disproportionately?
Moore, Stephen. “Capital Gains Taxes.” David R. Henderson (ed.). Concise Encyclopedia of Economics. Indianapolis: Library of Economics and Liberty.
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