Indispensable Economics Raising the capital gains tax

Jun 22, 2011

As everyone knows, the government has painted itself into a corner.  More and more spending on more programs, more bureaucracies, more entitlements, and more buying of votes with these programs has gotten the federal (and some state) government into the unenviable position of reaching the end of the tolerable income tax level, beyond which the populace will revolt, and at the end of the indebtedness limit, beyond which we cannot repay all the money it borrowed in order to fund these things beyond the tolerable tax level.  Calls are being made for a hike in taxes “on the rich,” and a hike on capital gains taxes. 

So let us examine what a capital gain is, and then examine the effect on the economy of higher capital gains taxes.  A capital gain is the proceeds less cost from the sale of a capital asset, such as property, stocks or bonds, a car, etc.  These proceeds are taxed at a lower rate than income, because if income tax rates were applied, most of the proceeds would be given to the government.  Supposed you win a million dollar lottery.  This is not a capital gain, and it taxed as income, which means that about one-half of the million dollars goes to the government. A capital gain, however, is taxed according to different rates.  According to the Tax Foundation, the current capital gains tax rate goes from 20 percent to 39.6 percent, depending on how long you have owned the asset.  The higher rates are for shorter time spans.  So if you held a piece of property for a year, you would pay virtually a 40 percent tax on the proceeds.  If you held it for five years or more, you would pay 20 percent.

What is behind the capital gain tax?  Those who propose a capital gains tax, or those who propose raising it to higher levels are motivated by a number of things.  Firstly, there are the government officials whose spending is so profligate, by which they “buy” votes by rewarding their supporters and harvesting more followers, that they need to tax everything that they can, and Americans are habituated to the thinking that everyone has to pay their “fair share” so that the racket can continue.  Then there are people motivated by false thinking.  Neither of these parties cares about you selling a seven year old car, or an old outhouse. Both of these are interested in people who sell, say, the Empire State Building.  These types of capital gains are the targeted both by government officials, and by the people of the second type of thinking, who have in their heads the image of rich people with yachts, with large living quarters on the most desirable locations in the world.  To this second group, it is a question of pure class warfare and envy.  In their minds, the wealthy sold this big asset so that they could live “high on the hog,” while the rest of the country toils away for a modest living.  There was an anecdote I heard when I was a kid, although the story pre-dated my birth, of rich people sitting around having cocktails and one of them says: “I wonder what the poor people are doing today.” 

This story is like the cartoon version of the truth, so let us examine what people do when they sell a major capital asset.  Firstly, why would a person or a company for that matter, sell a major capital asset?  Unless the person just wants cash to retire with, which is not that common, he or she wants to do something more profitable with the money.  Take our Empire State Building for instance.  That building is income property.  Companies rent the offices and the owner, after expenses, is the residual claimant, which means he or she, or their company, get what’s left.  It is this money that allows the owners to live a comfortable life, assuming that they can keep the building rented.  The owners do a great service to companies in providing such a building for companies to use.  But if the economy tanks, they might find companies who rent space in the building going out of business, and getting others to rent might be difficult, requiring the lowering of rents, so then the residuals will get smaller.

Now let us posit the scenario of a Mid-western city which is going to get a major league baseball and football franchise, and now needs a stadium.  The owners of the Empire State Building notice that even though the economy is not doing so well generally, and in New York, the Mid-west is doing better, and throughout the Mid-west receipts for sporting events are actually increasing.  The rule here is that money goes where it is most productive, because that is where it is most needed.  So the owners of the Empire State Building will find a buyer for the building, even if they sell it for less than they think it is really worth, to raise the cash to build a stadium.  (Of course, we are leaving out many technical details here, such having to bid for the contract, etc., but these are not relevant to the story)  But, and here is the key to the article, if the capital gains tax take too much of the proceeds, the owners of the building will not sell it because the sale will not render enough cash to build the stadium.  So,  the result of high capital gains taxes is to keep capital frozen in current projects and forestall new, more profitable projects.  Notice that the owners of the Empire State Building did not want to sell the building so that they could buy another mansion, but to enter a venture that will increase their own cash flow or income.  If they succeed, money will flow from where it is not really needed, New York, where things are in decline, to the Mid-west, where people are begging for investment funds. 

The result of all of this is that whatever the reason for wanting to foist higher and higher capital gains taxes on business folks, either to fund government profligacy or to soak the rich, the result is the same—economic stagnation.