Mulling Over Capital Gains Taxation

I’ve been thinking about capital gains taxation recently: just for fun, not for class specifically.

I looked something up on Wikipedia, and came across this interesting chart:

This is good for illustrating a number of points.

First, to review, capital gains taxes are not like most other taxes. Capital gains are the increase in the value of something measured as a stock variable, between the time of purchase and the time of sale. So they are not like an income tax, sales tax, excise tax, or VAT, all of which tax flows.

Second, generally, capital gains are only paid at the time you sell. The reason for this is that the piece of capital that is gaining value isn’t gaining liquidity. Yet, we pay our taxes with money. Imagine what would happen to investment if you had to buy capital with cash, and while your cash was tied up in that capital, pay incremental amounts of cash in tax on it as it increased in value: no one would invest as much. So, the practice is that when you turn that non-liquid piece of capital into liquid money (by selling it) then we collect all the tax since you bought the item all at once.

Third, there’s been a lot of quasi-romantic discussion of how much better the world was when we had higher tax rates. Maybe so. But the goal of tax reform over the last 35 years (and not just in the U.S.) has been to lower rates while closing loopholes too. Basically, the rate is lower, but we work harder at collecting it.

Fourth, one thing that makes capital gains tax revenue unusual is that it is wildly uneven through time.

So, now what’s going on in the graph?

The red line at the top is the highest capital gains tax rate in the U.S. It has been declining.

But, people figure out ways around tax rates with tax loopholes. So the yellow line shows our estimates of what the capital gains tax rate was effectively. Note that the yellow line is closer to the red line after 1986. This is the tightening of those loopholes, in exchange for a reduction in rates, that was part of the tax reform that took place in 1986.

Lastly, notice the solid green spikes. In the two spikes on the right, the tax rate was reduced before the spike. This reflects people selling assets at that time because they were holding on to them until the tax rate was reduced.

The same effect takes place, in the opposite way with the smaller spike towards the middle. In this case, people knew the top rate was going to be raised, so they sold and paid the tax while the low rate still prevailed.

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Do note that indexing capital gains for inflation is an important part of the debate. It’s just not too important in this graph. That’s why they include the red solid area at the bottom, which scales capital gains tax payments by GDP. The spikes are smaller, but they’re still there; and also, this is one of those situations where are brains may not be very good at getting the proportions right — the red spikes might be showing percentage gains above the baseline red level that are bigger than the green spikes, but the latter so dominate our field of vision that we don’t recognize this. I’m not saying that does happen here, just that it’s not the best case of graphic design I’ve ever seen.