My Beautiful Capital Gain
An investor ponders taxes and the 99 Percent
This past year was a very good one for me: a large media company purchased the enterprise in which I had made a relatively small investment. For the sake of discussion, let’s say my share of the deal netted me $7 million, more or less. A good day at the office by any standard.
For this happy transaction, my accountant advised me shortly thereafter that I would likely owe Uncle Sam a little more than $1 million in tax. A million dollars seemed like a large check to write to the government, and that started me thinking about America’s tax policy. Specifically, I recalled Warren Buffett’s observation that his secretary paid a higher tax rate than he did and that it was hard for him to justify that advantage. I wondered what Warren’s secretary would be taxed if he or she earned $7 million being a secretary. The answer is that secretary would have to pay close to $2.5 million in taxes, $1.5 million more than I would.
The difference, of course, is that my good fortune was a long-term capital gain, and the secretary’s good fortune was “earned income.” On the face of it, it’s hard to understand the logic of earned income being taxed at about two and a half times the rate of a capital gain. My first thought was of the advice of certain commentators: if I didn’t think I was paying enough tax, I could always voluntarily pay at the same rate as Warren’s secretary. Talk about a nonstarter: no way am I going to voluntarily pay more. That noble act would neither correct the unfairness of the system nor make much of an impact on the country’s unbalanced budget.
Perhaps I could justify my lower rate on the basis that I had made my investment a few years ago, that some of my return was due to inflation, and that government arguably bore some responsibility for that inflation. But when I dug a little further, I found that over the three years my investment was at risk, inflation averaged about 1 percent annually. Hardly enough to justify the $1.5 million tax advantage. If the goal of a lower rate for capital gains was to compensate for inflation, wouldn’t it be easier simply to index the gain for inflation?
LaMagna
How about the argument that my type of income is better for the economy than the secretary’s type of income because my investment creates businesses, jobs, and prosperity? Sorry, I can’t buy that. Earned income has the potential to create the same sort of economic value as investment income. As for the argument that my investment was at risk and I deserved a little bonus for taking that risk, such reasoning would have more merit if one could claim that earned income bore no risk, such as the risk of layoffs.
As for the argument that folks like me wouldn’t invest our money and stimulate the economy unless we got a preferential tax rate, I don’t buy that either. What else would we do with our money except to continue to invest in new and emerging businesses, even if our returns were subject to the same rates as our earned income?
Alas, I can find no way to justify my good-fortune tax rate. I reluctantly conclude that the few of us who can afford to make substantial investments (the fortunate One Percent) can also afford to invest in the careers of politicians who will vow to keep our unfair tax advantages.
—Dal LaMagna (MBA 1970) is president and CEO of Brooklyn, New York–based IceStoneUSA, which makes countertops out of recycled glass and cement. The founder of Tweezerman, he is the author of Raising Eyebrows: A Failed Entrepreneur Finally Gets It Right.
(Illustration by Robert Saunders, photo courtesy Dal LaMagna)
Your Comments
The money you invested was already taxed once at ordinary income tax rates, so why should you pay any tax at all for putting your money at risk? Just because you would gladly pay a higher cap gains rate doesn't mean others would.
A agree with you 100%. I don't get (or buy) the reasoning which is typically given for the diferentail in rates. In 1986, the US government equalized the rates. We saw no difference in the activity of people investing (as you suggested there would not be). Also, for the life of me I don't get the 15% carried interest rate, which I have to admit I have some of this. The whole structure of the tax system (including the corporate side)is patently unfair and riddled with special benefits for those with access to decision makers. Our Congress continually praises our military for putting their lives at risk for the benefit of the country. The very least that Congress can do is to set the example by putting their jobs at risk for the benefit of the country. I am sure the President would sign such a bill.
Inadvertently, Mr. LaMagna has fallen into the trap set by those who believe "fairness" only runs in one direction. Even if I believed in a more progressive tax code for the uber-rich and the elimination of the Bush tax cuts (both of which I support), why on God's green earth would I allow that to happen when it doesn't address our government's insatiable need to feed an ever-expanding bureacracy, its unwillingness to confront unsustainable entitlements, and its all-to-easy virtue in accomodating special interests, particularly as they corrode the tax code? Unless both sides of the equation, revenue and expense, are questioned on the issue of fairness, I'm digging my tax heels in. The world of Wall Street may be out of favor, but it does teach a valuable lesson. You can't win by negotiating with yourself.
Warren Buffett's secretary does not have a higher tax rate than him unless she is hit with the alternative minimum tax. If she is making around $100,000, her actual tax rate is approximately 15 to 18%, dependent on her deductions. Look at the tax tables, if she is a head of household, she pays no tax on net income on the first $12,400. She pays 15% on the next $34,950 and then she pays 25% on the rest, which will result in an actual tax rate of 15 to 18%.
42% of the wage earners in this country pay no tax or actual get money from the government. But the real statement is, why does the government take so much?! The federal government takes 22% of GNP to tell you how to live your life. (Bid you eat your carrots today?)
Brian Keane makes a good point, in that the money you invested had already been taxed once at ordinary rates. Moreover, had you lost money on this investment - and I presume by your book "Raising Eyebrows: A Failed Entrepreneur Finally Gets It Right" that you have lost money on previous investments - your loss would have been deductible against other capital gains you had (if any) also at a 15% tax rate. Thus, there is no mismatch in the rate you pay for a gain and the utility you receive for a loss. If you had no capital gains, you would only get to deduct $3,000 per year against ordinary income.
I have no problem unifying the rates for ordinary income and capital gains. However, if we can agree that government spends money less efficiently and effectively than individual taxpayers, I would suggest we'd be better off bring ordinary rates down to capital gains rates rather than vice versa.
If Buffett is correct, I agree it's unfair for a secretary to pay a higher rate than an investor. So let's bring everyone's rate down to a flat 15%. No reason to raise the rates of million $ earners. They don't use any more government services than a $50k earner.
Everyone should pay something and no one should get a tax refund if they pay not taxes. Let's get rid of this Rube Goldberg tax system and put some sanity to work.
I would note that the top income tax rate was lowered to the existing capital gains tax rate - which was not changed. The difference may seem subtle, but saying that the equalizing of the rates did not impact investment is a bit misleading. At best it had no impact on investment. That being said, one function of taxation (I would argue that it should be the only one) is to impact economic activity. Currently, we have become a nation of consumers with low levels of savings and equally low levels of investment and we need to generate more savings and more investment (those who took Econ 101 will remember that in an economy, savings always equals investments). Currently need to encourage savings and discourage consumption and a low capital gains tax is one way to do that.
Ultimately, I think that the discussion is really one about fairness and I do not believe that the tax code should take on the additional burden of promoting fairness. Taxation of any kind provides economic friction and the more the tax code can promote economic efficiency, the better.
I disagree 100%.
First, increasing capital gains taxes negatively impacts capital formation - without question. Numerous studies have documented this effect. A decrease in capital formation directly impacts the creation of jobs. It has been widely reported that one of the principal reasons for sluggish job growth in the current economic recovery is that new businesses are not being created at the expected pace. Capital formation, or lack thereof, is a key contributor to this dynamic.
Second, the US needs to remain an attractive destination for foreign investment. Global capital flows to wherever it is most productive and generates the most returns. You only need to look at the evidence of countries like Singapore, HK, Ireland, and others for concrete examples. The issue is not just about what one rich person might do with his money but what global investors do with their capital. The US cannot adopt a tax policy without regard to how other countries are attracting business and investment. Right now the US corporate tax rate is among the highest in the world. Do we also have to make the same mistake with respect to capital gains?
Third, using the notion of fairness as a defense of high capital gains taxes is incorrect. The capital gains rate is a policy lever and not a social lever. A "fair" policy should encourage investment for the explicit purpose of job creation. There is nothing more fair to an individual than to provide the dignity that comes from being gainfully employed. A government should care about the less fortunate for sure - but a government cannot achieve that by punishing success and standing in the way of economic growth. Many retirees also depend on capital gains as do young investors who dream of reaping the rewards of their hard work.
I'd like to see concrete action by people who truly feel that the capital gains tax (or any other tax for that matter) is too low or fundamentally unfair. If they do not want to voluntarily pay more to the government on the reasoning that doing so would not solve the underlying issues, perhaps they can do something else: fund research that shows how increasing the capital gains tax would create economic growth and opportunity. This is an important matter that merits an informed discussion.
To have a chance at balancing the federal budget and getting an equitable tax approach, we need to first get back to looking at Social Security and Medicare contributions and premiums as just that and not simply another form of income tax. Nowadays, the general approach is to consider them simply income taxes and, since Social Security contributions are capped, the very rich seem to pay much less a percent of income, but the very rich get only a tac above the same modest benefit as lower income people. I don't think FDR intended that Social Security be an income transfer program but rather a government-sponsored retirement system that would ensure that everybody had at least a rudimentary annuity to live on. The capital gains rate and dividend rate of 15% reflect the fact that a company (assuming a corporation) has already paid tax on its income, as the first commenter pointed out.
Now, I do believe that the very rich (and making $250,000 a year for a couple does not make you very rich) should equitably see a rate increase of perhaps back to the pre-Bush tax cut rates, including an increase in capital gains back to 20%. Based on the experience under Clinton, tax revenues would probably increase although increasing rates doesn't guarantee a revenue increase. Actually, we don't know what Warren Buffet's secretary takes home in income, but if a billionaire is not paying his secretary in six figures, I would be surprised, and she might be filing jointly, if married, so the whole argument around what rate she pays is a bit silly.
In summary, Obama had it about right when running four years ago - increase taxes on the rich back to the pre-Bush tax cut rates, but $250,000 is too low a threshold; he should about double it. But leave it at that and stop trying to set a rate based on what Warren Buffet's secretary is "probably" paying.
LaMagna has it just right! There is no way people will stop investing if the capital gains tax rate is 30-40%, same as upper-income tax rates. Check your economic history books, folks. Did anyone stop investing when tax rates reached 70+% under Eisenhower? I don't think so.
As for government vs. private efficiency - true that in many areas private is more efficient. But not in health care. Compare Medicare administrative costs to private insurer costs... which are a huge ripoff. Why they were ever allowed to create "Medicare Advantage" with average costs 17% higher than traditional Medicare is beyond me... just a political payoff to the insurance companies.