A capital gain (loss) is an increase (decrease) in the value of an asset, such as that realized from the sale of stocks, bonds, precious metals, and property. Since a capital gain is an addition to economic wellbeing, theoretically it should be included in a comprehensive income tax base. However, in the interest of administrative ease, capital gains are taxed on a realization basis (when the asset is sold) rather than on an accrual basis (when the gain is earned). Deferring taxes in this way makes a big difference in return because the deferral allows the investment to grow at the before-tax rather than the after-tax rate of interest. In effect, the government gives the investor an interest-free loan on taxes due.
Not all countries implement a capital gains tax and most have different rates of taxation for individuals and corporations. In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other income, but the tax rate for individuals is lower on “long-term capital gains,” which are gains on assets that had been held for over one year before being sold, in order to reward long-term asset-holding. The tax rate on long-term gains was reduced in 2003 to 15 percent or to 5 percent for individuals in the lowest two income tax brackets, although in 2011 these reduced tax rates are scheduled to revert to the rates in effect before 2003, which were generally 20 percent. Short-term capital gains are taxed at the higher, ordinary income tax rate. Countries without a capital gains tax include Argentina, Belgium, Hong Kong, Mexico, Netherlands, Germany, and Singapore.
The primary argument for a lower tax or no tax on capital gains is the avoidance of the “lock-in” effect, so called because the tax system tends to lock investors into their current portfolios. The postponement of realization in order to avoid the tax results in a misallocation of capital because it no longer flows to the most economically worthy destination, where its return is highest. Exchange inefficiency results because an asset is not being held by those who value it the most. Further, capital gains tax on owner occupied housing discourages mobility, yet another inefficient outcome, since the after-tax price might not be enough to pay for a new equivalent home. Some research has also shown that a lower tax increases the return to investment, thus encouraging the rate of investment and the start of new businesses, which aids economic growth. However, this result is not universally accepted by all researchers in the field.
From an equity standpoint, since capital gains are among the most unequally distributed sources of personal income, any across-the-board capital gains tax cuts will dramatically reduce the share of all income taxes paid by the very wealthiest taxpayers and will increase the share of taxes paid by lower and middle-income taxpayers. The large consequences of delaying taxes on investment returns provide further benefits to those high-income taxpayers with capital gains income.
- E. Burman and P. D. Ricoy, “Capital Gains and the People Who Realize Them,” National Tax Journal (1997);
- Engen and J. Skinner, “Taxation and Economic Growth,” National Tax Journal (1996);
- K. McKee, “Capital Gains Taxation and New Firm Investment,” National Tax Journal (1998);
- S. Rosen and T. Gayer, Public Finance (McGraw-Hill, 2007).
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