From: jwh@citi.umich.edu (Jim Howe)
Subject: Re: Taxing capital gains (was: why progressive tax rates)
Reply-To: jwh@citi.umich.edu
Organization: IFS Project, University of Michigan
Date: Mon, 31 Aug 1992 17:55:06 GMT

In article <1992Aug29.010016.1548@panix.com>, eck@panix.com (Mark Eckenwiler) writes:
|> In <168518096.MEDELMA@cms.cc.wayne.edu>, MEDELMA@cms.cc.wayne.edu sez:
|>> 
|>>What's your point? The anti-tax argument is based on a couple of assumptions,
|>>so perhaps you'd be good enough to address each individually:
|>> 
|>>1. Unidexed capital gains taxes tax inflation, resulting in exceptionally
|>>high marginal rates. I've posted sample calculations, so perhaps you'd be
|>>kind enough to post your calculations and show whay this isn't the case-
|>>if that's your argument.
|> 
|> I contend that cap. gains aren't any different in this regard from
|> other kinds of income.  My bank interest is also taxed even though a
|> portion of it accounts for inflation, and taxed *each year* to boot.
|> 

You are correct that capital gains and dividend and interest income
are not indexed for inflation.  They should all be index, IMHO.

|> Here are some sample figures for investments A and B as described in
|> my first article in this thread. My figures are based on 10% annual
|> return and a 30% tax rate.  Feel free to pick other less convenient
|> numbers in your own calculations :) Each investment starts with
|> $1,000.
|> 
|> 
|> Income source A: the column for each year shows, in order, starting value,
|> income, and end value after taxes are subtracted.
|> 
|>   Y1      Y2         Y3         Y4         Y5      
|> 
|> 1000    1070       1144.90    1225.04    1310.79
|>   
|>  100     107        114.49     122.50     131.08
|> 
|> 1070    1144.90    1225.04    1310.79    1402.55
|> 
|> 
|> Investment B: appreciates at 10% per annum, with a one-time tax at the end of
|> five years.
|> 
|> 1000 * (1.10)**5  =  1610.51 before tax
|> 
|>    less .3 * 610.51  =   183.15 in tax
|> 
|>       leaves 1427.36 after tax, or $24.81 more than under scheme A.
|> 
|> 
|> Your response is "ah, but those 1427-odd dollars are worth less in
|> year 5."  Right you are.  So are my 1402-odd bank account dollars.  So
|> why, from a strictly mathematical standpoint (*leaving aside the
|> policy arguments*), should cap. gains get special tax treatment?
|> 

The problem with your analysis is that you are comparing apples and
oranges.  You are comparing an investment which has gains realized
each year (interest payments, in this case) to an investment in
which the gain is realized at the end of a period of time.  If you
compared a situation where you earned 10% interest each year, and
you invested in another investment (say a stock) which appreciated
10% *and which you sold at the end of the year* and used to proceeds
to buy another investment for the next year, you would now have
an equal comparison.  Also note that not all interest paying investments
pay yearly.  If you have an investment which pays you interest at
the end of x years, you only pay tax on the interest in the year
that the interest is paid, not as it accrues.  The biggest difference
between capital investment and interest bearing investments is
the degree of risk.  One argument for a favorable rate on capital
gains is that it will encourage investment in capital.  Capital
is needed for economic growth but it is also a riskier investment.
Encouraging capital investment via a lower tax rate may be a smart
thing to do.  I have heard *no* compelling argument as to why
gains should not be indexed for inflation.


James W. Howe                  internet: jwh@citi.umich.edu
University of Michigan             uucp: uunet!mailrus!citi.umich.edu!jwh
Ann Arbor, MI   48103-4943