From: jwh@citi.umich.edu (Jim Howe)
Subject: Re: Taxing capital gains (was: why progressive tax rates)
Date: Tue, 01 Sep 92 11:34:00 EDT
Organization: IFS Project, University of Michigan
Reply-To: jwh@citi.umich.edu

In article <1992Aug31.211502.29249@panix.com>, eck@panix.com (Mark Eckenwiler) writes:
|> In <1992Aug31.175506.9395@lsa.umich.edu>, jwh@citi.umich.edu sez:
|> >
|> >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.  
|> 
|> It's not a problem -- it's a basic difference that underlies the
|> argument (which I dispute) that cap. gains are unfairly penalized
|> because of inflation over an n-year holding period.  CG-indexation
|> advocates claim that they suffer unfair adverse consequences because
|> of inflation, allegedly unlike annual interest recipients.  As my
|> figures demonstrate, this is hogwash.
|> 

Capital gains are taxed unfairly in comparison to income generated by
salary.  Salary income is indexed at the inflation rate to prevent
bracket creep.  Investment income is not indexed at all.  Lets assume
that the first $100 in earnings is taxed at 15% and anything above
that is taxed at 28%.  If a person earns $100 one year he will pay
15%.  If inflation is 5%, the bracket will have to move to $105 to
ensure that a COLA raise doesn't push the worker artificially into
a higher bracket.  Now consider the investment income situation.
Assume an investment returns 5%.  An investment of $2000 will yield
$100.  In the absence of inflation this $100 is a real gain and
should be taxed at 15%.  If inflation moves to 5% and the yield
remains the same, the next year the income is still $100, but the
inflation adjusted value is $0.  However the person will still
be required to pay 15% on purely inflationary gains.  Bracket
indexing doesn't work for investment income.  The reason is that
it takes a lot more money to generate a given level of investment
income.  The person earning the salary sees the full benefit
of indexing.  His $100 is properly indexed to $105.  He is
paying tax on his *real* income, not inflation distorted income.
The person with the investment income does not see the full benefit.
He should see indexing on his $2000, not his $100.

|> 
|> >  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. 
|> 
|> It may well be.  The question I originally posed -- which I keep
|> having to restate for some reason -- is "*Policy arguments aside*, why
|> should cap. gains be specially indexed for inflation?"  This is a
|> question that calls for a mathematical answer, not more policy
|> arguments (which may indeed have independent merit).
|> 

Investment income (including capital gains) should not be taxed
more punitively than salary income.  Salary income is currently
indexed, investment income is not (see above).

|> 
|> >I have heard *no* compelling argument as to why
|> >gains should not be indexed for inflation.
|> 
|> Similarly, I hear only policy arguments in favor of special CG
|> indexation.  BTW, if you could have indexation, would you insist on
|> the double benefit of retaining annual bracket indexation as well?

As I have shown above, there is no double benefit, as a result
I would certainly maintain annual bracket indexing.


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