Tuesday, December 20, 2005

Tax Tuesday!

It's back. Today: The Evils of Section 1(h)

I’ve gotten numerous emails from readers asking for my opinion on the capital gains tax. As I am an obliging individual, here it is:

First, some background. The tax rates on capital gains are set out in the somewhat complex 1(h). The bottom line is that most capital gains are taxed at 15% and the maximum rate on capital gains is 30%. These are incredibly favorable rates. Most taxpayers who have capital gains are in the highest tax bracket, which has a tax rate of about 39%. That is, if those capital gains were taxed as ordinary income (as I think they should), they would be taxed at 39% instead of 15%. And it bears repeating that the overwhelming majority of taxpayers who have capital assets (stocks, bonds, and some real property not used in a trade or business) are in the wealthiest quintile of American society.

The problem, then, is vertical equity, and it is two-fold. First, the very nature of capital assets (think stocks) is to allow the owner to choose the time when the appreciation is realized. That is the stock owner can choose the year in which he wants to pay taxes on the appreciation of the stock by selling it. It is not until the taxpayer sells the stock that he will be taxed on the increase in value over his initial investment. This is a luxury that a low income taxpayer does not have.

Secondly, when the taxpayer does sell the stock and realizes his gain, he doesn’t have to pay the ordinary rate. Instead, as described above, this portion of his income is taxed at the incredibly low rate of 15%. The low income taxpayer, on the other hand, will be taxed on every penny of his taxable income, usually at a rate above 15%.

So with this obvious inequity, why have special treatment for capital gains? The argument usually advanced is that lower capital gains rates prevent the capital lock-in effect, whereby the owner of highly appreciated property holds on to that property even when it would be economically more efficient to transfer that property to someone else who could use it more efficiently. The taxpayer holds on to the property to avoid paying tax on the appreciation.

But I say, get rid of the special treatment of capital gains. Tax the gains as ordinary income at the taxpayer’s highest marginal rate. And what about capital lock-in? Well the only reason capital lock-in would be a problem with no favorable gains rate is because of section 1014 (see Haiku below). But 1014 is a travesty itself, one of the most vertically inequitable sections in the code. My solution is to eliminate 1014 as well as 1(h). I wouldn’t even allow transfer basis at death. Treat death as a realizing event and you’ve solved this massive inequity.

This post is quite long but I still have a lot more to say. Well, more later.


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