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The Spurious, Curious Case for Low Capital Gains Taxes

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These are heady times for backers of low taxes on capital gains. Presidents Clinton and Bush both cut the capital gains rate, bringing the current levy on long-term gains down to 15%. That’s the lowest in more than 70 years, “gloriously low” in the words of economist Ben Stein, and it means that profits on stock market transactions are now taxed at a lower rate than the wages of average Americans.

 

There’s no good reason for this preferential treatment, and powerful reasons to end it. Leading the list is the simple fact that stock market “investors” are almost never real investors in the first place.

 

The argument for a low rate on capital gains is invariable (and in recent years, invariably effective): it holds that investments in the stock market grow jobs, grow businesses, and provide vital fuel for the United States economy. Partly as inducement and partly in gratitude, the argument goes, it behooves government to reward investors with low capital gains taxes.

 

A potent blend of myth, propaganda and misimpressions. Let’s look instead at some truths.

 

It’s routine on Wall Street these days for trading volume to run in the billions of shares. On any given day, only a tiny fraction of those billions has any valid claim to growing jobs or businesses or the economy. On many days not a single share qualifies as a bona fide investment.

 

Almost all the time, all that’s happening is money changing hands as shares move from sellers to buyers. Not a cent goes to the companies whose shares are traded. No jobs are created (except in the financial community, which is not the point here). No businesses are expanded. Investments are really being made not in the economy but in personal portfolios.

 

The only genuine stock market investments are those in initial public offerings (IPOs) and secondary offerings. In those cases alone does the money move on to do the work it’s purported to do. All the rest is aftermarket noise as the players place their bets at the tables down on Wall Street.

 

Securities markets clearly play an energizing role in the American economy. All the same it’s nonsense to claim that buyers of stocks deserve a tax break when they sell their shares at a profit. A tax break?  For making money in the market?

 

Now for more reasons why this is poor policy.

 

There’s a fairness issue that flows from taxing one kind of income differently from another. Income is income and should be taxed at the same rates no matter where it comes from; what’s good for the goose is good for the gander.

 

There’s the issue of income inequality, which has soared in America lately.  According to the David Cay Johnston book Perfectly Legal, the top one percent of taxpayers controls about half the nation’s financial assets. Two-thirds of the income of the 400 highest-income Americans comes from long-term capital gains. Undeniably, the benefits of tax breaks for capital gains flow overwhelmingly to the already-wealthy; undeniably, preferential rates on capital gains exacerbate income inequality.

 

Finally there’s a tax equity issue which our forebears even considered a moral issue. In 1924 Congress first differentiated between earned income (wages and salaries) and unearned income (e.g., capital gains and dividends), and taxed the unearned income at higher rates. It was deemed the right thing to do; old-timers would have shuddered at the notion of taxing wages at higher rates than capital gains.

 

Those were the days.  Now it’s 2007.

 

Under the trumped-up cover of spurring economic growth, average American workers have to pay higher taxes on their wages than if they made the same amount of money in the stock market.  They’re getting stiffed by carrying a heavier relative tax burden, getting fewer services or some of both.

 

The latest capital gains tax cut is set to expire in 2010, and the new Democratic Congress has indicated that it has no plans to visit the issue until after the 2008 elections. This gives them plenty of time to look beyond the propaganda, and to consider taxing capital gains at least as much as earned income. A political pipedream? It was the rule not long ago: from 1988 to 1992, long-term realized gains were essentially taxed at the same rate as other income.

 

Then the K Street apostles went forth and preached, and the spurious case became gospel. 

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Gerald E. Scorse has an M.B.A. from Baruch College. He is retired and lives in Manhattan.

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