By Mike Dorf
With the Republican Convention postponed by a day, this may be a good time to consider one of the main divisions between Republicans and Democrats over the last generation: views about the appropriate size of the capital gains tax. Republicans favor keeping the capital gains tax rate low or lowering it still further--in some proposals, to zero. Democrats, by contrast, typically favor taxing capital gains at the same rates as ordinary income is taxed. Here I want to explore one of the claims sometimes made in favor of a low or zero capital gains tax rate: That people whose gains are being taxed already paid tax on the income that formed the basis for the original investment that now has experienced a capital gain, and so it is unfair or "double taxation" to tax them on capital gains.
This claim is pretty clearly nonsense, as explained very nicely here. I can illustrate relatively simply. Suppose Smith is an accountant who earns $100,000 in 2012. Let's suppose further that he manages to save $10,000 of that money. That savings is "after tax." Now let's imagine two things he might do with it:
1) He could invest the $10,000 in the stock market. When he sells the stock shares, he will be taxed on any gain over the original investment.
2) He could put the $10,000 in an interest-bearing account at a bank. He will then be taxed each year on the interest the bank pays.
Under current law, the interest is taxed as ordinary income, whereas the stock investment will be taxed at the (typically) lower capital gains rate. (I say "typically" lower because the marginal tax rate on Smith's interest income will depend on his other income, his deductions, and so forth, but earning around $100k/year, his highest marginal tax rate on ordinary income will likely be higher than the 15% maximum rate for capital gains.) That makes the stocks a better investment along three dimensions: lower tax rate; ability to time realization; and compounding of gains before tax rather than after tax. To be sure, the stock investment carries risk, whereas the bank deposit is guaranteed by the FDIC. But there's no evidence that the advantages for capital gains are calibrated to compensate for the risk. Nor does it seem that the tax advantages for taking on the risks of capital investment make sense from a social perspective. Why would the government be encouraging riskier rather than safer investments by individuals? We might think it's good for there to be investment, but we get that anyway when the bank invests or loans out the money that Smith deposits under scenario 2.
In any event, put aside whether the particulars are justified or not. The larger point is that in both scenario 1 and scenario 2, Smith is investing post-tax income, so that the claim that he has paid already is not in any way limited to capital gains.
Indeed, the claim is not even limited to investment income in any conventional sense. Suppose that instead of investing the $10,000, Smith pays $10,000 for a series of classes to enable him to become a better accountant. As a result of the class, Smith earns $120,000 in 2013, up from 2012's $100,000. Is Smith able to deduct the $10,000 for the class as a business expense? Sure. But Smith cannot say that he shouldn't have to pay tax on the additional $10,000 bonus income on the ground that he "already paid" taxes on the money that enabled him to take the class that enabled him to earn the extra money. He hasn't yet paid a dime of tax on the second $10,000--just as in scenarios 1 and 2, Smith hasn't already paid any tax on the gain he makes in the stock market or from the interest on his savings account.
So the "already paid" idea is essentially fraudulent. And surely the likes of Mitt Romney and Paul Ryan must realize this, right? So why do they and their right-wing backers keep peddling it?
One likely answer is that it benefits the plutocrats who bankroll the Republican Party to keep capital gains taxes low and so they'll say whatever sounds like a justification to the average voter. And because the average voter will find the details of the foregoing argument too difficult or boring to follow, the already-paid/double-taxation line works.
But that's at best an incomplete explanation. After all, under the logic I've just expounded, the Republican capital gains rate slashers could and would say just about anything. They could say that taxing capital gains at ordinary income rates is triple taxation, or that it violates the constitutional requirement that taxes be apportioned, or that it's socialism. Why the particular claim of already-paid/double-taxation?
The closest I can come to answering that question is the following hypothesis: The Wall Street wing of the Republican Party believes that capital gains are, in some Platonic sense, not income. Sure, they understand that the Internal Revenue Code regards capital gains as income, but they don't.
Here's an analogy that may be helpful, or at least colorful. Suppose that Jones plants a small seed potato and then three weeks later digs up a much larger potato. Has Jones gained potatoes? Well, in one sense, no. He had one little potato. Now he has one big potato. So he still has only one potato. But in another sense, well, yes, of course Jones has experienced a potato gain. He now has much more potato-stuff than he did before. I believe that the ideological opponents of the capital gains tax (like Paul Ryan) take the first view--and think of capital investments as similar to potatoes. This view makes (some) sense of the already-paid/double-taxation idea. Ryan et al think: "A capital gain doesn't add anything to what I had before. It's just that what I had before but just grown bigger. I had a thousand shares of Exxon/Mobil before and that's still what I have, even if it's worth more."
Now notice that I haven't said that thinking of stock certificates as like potatoes is sensible. Why not think of them as more like apple trees? You plant a seed; you grow a tree; you get more apples, not just more apple-stuff. But judging by the apparent sincerity with which Republicans spout the capital gains line, it strikes me that they actually believe what they are saying, and the potato analogy is the closest I have been able to come to figuring out how that could possibly be.
Hence, if I were moderating one of the Presidential or Vice Presidential debates, I'd begin by asking the Republican candidate why he thinks that a share of stock is more like a potato than an apple. And that is reason number 749 why I won't be moderating any of the debates.