A Shortsighted Tax

January 14, 1963

Any tax cut that led to still another budget deficit—which means any tax cut not accompanied by an equal or more than equal cut in expenditures—would be a cruel deception of the American people. It could precipitate an inflation that would do immense harm. But this objection does not apply to proper tax reform. Our present system embodies rates and types of taxation that are not only inequitable, but actually reduce possible revenues at the same time as they retard economic growth.

An outstanding example is the capital-gains tax. This tax is cynically one-sided. It is a heads-I-win-tails-you-lose proposition of the government against the taxpayer. Short-term capital gains are taxed in full, to any amount, just as if they were added income. But capital losses can be deducted only against gains, if any, and not against income, except to a maximum of $1,000 in any one year. Long-term capital gains (i.e., gains from assets held longer than six months) are treated similarly as compared with losses, though such capital gains are taxed at a maximum rate of 25 percent.

GAINS VS. LOSSES

Prior to the market collapse and depression of 1929–33, capital gains were taxed as income, and at the same rates. And capital losses were fully deductible against income. But when J.P. Morgan revealed that he had paid no income tax for the preceding year, because his capital losses exceeded his ordinary income, his statement made front-page headlines. Then Congress one-sidedly “rectified” matters by refusing to allow deduction of more than $1,000 a year of capital losses against income, though it continued to tax short-term capital gains in full as income.

Another gross injustice of the present capital- gains tax is that the “gains” it taxes are often nonexistent. Suppose a man bought stock or real estate for $10,000 in 1939 and sold it for $21,800 in 1962. He would be taxed on a long-term capital gain of $11,800. Actually, as the cost of living also rose 118 percent in that period, he would have achieved no capital gain at all. His $21,800 in 1962 could buy no more than $10,000 bought in 1939. If he had sold his real estate or stock for $19,000, he would be taxed on a capital gain of $9,000, but he would have suffered an actual loss in real terms. Under past and prospective inflation, the long-term capital gains tax amounts to a large extent to nothing else but capital confiscation and expropriation.

Its evils do not end there. By taxing gains in full, and short-term gains at sometimes confiscatory rates, with loss deductions only against gains (except for a token deduction against income), it discourages all investment, and particularly of risk capital. It “locks in” capital. It penalizes investors heavily for transferring investments into new ventures. It stunts economic growth.

It is hard to imagine any reform of the capital-gains tax that would not be an improvement. Here are some possible alternatives:

1—Segregate capital gains and losses from ordinary income. Tax these segregated capital gains at the same rates as ordinary income, or at a flat rate calculated to maximize revenue. Allow deduction of losses against gains, and an indefinite carry-forward of losses until absorbed.

2—Cut the rate on long-term capital gains from a maximum of 25 percent to a maximum of 10 percent.

3—Follow the example of Britain. Don’t tax long-term capital gains at all. Or adopt the Swedish policy of tapering the tax off. (The Swedish taxpayer pays straight income tax on 100 percent of capital gains on assets held for less than two years, on only 75 percent of the gain on assets held between two and three years, on only 50 percent of the gain if the assets are held one year longer on only 25 percent if held one year longer still, and no capital-gains tax at all if the asset is held more than five years.)

4—At least allow the taxpayer to deflate his alleged capital gain to allow for the rise in the consumer price index over the period involved.

5—Allow the taxpayer a tax-free transfer of capital from any investment to another (a right that now applies only to his residence).

6—Enact some variation or combination of these reforms.