On Taxing Capital Gains
By Bruce Shields

The Vermont House is now discussing an increase in the tax on capital gains.  The premises for increasing this tax are wrong, and raising the tax rate may very well cause actual tax collections to drop.  The capital gains tax is a direct tax on capital assets, and as such has a very corrosive effect on business and on investment.

The tax falls more heavily on business property ownership for two reasons.  Capital gain on real estate is either exempt from taxation (for the owners of homes) or can be reduced through the mechanism of a like kind exchange.  Gain in the value of an asset is only taxable when the asset is sold.  Estate transfers fall under special valuation rules, so capital gains tax falls primarily on people active in business.  The only way to avoid the tax is a) not to sell at all, or b) structure the sale so as to spread the income over a number of years.  Why would an owner want to spread the gain, rather than simply sell the asset?

The so-called Progressive Income Tax increases the tax rate higher for each increment of income.  A person recognizing $100,000 income in a particular year might pay 20% of that income, i.e. $20,000 tax.  A person recognizing $200,000 income in the same year might pay almost 40%, or $80,000 tax.  So someone with $200,000 of value accumulated in a business will do much better to be paid over two years rather than one: the seller gets to keep $40,000 by spreading the income over time.

This problem is especially acute for businesses which own property.  If a like kind exchange is not possible (and the rules are byzantine in their complexity) the effect of rising real estate or commodity values over the past 10 years translates into a big hit on that business’s assets.  Because the capital gain tax is not indexed for inflation, merely owning an asset for a number of years potentially subjects a business to a large hit on its capital.  In siphoning off capital assets in this way, Vermont cripples the capacity of a business to move, rebuild, or effect strategic changes.  It is especially harsh on small business and sole proprietorships.

Worse for many people running self-directed retirement funds,  mutual fund companies are required by Federal law to distribute certain classes of capital gain annually, with the strike date December 1 -- long after the owner of the retirement account has any capacity to accommodate to receiving such income.  So someone with $100,000 invested in the Magellan Fund was maybe credited with $8,000 of capital gain for 2007.  But during December, Magellan’s Net Asset Value dropped by about $6000, and another $6000 in January.  So when the 1099 arrives, the taxpayer finds he must claim $8000 gain on an account which is worth $12,000 less.

When the Bush Tax Cuts were enacted in 2001, many people -- using the Static method of calculating tax collections -- predicted a huge deficit.  In fact, principally because of the "unlocking" of capital gains, the actual amount of tax collected from capital gains soared to record levels.  Thousands of business owners, owners of financial assets, and people who had long term ownership of strongly appreciated property began selling to people who could make more productive use of the assets.  The economy thrived, and income tax collections were larger than ever before.  Raising the capital gain tax may shut down those sales.  If that is the case, raising the rate may very well cause tax collections to shrink.  Before Vermont moves to shut off the spigot, someone needs to present a Dynamic, not a Static, Analysis of tax collections.  Taxing capital gains is a very bad idea -- which Sweden for one abandoned nearly 25 years ago.

Bruce P. Shields, Wolcott
bshields@pwshift.com