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It’s Time to End the Preference and Tax Capital Gains as Ordinary Income

The United States entered the COVID-19 crisis with an unusually large budget deficit for an economy at or close to full employment. Even if employment,…

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The United States entered the COVID-19 crisis with an unusually large budget deficit for an economy at or close to full employment. Even if employment, output, and growth were to recover quickly to where they were at the end of 2019 (something that is far from certain), the deficit, under current law, will remain large.


The good news is that interest rates are likely to remain well below the rate of GDP growth for the foreseeable future, as they have since the beginning of the century. As long as that remains the case, there is no danger of an “exploding debt” scenario in which a large but constant federal deficit causes debt to grow without limit as a share of GDP. At this point, the greatest danger to the recovery is premature austerity. Still, as the recovery proceeds, we are sure to hear it argued on both economic and political grounds that the deficit should be reduced.


At that point, the search will be on for ways to close the budget gap. Although everyone will roll out their favorite spending cuts, much of the heavy lifting is going to have to come on the revenue side of the budget. As former Trump adviser Gary Cohn put it recently, talking to CNN’s Fareed Zakaria,
Our next Congress, the Congress that sits down in 2021, almost has to sit down and look at our spending and our revenue side. … How we spend money? There are a lot of places where we could cut back. In addition to that, I think they have to look at our tax system and think of ways that we raise revenue.
No area of the tax code is more ripe for reform than the preferential treatment given to capital gains. While incomes from wages and salaries face a maximum tax rate of 37 percent, capital gains on assets held for more than a year, in most cases, are taxed at a maximum rate of just 20 percent.

The benefits of the capital gains tax preference flow predominantly to the rich. Some 70 percent of the benefits go to taxpayers with annual incomes of $1 million or more, who enjoy annual benefits of $145,000 each. Benefits for households with incomes of $50,000 or less average about $10. For years, backers have tried to find broader justifications for this tax break, contending that benefits to the few somehow trickle down to the rest, but their efforts are less than convincing.


Here are some of the many issues raised by the capital gains tax preference, and the many reasons why its elimination should be at the top of the list in the search for additional sources of federal revenue.



Are capital gains really income?


One argument for lenient tax treatment is that even if income is to be taxed, capital gains are not income at all, but only a reflection of a transfer of ownership of an existing asset. If we want assets to come under the control of those who can put them to best use, say defenders of the preference, we should not erect barriers to their purchase and sale. Just as we tax labor income when it is paid out to workers, we should tax capital income only when it is paid out as interest, dividends, royalties, or whatever, but not when ownership of an asset is transferred from one party to another.


That might make sense if it were possible to distinguish cleanly between income and capital gains, but it is not. Instead, it is all too easy to transform income from almost any source into something that looks like a capital gain.


Consider a fanciful example: I make a contract with my wife to supply 2,000 hours of labor over the coming year for a payment of $2,000. Under the terms of the contract, she can, if she wants, call on me to use those hours in any way she wants. She could ask me to mow the lawn and make lasagna for dinner, but she could also sell the local university an option that would allow it to buy my services at the same $2,000 she paid for them. The university willingly pays her $95,000 for the option, which is a good deal for them since they would otherwise have had to pay me $100,000 to teach my quota of courses. When we file our joint tax return come April 15, we will be taxed at the capital gains rate on my wife’s $95,000 income from the option sale, while I report ordinary income of $2,000. Our before-tax income is a little lower than it otherwise would be, but our total taxes are a lot lower.


Although this example seems absurd, the real world is full of situations where businesses can do much the same — structure a transaction to make it look like a capital gain instead of ordinary income. In fact, one law firm advertises an options-based strategy exactly like that described above, except that it is used to shelter income from real estate rather than from labor. Choices like organizing a firm as a partnership instead of a corporation, paying executives with stock options instead of a salary, or imaginatively structuring a real estate deal can also convert ordinary income to capital gains. The strategies are endless.


One of the most controversial ploys is the carried interest rule, which allows hedge fund and private-equity managers to structure the income they receive for their services in a form that qualifies for taxation as capital gains. Even some commentators who are otherwise enthusiastic about lenient taxation of capital gains draw the line at carried interest. For example, David Frum, who thinks a lower tax rate for capital gains is good policy, agrees that the rule is “utterly unjustifiable. If you’re investing with other people’s money,” he says, “What you are earning is income — and it should be taxed as such.” The 2017 Tax Cuts and Jobs Act, which slashed the corporate tax rate, was supposed to close the carried interest loophole, but it ended up making only minor modifications. For the most part, say tax analysts, the rule lives on.


Tax avoidance strategies that convert ordinary income to capital gains would be a problem even if they did nothing but generate inequities and reduce federal revenues, but that is not the whole story. Such strategies may require more than just waving an accountant’s wand over something a firm would do anyway. Instead, structuring transactions to take advantage of specific tax rules often requires changing actual business practices, such as the choice of financing methods, the timing of investments, even the choice of one’s whole line of business. Often, the changes would be unprofitable except for their tax advantages. Although proponents of the capital gains preference claim it supercharges growth and efficiency, tax-induced changes in business practices are a significant drag on the real economy.


Do we need a capital gains preference to correct for inflation?


A second argument used by supporters is that we need low tax rates on capital gains to avoid taxing “phantom” gains produced by inflation. The argument is superficially plausible. When there is inflation, asset owners may be taxed on nominal gains even when real asset values do not increase.


For example, suppose you buy some shares of stock at $100 and sell them for $120 a couple years later. Inflation has meanwhile pushed up the cost of living by 10 percent. That leaves you with an inflation-adjusted pretax gain of just $10. If you pay 37 percent tax as ordinary income on the $20 nominal gain, your tax rate on the $10 real gain is 74 percent. Cutting the rate on nominal capital gains to 20 percent reduces the real rate to 40 percent — not quite enough even to fully level the playing field, but a move in the right direction, it would seem.


But there are two flaws in that argument.


First, any arbitrary rule, such as a fixed lower tax rate or an exclusion of a portion of capital gains, can only crudely approximate the necessary adjustment for inflation. The 20 percent rate that is close to right in the example we just gave becomes too low if inflation slows (as it has in recent years). If inflation instead accelerated, it would become too high. Second, the rate that just levels the playing field for a person in one tax bracket could be too high or too low for those in other brackets.


A more nuanced approach would be to index the basis on which capital gains are calculated to reflect actual inflation between purchase and sale. That would avoid the taxation of phantom capital gains, but not a second, equally serious problem: Other forms of investment income, too, are subject to phantom taxation when there is inflation.


Suppose, for example, that in a zero-inflation world, borrowers would offer a 5 percent coupon rate on top-rated corporate bonds. If the rate of inflation rises to 5 percent, borrowers would be willing to offer a 10 percent nominal coupon rate on the bond, since they know they will be able to pay future interest and principle in less valuable dollars. The 10 percent nominal rate leaves your real return and their real interest cost at 5 percent. So far, so good. But suppose now that you are subject to a 20 percent tax on your interest income. In the zero-inflation case, your interest income after tax is 4 percent. In the inflationary case, you have to pay tax on the whole 10 percent nominal rate, leaving you an 8 percent nominal return after taxes. When you subtract 5 percent inflation, that 8 percent nominal return becomes just 3 percent. In short, even if borrowers adjust nominal interest rates to fully reflect inflation, inflation increases the effective tax rate on bondholders.


The situation would be similar for income from the common stock of a firm that has constant real profit, from which it pays a constant fraction in dividends. Faster inflation would increase the real effective rate of taxation on the dividends.


A helpful 1990 paper from the Congressional Budget Office explores the problem in detail. The paper confirms that faster inflation raises the effective tax rate on investment income, but it points out that the effect is inherently smaller for capital gains than for dividend or interest income. Attacking the problem of phantom capital gains in isolation by whatever means — a preferential capital gains rate, an exclusion, or indexation — only widens the gap between the way inflation affects capital gains and the way it affects interest and dividends. Doing so increases the attractiveness of tax avoidance strategies that involve inefficient business practices.


The ideal solution to distortions caused by inflation would be to index the entire tax system. Indexation would have to cover not only all forms of investment income, but also taxation of ordinary income, real estate, inheritance, and everything else. But trying to remove the effect of inflation on capital gains taxes separately is likely to make things worse, not better.


Do we need the preference to avoid double taxation of corporate profits?


“Double taxation” of corporate profits is a third common argument in defense of lenient tax treatment of capital gains. The idea is that corporate profits are taxed once at the business level and then again at the individual level when they are paid out as management bonuses, dividends, or capital gains.


It is true that a preferential rate on capital gains would be one way to attack the distortion — one way, but a bad one. A much better way would be to fix the flaws in corporate taxes that are the source of the problem rather than apply a Band-Aid to capital gains.


Actually, part of the job was done in the 2017 Tax Cuts and Jobs Act, which lowered corporate tax rates across the board. A further step would be to get rid of the numerous loopholes in the corporate tax system that allow a big chunk of corporate profit to escape taxation altogether while those unlucky enough not to qualify pay much more.


But the 2017 corporate tax cut left a key part of the job unfinished. If we want to enjoy the potential efficiency benefits of corporate tax reform, those taxes should not just be reduced; at the same time they should be shifted to the individual incomes of the managers and shareholders who are the ultimate recipients of corporate profits. To do that would require eliminating the capital gains preference. A regime that had no corporate income tax and full taxation of profits, whether earned by shareholders as capital gains, dividends, or in any other form, would eliminate double taxation once and for all without an unfair redistribution of the overall burden of taxation.


The lock-in effect


The “lock-in” effect is a final problem with capital gains taxation. As the tax is currently administered, people do not have to pay capital gains on an asset until it is sold. As a result, the after-tax return on an appreciating asset increases the longer it is held.


Compare a bond that pays a steady interest income every year to a stock that increases in value by the same amount each year. Over time, the effective tax rate on the stock would be lower even if the statutory tax rate were the same on both interest income and capital gains. The reason is that bondholders have to pay their tax year by year, while stockholders can defer payment of the tax until they sell their shares, possibly many years later.


Moreover, if people still have not sold their stock or other assets when they die, their heirs never have to pay taxes on the capital gains at all. Instead, the value of the assets is “stepped up” to the market value at the time of the original purchaser’s death. In the meantime, the original owners can live quite well by borrowing against the value of the assets. When they die, their heirs can sell enough shares to pay off the loans, without paying capital gains taxes either on those shares or the ones they keep.


The lock-in effect, then, creates an artificial incentive for owners to hold on to stocks or real assets longer than they otherwise would. In many cases, that means that assets do not move smoothly from the hands of those who own them to those of new owners who could make better use of them. Furthermore, the lock-in effect greatly reduces the revenue that the government realizes from capital gains taxes.


Unfortunately, removing the tax preference and taxing capital gains at the same rate as ordinary income would, by itself, make the lock-in problem worse. Assets would move from hand to hand even more slowly than they do now. As a result, the increase in revenue from lifting the capital gains preference would be disappointingly small.


Fortunately, there are ways to overcome the lock-in problem. A recent study from Brookings by Grace Enda and William G. Gale discusses several possible reforms.


Two of the simplest reforms attack the so-called “Angel of Death” loophole that allows heirs to fully or partially escape capital gains taxes. One version would eliminate the valuation step-up at death. Suppose John Sr. buys an asset for $1,000 in 1990 and dies in 2010 when the asset is worth $2,000. John Jr., the heir, finally sells the asset in 2020 when it is worth $3,000. Under the current regime, John Jr. pays no capital gains tax until 2020, and then only on the $1,000 gain that has occurred since the time of inheritance. Without the step-up, John Jr. would pay tax in 2020 on the full $2,000 gain that had taken place since the original purchase. An even stronger version of the same reform would require John Jr. to pay tax on the first $1,000 of the gain in 2010, at the time of inheritance, and pay the tax on the remaining $1,000 when the asset is sold in 2020.


A still more far-reaching reform would be to tax capital gains annually on an accrual or mark-to-market basis. Suppose that your tax rate is 30 percent, and in year 0, you buy 100 shares of stock at $50 a share. They rise in price to $100 in Year 1, fall to $75 in Year 2, and rise again to $150 in Year 3, at which point you sell them. Under mark-to-market taxation, in Year 1 you pay tax of $1,500 on a capital gain of $5,000; in Year 2, you have a negative tax liability of $750 on a capital loss of $2,500, which you can carry forward; and in Year 3, you have a capital gain of $7,500 on which you owe tax of $2,250, $750 of which you cover with the carried-forward loss. Your total tax over the 3 years is $3,000, the same as it would be if you were taxed only at the time of sale, but because there is no deferral of taxes, there is no lock-in effect.


Mark-to-market taxation would be easy to implement for assets like stocks and bonds that were actively traded, but not so easy for hard-to-value assets like real estate or private business interests. An approach called retrospective taxation could be used in such cases. Under that system, capital gains would be taxed at the time of sale, but the tax rate would be higher the longer the asset had been hed. The rate of increase in the tax rate would depend on market interest rates. If it were done right, the cost of the rising tax rate would exactly balance out the benefit of deferring taxes until sale. In short, retrospective taxation would eliminate the lock-in effect without encountering the problem of annual evaluation of hard-to-value assets.


Any of these reforms, alone or in combination, would mitigate the lock-in effect. As a result, capital markets would operate more efficiently, since assets would move more freely into the hands of the owners who could put them to the best use. It would also increase the revenue gain from elimination of the capital gains tax preference.


The bottom line


Those who defend the preferential rate on capital gains are right when they argue that all taxes affect business decisions. But it is a non sequitur to say that because they affect business decisions, capital gains taxes should be as low as possible. The proper conclusion, instead, is that we should consider capital gains taxes in the context of the tax system as a whole:


  • Taxing capital gains at lower rates than other forms of investment income does little to encourage investment in general. However, it does a lot to encourage the structuring of investment in ways that avoid taxes, even if they are inherently less efficient.

  • Theoretically, an ideal tax system would be fully indexed for inflation, but singling out capital gains for special treatment while other forms of capital income are not adjusted actually increases the degree to which inflation undermines the equity and efficiency of the tax system.

  • A case can be made against double taxation of corporate profits, but the proper reform would be to tax capital gains and dividends as ordinary income at the same time that profit taxes at the corporate level were reduced or eliminated.

  • The lock-in effect is real, but the appropriate way to mitigate it would be through elimination of the angel-of-death loophole while taxing all capital gains on a mark-to-market or retrospective basis.

In short, as we look ahead to the likely need for additional federal revenues as the U.S. economy fully recovers from the COVID-19 downturn, a thorough reform of our system for taxing capital gains should be a high priority.


Based on a previous post at NiskanenCenter.org. Photo courtesy of Pixabay.com.



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Spread & Containment

War, peace and security: The pandemic’s impact on women and girls in Nepal and Sri Lanka

The impacts of COVID-19 must be incorporated into women, peace and security planning in order to improve the lives of women and girls in postwar countries…

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Nepalese girls rest for observation after receiving the Moderna vaccine for COVID-19 in Kathmandu, Nepal. (AP Photo/Niranjan Shrestha)

Attention to the pandemic’s impacts on women has largely focused on the Global North, ignoring countries like Nepal and Sri Lanka, which continue to deal with prolonged effects of war. While the Nepalese Civil War concluded in 2006 and the Sri Lankan Civil War concluded in 2009, internal conflicts continue.

As scholars of gender and war, our work focuses on the United Nations Security Council Resolution 1325 on women, peace and security. And our recently published paper examines COVID-19’s impacts on women and girls in Nepal and Sri Lanka, looking at policy responses and their repercussions on the women, peace and security agenda.

COVID-19 has disproportionately and negatively impacted women in part because most are the primary family caregivers and the pandemic has increased women’s caring duties.

This pattern is even more pronounced in war-affected countries where the compounding factors of war and the pandemic leave women generally more vulnerable. These nations exist at the margins of the international system and suffer from what the World Bank terms “fragility, conflict and violence.”

Women, labour and gender-based violence

Gendered labour precarity is not new to Nepal or Sri Lanka and the pandemic has only eroded women’s already poor economic prospects.

Prior to COVID-19, Tharshani (pseudonym), a Sri Lankan mother of three and head of her household, was able to make ends meet. But when the pandemic hit, lockdowns prevented Tharshani from selling the chickens she raises for market. She was forced to take loans from her neighbours and her family had to skip meals.

Some 1.7 million women in Sri Lanka work in the informal sector, where no state employment protections exist and not working means no wages. COVID-19 is exacerbating women’s struggles with poverty and forcing them to take on debilitating debts.

Although Sri Lankan men also face increased labour precarity, due to gender discrimination and sexism in the job market, women are forced into the informal sector — the jobs hardest hit by the pandemic.

Two women sit in chairs, wearing face masks
Sri Lankan women chat after getting inoculated against the coronavirus in Colombo, Sri Lanka, in August 2021. (AP Photo/Eranga Jayawardena)

The pandemic has also led to women and girls facing increased gender-based violence.

In Nepal, between March 2020 and June 2021, there was an increase in cases of gender-based violence. Over 1,750 incidents were reported in the media, of which rape and sexual assault represented 82 per cent. Pandemic lockdowns also led to new vulnerabilities for women who sought out quarantine shelters — in Lamkichuha, Nepal, a woman was allegedly gang-raped at a quarantine facility.

Gender-based violence is more prevalent among women and girls of low caste in Nepal and the pandemic has made it worse. The Samata Foundation reported 90 cases of gender-based violence faced by women and girls of low caste within the first six months of the pandemic.

What’s next?

While COVID-19 recovery efforts are generally focused on preparing for future pandemics and economic recovery, the women, peace and security agenda can also address the needs of some of those most marginalized when it comes to COVID-19 recovery.

The women, peace and security agenda promotes women’s participation in peace and security matters with a focus on helping women facing violent conflict. By incorporating women’s perspectives, issues and concerns in the context of COVID-19 recovery, policies and activities can help address issues that disproportionately impact most women in war-affected countries.

These issues are: precarious gendered labor market, a surge in care work, the rising feminization of poverty and increased gender-based violence.

A girl in a face mask stares out a window
The women, peace and security agenda can help address the needs of some of those most marginalized. (AP Photo/Niranjan Shrestha)

Policies could include efforts to create living-wage jobs for women that come with state benefits, emergency funding for women heads of household (so they can avoid taking out predatory loans) and increasing the number of resources (like shelters and legal services) for women experiencing domestic gender-based violence.

The impacts of COVID-19 must be incorporated into women, peace and security planning in order to achieve the agenda’s aims of improving the lives of women and girls in postwar countries like Nepal and Sri Lanka.

Luna KC is a Postdoctoral Researcher at the Research Network-Women Peace Security, McGill University. This project is funded by the Government of Canada Mobilizing Insights in Defence and Security (MINDS) program.

Crystal Whetstone does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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Government

CDC Announces Overhaul After Botching Pandemic

CDC Announces Overhaul After Botching Pandemic

After more than two years of missteps and backpedaling over Covid-19 guidance that had a profound…

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CDC Announces Overhaul After Botching Pandemic

After more than two years of missteps and backpedaling over Covid-19 guidance that had a profound effect on Americans' lives, the Centers for Disease Control (CDC) announced on Wednesday that the agency would undergo a complete overhaul - and will revamp everything from its operations to its culture after failing to meet expectations during the pandemic, Bloomberg reports.

Director Rochelle Walensky began telling CDC’s staff Wednesday that the changes are aimed at replacing the agency’s insular, academic culture with one that’s quicker to respond to emergencies. That will mean more rapidly turning research into health recommendations, working better with other parts of government and improving how the CDC communicates with the public. -Bloomberg

"For 75 years, CDC and public health have been preparing for Covid-19, and in our big moment, our performance did not reliably meet expectations," said Director Rochelle Walensky. "I want us all to do better and it starts with CDC leading the way.  My goal is a new, public health action-oriented culture at CDC that emphasizes accountability, collaboration, communication and timeliness."

As Bloomberg further notes, The agency has been faulted for an inadequate testing and surveillance program, for not collecting important data on how the virus was spreading and how vaccines were performing, for being too under the influence of the White House during the Trump administration and for repeated challenges communicating to a politically divided and sometimes skeptical public."

A few examples:

Walensky made the announcement in a Wednesday morning video message to CDC staff, where she said that the US has 'significant work to do' in order to improve the country's public health defenses.

"Prior to this pandemic, our infrastructure within the agency and around the country was too frail to tackle what we confronted with Covid-19," she said. "To be frank, we are responsible for some pretty dramatic, pretty public mistakes — from testing, to data, to communications."

The CDC overhaul comes on the heels of the agency admitting that "unvaccinated people now have the same guidance as vaccinated people" - and that those exposed to COVID-19 are no longer required to quarantine.

Tyler Durden Wed, 08/17/2022 - 12:22

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Economics

Why Is No One at Nike Working This Week?

And will the move gain broader acceptance among American employers?

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And will the move gain broader acceptance among American employers?

You go into an office, pull at the door and find that it doesn't give and nobody's there. 

It may sound like the start of the common rushing-to-the-office-on-a-Saturday nightmare but, more and more, collective time off is being embraced by employees as part of a push for a better work culture.

While professional social media platform LinkedIn  (MSFT) - Get Microsoft Corporation Report and dating app Bumble  (BMBL) - Get Bumble Inc. Report had already experimented with collective time off for workers, the corporate ripples truly began with Nike  (NKE) - Get Nike Inc. Report.

In August 2021, the activewear giant announced that it was giving the 11,000-plus employees at its Oregon headquarters the week off to "power down" and "destress" from stress brought on by the covid-19 pandemic.

"In a year (or two) unlike any other, taking time for rest and recovery is key to performing well and staying sane," Matt Marrazzos, Nike's senior manager of global marketing science, wrote to employees at the time.

Nike Is On Vacation Right Now

The experiment was, not exactly unexpectedly, very well-received — a year later, the company instituted its second annual "Well-Being Week." Both the corporate headquarters in Beaverton, Ore., and three Air Manufacturing design labs with over 1,500 employees are closed for a collective paid vacation from Aug. 15 to 19.

"We knew it would be impactful, but I was blown away by the feedback from our teammates [...]," Nike's Chief Human Resources Officer Monique Matheson wrote in a LinkedIn post.

"Because everyone was away at the same time, teammates said they could unplug – really unplug, without worrying about what was happening back at the office or getting anxiety about the emails piling up."

Shutterstock/TheStreet

Of course, the time off only applies to corporate employees. To keep the stores running and online orders fulfilled but not exacerbate the differences between blue and white collar workers, Nike gave its retail and distribution employees a week's worth of paid days off that they can use as they see fit.

Nike has tied the change to its commitment to prioritize mental health. In the last year, it launched everything from a "marathon of mental health" to a podcast that discusses how exercise can be used to manage anxiety and depression.

Rippling Through the Corporate World?

But as corporations are often criticized for turning mental health into positive PR without actually doing much for employees, the collective week off was perhaps the most significant thing the company did for workers' mental health.

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The practice of set office closures has long been common practice in many European countries. In France, not only corporate offices but even restaurants and retail stores empty out over the month of August for what is culturally considered sacred vacation time. 

But as American work culture prioritizes individual choice and "keeping business going" above all else, the practice has been seen as radical by many corporate heads and particularly small businesses that may find it more difficult to have such a prolonged drop in business. 

But in many ways, the conversations mirror some companies' resistance to remote work despite the fact that one-fourth of white-collar jobs in the U.S. are expected to be fully remote by 2023

"This is the kind of perk that makes employees want to stay," industry analyst Shep Hyken wrote in a comment for RetailWire. "And knowing they can’t completely shut the entire company down, I like the way they are compensating the distribution and retail store employees."

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