Tuesday, September 20, 2011

Capital Games: Buffet BS.

The new proposal to "close loopholes" that allow "rich people" like Warren Buffet to pay a lower (capital gains) tax rate than his secretary pays (on current earned income) offers an enlightened Republican response that is not only reasonable, but ought to be supported by a broad base of the electorate.

The problem with comparing long-term capital gains apples to other income oranges is that the former treats purely paper "gains" as if they were real. Let's try a hypothetical example to flesh this out:

Suppose that ten years ago, I bought shares in a European company at €100/share. On the exact same day, a German citizen also bought shares at that same price. (Over the intervening years, we may or may not have gotten dividends from the company, in which case we'd have paid taxes on those dividends. Whether we did or not has no real bearing on the rest of this.) Today, we each sell our shares, at exactly €100/share. We didn't make any long-term capital gain on our shares, but we didn't lose any either.

But wait. In the intervening decade, the US Dollar lost value against the Euro. My broker puts $150 into my account for every share I sold. (A "low" inflation rate of just over 4% is all it takes to erode 50% of the purchasing power of a unit of currency in just ten years.) And now the IRS tells me I have to pay tax on that $50/share "profit". Never mind that $150 today isn't worth any more than $100 ten years ago.

Why should I be taxed for my $50/share "profit" when I have not really profited at all. My German counterpart pays no tax for two reasons: First, the Bundeszentralamt für Steuern (Federal Central Tax Office) would not consider him to have made a profit by selling for precisely what he'd originally paid for the asset. Secondly, Germany taxes capital gains at the rate of ZERO.

Now, my proposal is not to calculate capital gains in Euros or any other currency that gains and loses value. Instead, I propose that real capital gains on assets held over a year be taxed at the same rate as any other income, but that the calculation of what actually constitutes a "gain" in the first place.

A slight increase in complexity of calculating the profit/loss for an asset held over a year is required: The taxpayer should be allowed to refer to a published table of an appropriate inflation index (such as CPI) to calculate what tax codes call a "stepped-up basis" in the asset: The taxpayer would be allowed to subtract the value in current dollars of their original investment.

What would the effect be of this proposal? For assets held just a few years that appreciate very quickly, the effective tax rate could actually go up a bit from what people are currently paying, but for assets held for a longer time, it will go down or even be eliminated in the case of assets that do not gain any real value. I don't know whether it would be revenue-neutral, but it would be a fairer way to tax capital gains, and it would encourage people to make long-term investments, which should be good for the economy.

I do know this: it would deprive the Left of one of their big class-warfare weapons. They could no longer point to "special loopholes for rich people" to gain votes. It would also deprive the government of the perverse incentive to print too much money, debase the currency, and get to collect tax on inflationary "gains".

And because Warren Buffet makes a lot of money on capital gains, he ought to get his wish, and pay a higher rate.
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