Capital Gains

The lower tax rate on long-term capital gains has entered the national conversation. Last year Warren Buffett called for higher taxes on the "mega-rich."

The mega-rich pay income taxes at a rate of 15 percent on most of their earnings but pay practically nothing in payroll taxes.....The taxes I refer to here include only federal income tax, but you can be sure that any payroll tax for the 400 [with the most reported income] was inconsequential compared to income. In fact, 88 of the 400 in 2008 reported no wages at all, though every one of them reported capital gains.

Mitt Romney's tax returns showed that the bulk of his income is also derived from capital gains, and the argument raged anew. President Obama staked out his position in the State of the Union address:

Right now, because of loopholes and shelters in the tax code, a quarter of all millionaires pay lower tax rates than millions of middle-class households. Right now, Warren Buffett pays a lower tax rate than his secretary....But in return, we need to change our tax code so that people like me, and an awful lot of members of Congress, pay our fair share of taxes....Tax reform should follow the Buffett Rule. If you make more than $1 million a year, you should not pay less than 30 percent in taxes.

The taxation of capital gains raises issues of public policy (e.g., incentives for business investment, differential treatment of capital versus labor) and fairness (e.g., tax-rate progressivity, taxing the same income twice).

Clarity of the debate isn't helped by the inclusion of payroll taxes, which are a combination of tax, medical insurance, and savings plan, like an IRA or 401(k), for which one receives benefits later. There are even problems if we limit the discussion to the pure Federal income tax, where partisans either through ignorance or willful mischaracterization confuse marginal tax rates with effective rates. For example, in 2011 a family of four with no itemized deductions would pay Federal Taxes of $10,656 (14.5%) on Adjusted Gross Income of $100,000:

Adjusted Gross Income  $100,000
Standard Deduction      (11,600)
Exemptions  (4x$3,700)  (14,800)

Taxable Income          $73,600

Tax per Tax Tables      $10,656

The family's tax bracket is 25%--that is, the next dollar of income is taxed 25 cents--but its effective rate is 14.5%, which is lower than Mitt Romney and Warren Buffett's effective rate, excluding payroll taxes.

However this discussion plays out, one thing is certain: it's better for everyone, rich or poor, to have capital gains than not. My January 7th portfolio is performing extraordinarily well, thanks to Netflix. If these prices persist or even continue to rise during the next year, we'll have a nice long-term gain that we'll be happy to pay taxes on.