Labyrinth of Capital Gains Tax Policy : RE: I need some economic s tutoring

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From: Zhang, Yangkun (Yangkun.Zhang@FMR.COM)
Date: Mon Oct 16 2000 - 08:59:26 PDT

> OK, I understand the usual argument about why capital gains taxation
> is bad -- discourages investment, etc. However, what if I bought a
> business in 1981, and for earnings of $1M/yr at 14% interest rates


> From that scenario, I have to wonder why we bother trying to color
> dollars -- isn't calling some income income, and other income capital
> gains, just as bad as calling some income usury, and other income
> return for forex risk? (as practiced by medieval accountant ninjas)

You're absolutely correct in your assessment. Capital gains should
theoretically be taxed no differently from that of normal income. However,
since (to paraphrase Mr. Greenspan) the most efficient capital gains tax
rate is zero, and since getting a zero income tax rate (i.e., repeal of the
16th Amendment) is next to impossible, a good compromise is a lower capital
gains tax structure than that of normal income. A good book to read on the
topic is

 The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed by
Leonard E. Burman: ISBN: 0815712707

When Clinton first got elected, he had many Republican supporters. Why was
this? According to Red Herring:

After further investigation, we have learned that many of Mr. Clinton's
Republican supporters were able to accept their economic differences with
the candidate because he had at least promised to support a scaled down
capital gains tax cut for investments in start-up businesses.

Historically, whenever the capital gains tax rate has been lowered,
institutional investors have poured more money into private venture capital
pools, and individual "angel" investors have committed more capital to small
growth companies. Congress lowered the capital gains tax rate across the
board from 50% to 28% in 1978, and to 20% in 1980. In the eight years after
the cut, the venture industry took in close to $20 billion of institutional
capital to invest in new companies. The per annum figure of new capital
invested climbed from $200 million raised in 1978 to a high of $4.2 billion
in 1986. Conversely, in 1986, when the Tax Reform Act eliminated the capital
tax differential, institutional venture capital investments in new
developing companies plummeted to under $1 billion by 1992. According to the
National Venture Capital Association, individual investors typically provide
over 90% of the start-up capital to small companies. The 1986 tax changes
also steered these investors away from making long-term, high risk

Of course, Clinton reneged on his capital gains tax cut, and an actual
capital gains cut was not implemented until the Republican congress got
elected and Newt pushed through his TRA (Taxpayer's Relief Act) 97. Note
that Reagan was actually who RAISED the capital gains tax rate in 1986, in
part causing the crash of 87. Reagan, unfortunately, listened way too much
to these traditionally (i.e., Keynesian trained) economists. That was the
only Reagan economic misstep.

On a side note: it is not helpful to claim that the GOP is necessarily good
for economics or the Dem bad for economics. Before Reagan, the biggest tax
cutter was JFK, and the one who implemented the most "progressive" (read,
confiscatory) was Nixon, who tried to wage war on the rich via the AMT
(Alternate Minimum Tax) and crushed the whole economy in the process.
However, RIGHT NOW, Bush's economic plan does seem a lot better than Gore's.
Again, to paraphrase Mr. Greenspan--the best thing to do is to pay down the
debt (which neither candidate wants to do), but the next best thing is a
huge tax cut (which is what Mr. Bush wants) and the worst thing is to have
the government spend it all on entitlement programs (which is what Mr. Gore

> Why wouldn't uniform taxation let the market decide which risky
> investments were worth making? Isn't the current system just a
> legislatively imposed bias? (in which case the optimal economic
> policy for the United States would be to abolish the tax category
> entirely?)

Again, you're absolutely right. Except that what you're proposing seems to
be politically unacceptable to the mass public, who, unfortunately, seems to
have no interest in economics--even though it affects each one of us. I
would certainly like to see a Kemp/Forbes/Armey style 20% flat tax (with
$30,000 exemption for families--so it is actually progressive) or a
consumption tax. But considering what vehement opposition I've heard from
the public on Talk of the Nation's (go to, and do a search on "flat
tax") programs on the flat tax, it will never get passed. It's a great idea,
but the public always seems to think that no taxation on dividends means
that it doesn't get taxed. It's not true of course, since dividends are
already taxed as corporate income--but have you ever tried to explain the
tax system to the unwashed masses? They won't understand it--and they fall
prey easily to ludicrous concepts of progressively confiscatory taxation
policies. If you think I'm wrong, try explaining to anyone the difference
between relatively simple concept of Incentive Stock Options versus
Non-Qualified Stock Options and who pays what taxes and when. I suspect (and
USA Today apparently back me up on this) that most people who get stock
options 1) do not know what type of options they have, and 2) do not know
the tax implications thereof.

In case you're wondering, the cost of incentive options (i.e., the
difference between the strike price and the exercise price) has to be
charged against corporate income, but you do not pay taxes on it under
exercise time, and if you held it for more than a year, you get long term
gains treatment (20%, or 18% for shares held after Jan 1, 2001 for more than
5 years) with the possibility of invoking the AMT (no thanks to Nixon!).
Nonqualified options, on the other hand, do not have to be charged against
corporate income for ACCOUNTING PURPOSES, and yet the corporation still gets
to deduct the cost against their income for tax purposes! You, on the other
hand, foots the entire tax bill AS NORMAL INCOME, to the full federal rate
of 39.6%! Needless to say, unless you're a big-shot or a founder, you
typically get non-qualified options. And this, my friend, is an example of a
SIMPLE RULE in our tax structure. Just imagine what a complex one would

> Can immigration really have that much effect on the distribution as
> a whole? At under a million per year, into a country of 270 million,
> it seems unlikely that immigrants account for 20-30% of the entire
> population having no significant net worth. (has this changed in
> the last 7 years? anyone know where I can find more recent data?)

Well, a million may be the official figures, but I can't imagine how they
calculate the total amount of illegal immigration--I suspect the figures are
higher than that. But even assuming a million a year, over the period of 10
years that would be 10 million people (assuming no emigration, whose
statistics are also fuzzy). If these immigrant have little to no net worth,
and if you add these to the approximately 4% of the population deemed
"structurally unemployed", then that would give you about 6-7% or so of the
population with very little or no income. Certainly, that would drag down
the bottom quintile. It is not necessary that the entire, or even a large
proportion of the bottom quintile are immigrants (illegal or otherwise),
only that a significant amount of immigrants have little or no (reported)

> Does anybody ever account for age in these quintile things? As far

Actually, now that you mentioned it--I have seen a study (which I can't
find) which DOES account for age. As one would expect, young people are
poor, and old people are rich. :-)

> of three or so either way). Shouldn't we be measuring income
> mobility relative to age cohorts, rather than averaged over the
> population as a whole?

Yes, you're right--we SHOULD be doing that. But then again, the Citizens for
Tax Justice wouldn't care either way. A lot of "progressive" organizations
seems hell bent on keeping the quintiles alive and well.

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