It started when a friend of mine asked the question:
Question for those more financially savvy than I am: what is the economic logic behind taxing capital gains at a lower rate than regular income? It seems like the lower tax rate is intended to foster economic growth by encouraging investors to hold onto the asset(s) in question for longer, thus reducing market churn and encouraging long-term investment. Is that the sole reason?
What disturbed me about the ensuing discussion is a sentiment that comes up frequently when discussing Wall Street, “speculation”, high-frequency trading, banking, and just about any other finance related activity, industry, and profession.
One person expressed it this way:
Today [the capital gains tax rate] is also applied to short sells and other casino-like behavior where the asset is bought and resold in a matter of days or even hours and there is absolutely no justification for that.
Another person said it like this:
If you take money you have saved and invest it in a new company, like a VC investing in a new technology startup, this actually creates new jobs. This money should be taxed differently than plunking money down long term on something like…betting oil futures rise in the next year.
The problem is that our tax law treats the two the same. One reinvests capital into the economy to create jobs (good) the other shuffles it around (usually with insider information) to make sure that gains outpace infaltion. The other side effect of investing like this is that it ties capital up in a way that ensures no new jobs get created (bad).
For thousands of years, people have displayed open hostility to those who make money through finance. This has most frequently manifested itself through antisemitism and marxist anticapitalism, resulting in the murder of tens of millions across the globe.
Murder is out of fashion now, so it’s popular to advocate that certain undesirable individuals/professions be taxed to death. But the thinking is the same: if we could just stop certain people from trading in a certain way, all our economic woes would go away. History shows that this has never worked. And there is no reason to believe it ever will work.
Just because you don’t understand something doesn’t mean it doesn’t provide a ton of value. And just because you can’t see the effects of a policy or course of action doesn’t mean there aren’t any.
Anyway, here is my response to the original question:
Encourage investment. The lower the tax rate, the lower the returns need to be for a given investment to make sense. Warren Buffet has talked extensively about this.
Thus the ideal capital gains tax rate is zero, which would lead to significant job creation over time (with the caveat of point number 5 below). This means that it is entirely plausible that a zero capital gains rate would actually increase total government tax receipts as a result of income taxes on new jobs.
Avoid multiple taxation. In order to make investment income, all of these things must happens: a person must make money (which is taxed), invest that money in a corporation, the corporation must make money (which is taxed), the corporation must issue dividends to the individual (which is taxed). Thus, capital gains taxes actually represent triple taxation. Some will say this is fair because a small portion of people in this country have never worked and should pay through the nose. But it’s unfair to the overwhelming majority of people - think anyone who is on the verge of retirement and has dutifully contributed to retirement accounts for decades.
In a very narrow set of circumstances, the second tax (corporate tax) can be avoided, but that is very uncommon and not relevant to the original question.
Inflation. Lets say you invested $1,000 in Microsoft 10 years ago at about ~$25/share and you sold it today ~$31 for a total of $1240. Unfortunately, you just lost money because of inflation - according to the BLS , $1000 ten years ago is the same as $1275 today, resulting in a de fact loss of $35. Even more unfortunate, the federal government doesn’t care - you pay 15% tax on the raw $240 “profit”. This results in increasing your loss from $35 to $71.
It is easy to imagine situations where the capital gains tax could turn even a modest real gain into a real loss.
Capital gains disproportionately hurts seniors. Young people typically have very little investment income, but they can work long and hard and make money. Old people can’t and have to rely on whatever provision they made earlier in their lives.
All of that said, it doesn’t really matter in terms of institutional investment. There is an enormous body of work showing that temporary, whether actually temporary or perceived transience due to political volatility, tax rate cuts have almost no impact on invest decision making. Our current political/economic environment, where raising the capital gains tax is even merely discussed, is enough to massively deter investment. The only way to stimulate investment is through credibly permanent tax cuts.