Right to Opine

There’s been a lot of overblown rhetoric coming from the Left lately about the capital gains tax. Even some big investors—like Warren Buffett—who know better have been banging their drums to raise the capital gains rate. To see why this is terribly wrong-headed we need to look at the purpose and impact of taxes and see how that relates to capital gains.

Taxes are imposed for two reasons. The first, and most obvious, is to generate revenue for the government. Everyone agrees that some level of taxation is requisite and reasonable in order to fund necessary government functions. The second, often overlooked, is to encourage or discourage specific behaviors.

Having recently moved from Arizona to North Carolina, I can attest to an obvious example of the complex interaction of these two purposes: cigarette taxes. Many states impose high taxes on cigarettes in order to discourage smoking. Arizona’s cigarette tax is $2 per pack, while North Carolina’s is $0.45. When AZ raised its rate from $1.18 to $2, total revenues from the tax fell as smokers quit. In NC, not only is the tax low, but practically everyone in the state lives within a mile of a tobacco farm—and smoking is rather prevalent. When NC initially raised its rate from $0.05 to $0.30, there was a drop in sales volume, but not enough to counter the tax increase—tax revenues increased marginally. Another interesting impact of taxation rears its head here: when NC raised its cigarette tax, sales increased significantly in neighboring South Carolina which, at the the time, maintained a $0.07 tax rate. I doubt that South Carolinians suddenly started smoking in droves—those sales were going north across the state line. In AZ, sales on Indian reservations—which do not tax tobacco—went up as well, mitigating the smoking cessation effect and leaching both cigarette and sales tax revenues from the state.

I use this as the near-perfect example because it highlights the tension between the purposes and effects of a tax. When tax rates are increased, there may be a corresponding increase in revenues, or there may be a decrease as demand for the underlying activity or product decreases. It may well be that the effect of decreasing smoking incidence is of greater societal benefit than the loss in revenue is detrimental. But that goal is diminished when demand can be met simply by taking business elsewhere. What is of importance here is not to discuss the cigarette tax specifically, but to see and understand the effects of tax increases.

Now let’s slide into the capital gains tax (CGT). Simply speaking, a capital gain is realized when an investor sells an interest in something (most often in the form of property or stocks, bonds, or fund shares in a business, or dividends) for an amount higher than he originally paid. Taxes on the gain are paid at 15% for long-term investments (reduced to 0% for the bottom two personal income tax brackets) or the personal rate for short-term investments (less than a year). Consider a simple example.

An investor buys into a company for $1000, and later sells for $2000. The capital gain is $1000, so at the current 15% rate, he would pay $150 in capital gains tax. That sounds like a screaming deal, right? The guy just walked off with an 85% return on his investment! This is exactly what the Left and their media tail-waggers want you to think. The problem is that they’ve left out a huge factor in the equation: time. If the sale were made relatively soon after the purchase, then the investor really did come out with a screaming deal. But the overwhelming majority of investments don’t double in value over a short period. In fact, when you look at the stock market as a whole you begin to see why financial advisors tell you to pick solid investments for the long-term. Suppose instead that the investor keeps his money in the company for a number of years. Well, if inflation were only 3% then in 17 years his initial $1000 has inflated to $1650 so his real gain from the sale is only $350. That same $150 tax is 43% of the real gain. If, as the Left wishes, we raise the capital gains rate to 35% to match the top personal rate of 35%, then his tax becomes $350 and completely swallows his real gain. In the end he’s only left with the money he started with at its new, inflated value.

One effect, then, of a capital gains increase is to make long-term investment less valuable. Mega-investors like Warren Buffett and George Soros are very well aware of this impact on the market, and use it to their advantage. Think of how often you read in the paper that one of those two just invested hundreds of millions of dollars in some particular venture—nearly every week. Billionaires like those two can afford to play more often in the medium-term market—and do—because they can afford to take the occasional significant loss. (Consider in particular that Soros made his name by shorting the pound in the U.K., contributing greatly to the crash of their monetary system.) Now you can see why Buffett has no problem raising the capital gains rate—because his investments are often of shorter term, they are less impacted by inflation. (Short enough to diminish the effect of inflation, but long enough to avoid the short-term CGT, which is the same as the higher personal income rate.)

The second effect of a capital gains increase is—as in the case of the cigarette tax—to move monetary transactions (and the profits they generate) elsewhere. Why do you think so many people worldwide sink their money into Asian, Caribbean, and South American banks and funds? Barbados, with no CGT, reportedly has over $25 billion in Canadian investments. Other growing economies with no CGT include Belize, the Cayman Islands and Jamaica and, on the other side of the Pacific: Hong Kong, Malaysia, and Singapore. Do you think it sheer coincidence that many of these are also major financial centers with investors from around the world? And even Brazil, with a CGT of 15%, stands to gain if we were to raise our rate to the Left’s envisioned 35%. Their economy is booming. Do you really think that if we raise our rate investors from both here and abroad will even hesitate to move their funds to Brazil? Get real.

You don’t improve an economy by undermining the capital base upon which growth is built. Before you buy into the class warfare rhetoric being spewed by the current denizens of the White House, consider the real purpose and effect of taxes and decide for yourself where the greater good of our nation lies.