6 ms·

Ordinary Income vs Capital Gains

31 points by cwan 15y ago

ulf 15y ago
The major problem with the much cheaper taxing of capital gains remains the growing inequality: Of every you dollar you earn through your own labor, you get less (until you pass the max threshold). And this while your capacity of personal labor is clearly somehow limited. On the other hand, people earning one million dollars from capital gains are taxed equally with people who earn one billion.
- triviatise 15y ago
  not saying if this is right or wrong, but with dividends at least, they are taxed first at the corporate rate and then again when they are distributed as dividends. Increases in equity on average, but not in the short term, coincide with accumulation of shareholders equity via retained earnings.
  - meric 15y ago
    >> they are taxed first at the corporate rate and then again when they are distributed as dividends. >> Really? Well that sucks. What logically should happen is if you receive dividends and the company already paid 30% tax on it, and your personal tax rate is 45%, you should pay only the extra 15% tax. (And it does happen over here in Australia). Otherwise what you get is that companies, in shareholder's interest, try not to give out so much dividends because they will be taxed twice. Instead they keep the cash to boost the share price so shareholders make capital gains. You'd ask, what is really the point of buying stock in a company that will never pay dividend in its lifetime?
    - yummyfajitas 15y ago
      You'd ask, what is really the point of buying stock in a company that will never pay dividend in its lifetime? They can distribute profits via share buybacks. Instead of distributing 1% of the companies value as dividends, they can buy back 1% of shares. You then have the option of selling 1% of your shares back (equivalent to taking dividends) or keeping your shares (equivalent to reinvesting dividends). This only works if you are a big shareholder - if you are a small time player on ETrade, transaction costs will kill this idea.
      - _delirium 15y ago
        That's in practice what happens, but it does make for a bit of strangeness from the perspective of fundamental valuations. At least in idealized theory, a stock is worth the time-discounted value of its future dividends plus any terminal liquidation payout (if the company eventually gets sold for cash). A share buyback increases the share of a company that a given stockholder owns, by getting rid of some of the other outstanding shares. That should make the share more valuable, because it's now entitled to a larger percentage of those future earnings... but raising the percentage of future earnings you're entitled to is only valuable if there are any! So either there have to eventually be some dividends or a cash sale, or else we have to abandon that view of valuation as having any tie to future earnings.
        yummyfajitas 15y ago
        Share buybacks and dividends are mathematically equivalent: 1% share buyback when you own 100 shares (price=$100) -> $100 cash in your hands + 99 shares valued at $100/share. 1% of corporate value distributed as dividends -> $100 cash in your hands + 100 sharesvalued at $99 (since 1% of corporate value was given away).
    - roel_v 15y ago
      "What logically should happen is if you receive dividends and the company already paid 30% tax on it, and your personal tax rate is 45%, you should pay only the extra 15% tax. (And it does happen over here in Australia)." I was skeptical of this claim but Wikipedia confirms - that's an interesting scheme. It basically eliminates taxation as a decision factor in incorporating a company or not. That's interesting, I never heard of such a construct before, although it's quite obvious. In most of Western Europe, there are different rates for dividend and income tax. So if you own a company, the company first pays e.g. 20% 'profit tax' on it, and then you pay 25% on the dividends; in the end, roughly coming out to the same marginal highest tax bracket for the income tax.
- cynicalkane 15y ago
  There are two counterpoints to this. The first is that capital gains taxes tend to be on investments made with income you've earned, so there's already been an income tax. The second is almost all of the uber-rich made their fortunes by growing a small company into a big one, so it's not as though they're already being taxed (through progressive corporate taxes). There are obvious flaws to this scheme, but it's pretty hard to tax income in a fair way. Some places (notably the EU) favor using a consumption tax instead.
  - _delirium 15y ago
    > The first is that capital gains taxes tend to be on investments made with income you've earned, so there's already been an income tax. I don't really get this counterpoint; isn't everything in the economy a flow of money that has been taxed at a previous point in the flow? If I have $100,000 that I've already paid taxes on, I could invest it in external assets and hope to make capital gains on them; or I could plow it back into my own occupation and use it to generate income (say, by setting up an art studio). Why should I pay more taxes in the second case? Consider two eBay-painting-seller scenarios. In the first, I buy painting materials, paint paintings, and then sell them on eBay. In the second, I buy existing paintings on eBay that I think are underpriced, and then resell them later for a profit. Why should I pay more taxes in the first case, just because I painted the paintings? In both cases my occupation is basically "selling paintings on eBay", but in one I'm creating new ones and selling them for an income, and in the other I'm flipping existing paintings, making a capital gain. In both cases the starting capital is money I've already paid taxes on. If anything, the first occupation seems like the one policy should encourage, rather than the second, but at the very least I don't see any reason to actively encourage the second version over the first.
    - cynicalkane 15y ago
      I am not a tax lawyer, but my understanding is that capital gains only count as such if you've held the asset for at least a few years. By the way, in the first case, your outlays are tax-deductible. (edit: I'm not an expert, so downvoters, please explain your disagreement.)
deleted 15y ago
[deleted]
spenrose 15y ago
The thrust of this post is wrong; while I'm looking for a good breakdown of tax burden by quintile I'll just observe: "We live in NYC and according to our accountants, we pay a marginal fully loaded tax rate of 47.62%. That means we keep about half of the ordinary income the Gotham Gal and I generate." The second sentence glides over the key word in the first sentence, "marginal". AVC and GG pay much lower rates on the first income they earn during the year -- it is only the income that exceeds what most people will ever earn during a year that is taxed at the higher income rate. Conversely, the first income -- the income they have in common with ordinary people -- is subject to social security and unemployment tax -- but the extraordinary income that makes them very wealthy is not. They also probably pay much less of their income in sales tax and small fees that most Americans. Finally, according to the IRS in several recent years 10% of the capital gains income in the entire country has gone to the richest 400 tax payers, whose average tax rate is not the 47% rate AVC cites, but 17%: http://krugman.blogs.nytimes.com/2011/04/30/who-benefits-from-bubbles/ http://krugman.blogs.nytimes.com/2011/04/30/who-benefits-fro... Edit: here's total tax distribution by quintile: http://curiouscapitalist.blogs.time.com/2009/01/07/moving-from-judd-greggs-dubious-tax-math-to-robert-reichs-dubious-tax-language/ http://curiouscapitalist.blogs.time.com/2009/01/07/moving-fr... . Note that the 34.5% paid by the richest 20% drops sharply for the very richest.
- yummyfajitas 15y ago
  Yes, instead of paying taxes directly, the corporations owned by those 400 taxpayers paid taxes on profits (15-35%). Then their owners paid an additional 15-35% tax on those profits (averaging out to 17% for the top 400). I agree - we should make it fairer. We should eliminate taxes on corporations and replace it with taxes on their owners. It's unfair that the owners of corporations are taxed at such high rates, but the taxes they pay are ignored by journalists and propagandists.
  - yequalsx 15y ago
    When dealing with corporate tax rates one should talk about effective tax rate. There are quite a few examples of corporations paying very little tax on their profits. Some even pay zero tax whilst making billions in profit. I believe that the effective tax rate on U.S. corporations is roughly the industrialized nation average. Having no corporate tax would make the U.S. an outlier in terms of tax policy. This doesn't make it unsound but does make me hesitant to agree with you on this point. Are the tax policies of most nations unfair to corporations? I have a hard time believing this to be so. Imagine a business with one owner. The owner employs 5 workers. Shouldn't the business pay tax on the profits? Suppose the business owner makes a profit of $100,000. Should this be tax free because he/she owns a business? If the business owner made $100,000 while working at 3M then the salary (profit) would be taxed. I think the philosophy under girding the tax system is that, roughly speaking, any entity that gets money [edit] should pay tax on it. This seems fair to me. There are notable exceptions of course. If I find $5 million dollars in gold while on a walk I pay tax on the whole amount. If I get the money because someone died I don't.
jbellis 15y ago
Note that many states, including California, tax capital gains at the same rate as ordinary income.
gopi 15y ago
Most of the small business in US are pass thro entities so they pay ordinary income tax rates and also they reinvest the money back into business. They are inherently non-scalable business so the owners don't realize wealth by selling the business instead they get it thro the profits from operating the business... IMO, its not ethical that his tax rate is double than that of a tech entrepreneur or a wall street hedge fund guy. My personal preference would be a lower overall rate (25%) with no deductions for both ordinary income and capital gain. For a brief time in US history (in the Reagan administration) this was the case and from what i read it never discouraged capital investment.
kleiba 15y ago
> And when you go to the pay window [...], you will be sharing a lot less with the government and keeping a lot more. Ever used a road? Or went to a public school? Do you have a local library? Your tax money doesn't go to the government, it goes to the state. And yes, the state has an expensive administration, but by and large the state is all of us.
- dpatru 15y ago
  Roads are paid for with gas taxes, something that is hard to avoid if you drive. Public schools and libraries are supported by property taxes, again, something all residents pay. Income taxes primarily go to the federal government to pay for military bases abroad, wars, and a lot of other functions that either aren't needed or could be better done by non-government entities.
  - maigret 15y ago
    Interesting. In Germany, the law states that taxes can't be bound to a certain goal. Taxes all go to a big budget basket, which is then allocated by the year budget. It means that the oil tax can finance school, military, or anything.
- orijing 15y ago
  Most of your taxes to the federal government actually get spent for Medicare, Medicaid, Social Security, Defense and Interest expense. Unfortunately, just Medicare, Social Security and interest expense cost over 2.4 trillion dollars. And yes, that's more than the 2 trillion that the government makes... And we haven't even paid for the actual services and defense! [1] http://www.nytimes.com/packages/html/newsgraphics/2011/0119-budget/index.html?hp&ref=politics http://www.nytimes.com/packages/html/newsgraphics/2011/0119-...
dbfclark 15y ago
Several points from a NYC taxpayer: 47.62% is the top marginal fully loaded tax rate on ordinary income. That is, 35% individual federal plus 8.97% state tax plus 3.88% city, less rounding and maybe a few dollars of unused credits. This is the rate on the next dollar of ordinary income (and the number you use if you wish to maximize your claimed tax rate). The claimed capital gains number of 27.63% is 15% plus that same amount for state and local taxes, which do not treat capital income differently (the .62% on the end of both is the giveaway). Neither of these numbers is an effective tax rate (=tax actually paid/pretax income), or "tax pressure," whatever that is -- at my guess, Mr. Wilson probably pays effective tax in the 30-40% range, depending on how much capital gains he realized in the year. On capital gains rates generally, tax does work on the margins, but this means that we should worry about what kind of investments are incentivized by lower capital gains rates. I seriously doubt that a Mr. Wilson taxed at the regular income rate for capital gains would put even one fewer dollar into his fund, making 20+% pretax, if his other choice were, as he says, the mattress making 0%. Even at equal income and capital gains rates, the incentive to maximize your returns is pretty strong, so the idea that the differential rate is changing behavior in a useful way needs more analysis than Mr. Wilson gives it. For corporate taxes, effective rates are indeed what matters when comparing tax burdens since corporations get such a variety of credits; that said, the fewer deductions/lower rates tradeoff is free economic growth and we should do it (it'll never happen, though, since congress is too dysfunctional). And last on "double taxation": gopi is right that most corporations are organized as passthrough entities -- they pass all income through to their owners, who then pay tax on it. Those that aren't do have lower taxation of dividends to make up for the equivalence of share buyback and dividends.
truthtechnician 15y ago
Taxing income higher than capital gains encourages investment over consumption.

31 points by cwan 15y ago

ulf 15y ago

The major problem with the much cheaper taxing of capital gains remains the growing inequality: Of every you dollar you earn through your own labor, you get less (until you pass the max threshold). And this while your capacity of personal labor is clearly somehow limited. On the other hand, people earning one million dollars from capital gains are taxed equally with people who earn one billion.

triviatise 15y ago
not saying if this is right or wrong, but with dividends at least, they are taxed first at the corporate rate and then again when they are distributed as dividends. Increases in equity on average, but not in the short term, coincide with accumulation of shareholders equity via retained earnings.
- meric 15y ago
  >> they are taxed first at the corporate rate and then again when they are distributed as dividends. >> Really? Well that sucks. What logically should happen is if you receive dividends and the company already paid 30% tax on it, and your personal tax rate is 45%, you should pay only the extra 15% tax. (And it does happen over here in Australia). Otherwise what you get is that companies, in shareholder's interest, try not to give out so much dividends because they will be taxed twice. Instead they keep the cash to boost the share price so shareholders make capital gains. You'd ask, what is really the point of buying stock in a company that will never pay dividend in its lifetime?
  - yummyfajitas 15y ago
    You'd ask, what is really the point of buying stock in a company that will never pay dividend in its lifetime? They can distribute profits via share buybacks. Instead of distributing 1% of the companies value as dividends, they can buy back 1% of shares. You then have the option of selling 1% of your shares back (equivalent to taking dividends) or keeping your shares (equivalent to reinvesting dividends). This only works if you are a big shareholder - if you are a small time player on ETrade, transaction costs will kill this idea.
    - _delirium 15y ago
      That's in practice what happens, but it does make for a bit of strangeness from the perspective of fundamental valuations. At least in idealized theory, a stock is worth the time-discounted value of its future dividends plus any terminal liquidation payout (if the company eventually gets sold for cash). A share buyback increases the share of a company that a given stockholder owns, by getting rid of some of the other outstanding shares. That should make the share more valuable, because it's now entitled to a larger percentage of those future earnings... but raising the percentage of future earnings you're entitled to is only valuable if there are any! So either there have to eventually be some dividends or a cash sale, or else we have to abandon that view of valuation as having any tie to future earnings.
      - yummyfajitas 15y ago
        Share buybacks and dividends are mathematically equivalent: 1% share buyback when you own 100 shares (price=$100) -> $100 cash in your hands + 99 shares valued at $100/share. 1% of corporate value distributed as dividends -> $100 cash in your hands + 100 sharesvalued at $99 (since 1% of corporate value was given away).
  - roel_v 15y ago
    "What logically should happen is if you receive dividends and the company already paid 30% tax on it, and your personal tax rate is 45%, you should pay only the extra 15% tax. (And it does happen over here in Australia)." I was skeptical of this claim but Wikipedia confirms - that's an interesting scheme. It basically eliminates taxation as a decision factor in incorporating a company or not. That's interesting, I never heard of such a construct before, although it's quite obvious. In most of Western Europe, there are different rates for dividend and income tax. So if you own a company, the company first pays e.g. 20% 'profit tax' on it, and then you pay 25% on the dividends; in the end, roughly coming out to the same marginal highest tax bracket for the income tax.
cynicalkane 15y ago
There are two counterpoints to this. The first is that capital gains taxes tend to be on investments made with income you've earned, so there's already been an income tax. The second is almost all of the uber-rich made their fortunes by growing a small company into a big one, so it's not as though they're already being taxed (through progressive corporate taxes). There are obvious flaws to this scheme, but it's pretty hard to tax income in a fair way. Some places (notably the EU) favor using a consumption tax instead.
- _delirium 15y ago
  > The first is that capital gains taxes tend to be on investments made with income you've earned, so there's already been an income tax. I don't really get this counterpoint; isn't everything in the economy a flow of money that has been taxed at a previous point in the flow? If I have $100,000 that I've already paid taxes on, I could invest it in external assets and hope to make capital gains on them; or I could plow it back into my own occupation and use it to generate income (say, by setting up an art studio). Why should I pay more taxes in the second case? Consider two eBay-painting-seller scenarios. In the first, I buy painting materials, paint paintings, and then sell them on eBay. In the second, I buy existing paintings on eBay that I think are underpriced, and then resell them later for a profit. Why should I pay more taxes in the first case, just because I painted the paintings? In both cases my occupation is basically "selling paintings on eBay", but in one I'm creating new ones and selling them for an income, and in the other I'm flipping existing paintings, making a capital gain. In both cases the starting capital is money I've already paid taxes on. If anything, the first occupation seems like the one policy should encourage, rather than the second, but at the very least I don't see any reason to actively encourage the second version over the first.
  - cynicalkane 15y ago
    I am not a tax lawyer, but my understanding is that capital gains only count as such if you've held the asset for at least a few years. By the way, in the first case, your outlays are tax-deductible. (edit: I'm not an expert, so downvoters, please explain your disagreement.)

deleted 15y ago

[deleted]

spenrose 15y ago

The thrust of this post is wrong; while I'm looking for a good breakdown of tax burden by quintile I'll just observe: "We live in NYC and according to our accountants, we pay a marginal fully loaded tax rate of 47.62%. That means we keep about half of the ordinary income the Gotham Gal and I generate." The second sentence glides over the key word in the first sentence, "marginal". AVC and GG pay much lower rates on the first income they earn during the year -- it is only the income that exceeds what most people will ever earn during a year that is taxed at the higher income rate. Conversely, the first income -- the income they have in common with ordinary people -- is subject to social security and unemployment tax -- but the extraordinary income that makes them very wealthy is not. They also probably pay much less of their income in sales tax and small fees that most Americans. Finally, according to the IRS in several recent years 10% of the capital gains income in the entire country has gone to the richest 400 tax payers, whose average tax rate is not the 47% rate AVC cites, but 17%: http://krugman.blogs.nytimes.com/2011/04/30/who-benefits-from-bubbles/ http://krugman.blogs.nytimes.com/2011/04/30/who-benefits-fro... Edit: here's total tax distribution by quintile: http://curiouscapitalist.blogs.time.com/2009/01/07/moving-from-judd-greggs-dubious-tax-math-to-robert-reichs-dubious-tax-language/ http://curiouscapitalist.blogs.time.com/2009/01/07/moving-fr... . Note that the 34.5% paid by the richest 20% drops sharply for the very richest.

yummyfajitas 15y ago
Yes, instead of paying taxes directly, the corporations owned by those 400 taxpayers paid taxes on profits (15-35%). Then their owners paid an additional 15-35% tax on those profits (averaging out to 17% for the top 400). I agree - we should make it fairer. We should eliminate taxes on corporations and replace it with taxes on their owners. It's unfair that the owners of corporations are taxed at such high rates, but the taxes they pay are ignored by journalists and propagandists.
- yequalsx 15y ago
  When dealing with corporate tax rates one should talk about effective tax rate. There are quite a few examples of corporations paying very little tax on their profits. Some even pay zero tax whilst making billions in profit. I believe that the effective tax rate on U.S. corporations is roughly the industrialized nation average. Having no corporate tax would make the U.S. an outlier in terms of tax policy. This doesn't make it unsound but does make me hesitant to agree with you on this point. Are the tax policies of most nations unfair to corporations? I have a hard time believing this to be so. Imagine a business with one owner. The owner employs 5 workers. Shouldn't the business pay tax on the profits? Suppose the business owner makes a profit of $100,000. Should this be tax free because he/she owns a business? If the business owner made $100,000 while working at 3M then the salary (profit) would be taxed. I think the philosophy under girding the tax system is that, roughly speaking, any entity that gets money [edit] should pay tax on it. This seems fair to me. There are notable exceptions of course. If I find $5 million dollars in gold while on a walk I pay tax on the whole amount. If I get the money because someone died I don't.

jbellis 15y ago

Note that many states, including California, tax capital gains at the same rate as ordinary income.

gopi 15y ago

Most of the small business in US are pass thro entities so they pay ordinary income tax rates and also they reinvest the money back into business. They are inherently non-scalable business so the owners don't realize wealth by selling the business instead they get it thro the profits from operating the business... IMO, its not ethical that his tax rate is double than that of a tech entrepreneur or a wall street hedge fund guy. My personal preference would be a lower overall rate (25%) with no deductions for both ordinary income and capital gain. For a brief time in US history (in the Reagan administration) this was the case and from what i read it never discouraged capital investment.

kleiba 15y ago

> And when you go to the pay window [...], you will be sharing a lot less with the government and keeping a lot more. Ever used a road? Or went to a public school? Do you have a local library? Your tax money doesn't go to the government, it goes to the state. And yes, the state has an expensive administration, but by and large the state is all of us.

dpatru 15y ago
Roads are paid for with gas taxes, something that is hard to avoid if you drive. Public schools and libraries are supported by property taxes, again, something all residents pay. Income taxes primarily go to the federal government to pay for military bases abroad, wars, and a lot of other functions that either aren't needed or could be better done by non-government entities.
- maigret 15y ago
  Interesting. In Germany, the law states that taxes can't be bound to a certain goal. Taxes all go to a big budget basket, which is then allocated by the year budget. It means that the oil tax can finance school, military, or anything.
orijing 15y ago
Most of your taxes to the federal government actually get spent for Medicare, Medicaid, Social Security, Defense and Interest expense. Unfortunately, just Medicare, Social Security and interest expense cost over 2.4 trillion dollars. And yes, that's more than the 2 trillion that the government makes... And we haven't even paid for the actual services and defense! [1] http://www.nytimes.com/packages/html/newsgraphics/2011/0119-budget/index.html?hp&ref=politics http://www.nytimes.com/packages/html/newsgraphics/2011/0119-...

dbfclark 15y ago

Several points from a NYC taxpayer: 47.62% is the top marginal fully loaded tax rate on ordinary income. That is, 35% individual federal plus 8.97% state tax plus 3.88% city, less rounding and maybe a few dollars of unused credits. This is the rate on the next dollar of ordinary income (and the number you use if you wish to maximize your claimed tax rate). The claimed capital gains number of 27.63% is 15% plus that same amount for state and local taxes, which do not treat capital income differently (the .62% on the end of both is the giveaway). Neither of these numbers is an effective tax rate (=tax actually paid/pretax income), or "tax pressure," whatever that is -- at my guess, Mr. Wilson probably pays effective tax in the 30-40% range, depending on how much capital gains he realized in the year. On capital gains rates generally, tax does work on the margins, but this means that we should worry about what kind of investments are incentivized by lower capital gains rates. I seriously doubt that a Mr. Wilson taxed at the regular income rate for capital gains would put even one fewer dollar into his fund, making 20+% pretax, if his other choice were, as he says, the mattress making 0%. Even at equal income and capital gains rates, the incentive to maximize your returns is pretty strong, so the idea that the differential rate is changing behavior in a useful way needs more analysis than Mr. Wilson gives it. For corporate taxes, effective rates are indeed what matters when comparing tax burdens since corporations get such a variety of credits; that said, the fewer deductions/lower rates tradeoff is free economic growth and we should do it (it'll never happen, though, since congress is too dysfunctional). And last on "double taxation": gopi is right that most corporations are organized as passthrough entities -- they pass all income through to their owners, who then pay tax on it. Those that aren't do have lower taxation of dividends to make up for the equivalence of share buyback and dividends.

truthtechnician 15y ago

Taxing income higher than capital gains encourages investment over consumption.