If we could ever get our left wing friends to stop salivating at the thought of sticking it to the rich long enough to focus on what is good for the American economy as a whole, we might get them to concede that we should decrease or eliminate the capital gains tax.
The Tax Policy Blog has published a post written by Steven Pahuskin and Lawrence Summers which summarizes the arguments of two of America’s leading economists that capital gains taxes are, a) bad for the economy; and b) possibly unconstitutional:
Dr. Daniel Mitchell – Capital gains taxes impede economic growth and, therefore, are immoral
Dr. Mitchell first explained that capital gains taxation discourages savings by favoring consumption of disposable income. People who invest their disposable income, which has already been taxed under the income tax, are taxed through the capital gains tax, the dividends tax, and eventually the death/estate tax. These extra taxes encourage taxpayers to use their money quickly rather than saving their money for long-term economic prosperity and growth.
Mitchell also argued that the capital gains tax is a form of preemptive double taxation. When an individual or corporation performs a service or sells a good, the money received is generally considered taxable income. Any after-tax income used to invest is taxed again upon realized gains. By taxing the investor’s income twice, the government double-dips and potentially deters investment and savings.
Dr. Richard W. Rahn – Capital gains taxes are unconstitutional under the 16th amendment
Dr. Rahn took Mitchell’s analysis a step further. He argued that capital gains taxation is unconstitutional under the 16th Amendment.¹ The 16th Amendment states that “the congress shall have the power to lay and collect taxes on income, from whatever source derived…” [emphasis added]. Rahn pointed out that capital gains are not considered income under any definition of the word, in any dictionary, or any IRS definition.
Rahn also argued that capital gains taxes are effectively a tax on inflationary gains, nominal changes that do not reflect real accumulation of wealth. In the event that the investment does not outperform inflation, the government is taxing twice on a loss instead of a profit. Therefore, imposing a tax on capital gains is an overreaching and unconstitutional exercise of Congress’s power to tax.
Mitchell and Rahn – Lowering or eliminating the capital gains tax would increase government revenue
Both Mitchell and Rahn argued that the government would raise more revenue if it decreased or repealed capital gains taxation. In 1977, capital gains were taxed at 40% and the IRS collected $7.8 billion, compared to $122 billion with a 15% rate in 2007. Even after factoring in inflation and other economic factors, the government collected more revenue with the lower rate.
The decrease in rate created incentives for investors to inject more money into the economy, thereby expanding the tax base. Decreased capital gains tax rates also provide disincentives to wealthy investors in avoiding or evading the tax, increasing the amount of revenue generated by the capital gains tax.
There is ample evidence that low capital gains rates stimulate economic growth, but I have never heard the argument that a tax on capital gains is unconstitutional.
And when Mr. Rahn says that the word income has not been defined to include capital gains “under any definition of the word, in any dictionary, or an IRS definition” he is plain wrong.
Here’s the operative section of the Internal Revenue Code (emphasis added):
Section 61: Gross Income defined
(a) General definition – Except as otherwise provided in this subtitle, gross income means
all income from whatever source derived, including (but not limited
to) the following items:(1) Compensation for services, including fees, commissions,
fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.
Number 3, above – gains derived from dealings in property – sounds like capital gains to me.
Perhaps Rahn could sell a capital asset in 2010 and intentionally fail to pay the tax on the gain.² Then, when the IRS audits his return and issues a Notice of Deficiency, he could challenge in the courts the legality of the capital gains tax.
He won’t win, though, because the word “income” as used in the tax code has historically been given the broadest of definitions by the courts.
Footnotes:
¹ The sixteenth amendment states:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
² Rahn should attach a disclosure to his return stating that he is taking this questionable position. This will prompt the IRS dispute he seeks and insulate him from a charge of tax fraud or evasion.
5 responses so far ↓
1 Knox Marlow // Jun 4, 2010 at 3:58 pm
The distinction between “capital gain” and “ordinary income” is completely arbitrary. The fact that people spend so much time, effort and resources arguing that capital gains should be taxed at lower rates (or vice versa) is a symptom of our terminally ill tax regime.
Although we don’t all have significant “investment capital” (cash), we all have some amount of “intellectual capital” (job-specific know how). Obviously, certain individuals possess more (or more valuable) intellectual capital than others. However, all of us who perform services for a living (lawyers, teachers, plumbers, bus drivers, etc.) are “monetizing” our accumulated intellectual capital.
I see no reasonable basis to distinguish the tax treatment of returns on intellectual capital and investment capital, respectively. We could significantly improve our tax system by eliminating the distinction between capital gains and ordinary income, and then (critically important) LOWERING individual income tax rates. (I would also reform the corporate income tax rules to eliminate, as far as possible, the double taxation imposed on corporate income.)
Note: I believe taxes hamper growth and distort economic decisions, so we need to downsize government spending (and the relentless pressure for increased tax revenue). However, in my opinion, the political debate around the taxation of capital gain is simply a red herring and obstructs the possibility of meaningful tax reform (along with a zillion other obstructions).
2 vincent // Jun 7, 2010 at 11:03 am
Lets get rid these taxes and reform the whole tax system.
3 Russia Scraps Capital Gains Tax to Boost Economy // Jun 20, 2010 at 5:11 pm
[...] The Capital Gains Tax is Bad for the Economy and May Be Unconstitutional [...]
4 Megan // Feb 6, 2012 at 1:15 pm
acctually the entire tax system is practicaly unconstitutional since when the taxes were first put into place the common working man wasn’t liable to taxes. It was all voulentary. I would love to see the government just cut spending. Pay off this massive debt. I’m 14 I don’t want to be paying it off, I don’t want my kids to have to pay it off either. I just wish they would stop sending billions of dollars to help spur mango production in pakastan and focus on their own growing national debt
5 Peter // Feb 6, 2012 at 3:56 pm
Megan,
Actually not. The Supreme Court has ruled, hundreds of times, that the federal income tax is constitutional.
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