Last week I wrote about capital gains taxes, which elicited a number of comments. The argument made most often was that capital gains taxes should not be increased because capital gains is a double tax.
The notion is that the money you use to invest in the stock market has already been taxed and therefore is double taxed when you sell the stock. The problem with this belief is that your original investment is not subject to capital gains tax. Only the gain is subject to the tax. For example if you invest $1,000 and a year later you sell the stock for $1,500 only the additional $500 is subject to any capital gains tax.
The second and considerably more complex idea of how capital gains is a double tax is based on the idea that corporations already pay a rate of 35% on their income so when you as the investor pay your 15% you are actually paying an additional second tax.
One of the biggest problems with this line of thinking is the fact that around 69% of corporations paid no federal income tax and according to the Wall Street Journal the average corporate tax rate is 12.1% of profits, not 35%. Obviously if the company paid no taxes then it would be difficult to claim double taxation.
Additionally this argument relies on the idea that stockholders bear 100% of the burden of this imaginary 35%. Analysis on the topic suggests this tax burden is instead shared by workers, consumers and shareholders – lowering the shareholders’ tax burden even further.
It should be noted that capital gains is derived from many sources, and the double-tax argument cannot be applied to many of them. As an example, Mitt Romney had $13 million in carried interest, which is taxed as capital gains even though it is really just commission and has not been taxed at any other point.
The same is true of stocks. For an investor to earn money in the stock market, the companies they invest in do not have to make a profit. Stock prices often increase on the perception of future profit rather than actual profit. As I mentioned previously high frequency trading accounts for around 70% of the stock market volume and these investors manage to make small profits every minute completely unrelated to the companies’ performance over the past few minutes.
So is it possible that you as an investor are being double taxed on your investment? Yes. But even when that is the case the double taxed rate is typically lower than the rate you would pay if you had earned this money in the form of wages.
But the best proof that the capital gains tax is an advantage over other ways of earning money is the fact that the richest Americans earned 81.3% of their income from capital gains, dividends and interest while only 6.5% of their income came from salaries and wages.