I have been thinking about wealth taxes that have been proposed and it occurred to me that we already have a few of them (property taxes are one, I’ll get to the other below) but we don’t think of them as wealth taxes. That led me to think about some other illogical tax items. This is just about the items related to capital gains; I may or may not go on to other topics in future posts.

I wrote up some reform ideas a few years ago here and here but this is new.

Here are a few oddities just to illustrate some problems. Let’s assume that inflation is 3% (and always was); long-term capital gains rates are 20%; short-term capital gains/ordinary income rates are 40%; and corporate tax rates are 25%. The numbers aren’t really important, but I want to be able to do some simple examples with nice easy round numbers that are close to what exist though not exact (state taxes, Medicare surcharges, brackets, etc. would all change them for various taxpayers anyway).

- Situation 1: Taxpayer Alpha bought Stock X 20 years ago for $100,000 and it has grown at an average compounded rate of 3%. Since inflation has been 3% the real wealth has not increased. Nonetheless, if sold the taxes would be about $16,000 [($100,000 * 1.03^20 – $100,000) * 20%]. This is a wealth tax basically set at the rate of inflation times the tax rate (so in this case 3%*20%), but only collected upon disposition so there are some compounding differences. Our taxpayer, in purchasing power, is $16,000 poorer. We have had low inflation for so long I don’t think people appreciate the damage that income taxes
*combined*with inflation do. - Situation 2: Taxpayer Alpha dies and leaves Stock X to Taxpayer Bravo. There are no taxes. (Step-up in basis.)
- Situation 3: Company X pays a special dividend (qualified) of $80,000. Taxes would be $16,000.
- Situation 4: Taxpayer Charlie buys Stock Y one year ago for $100,000 and it is now worth $180,000 (roughly the same as the previous example). Since it has not been a year-and-a-day, sales would result in taxes of $32,000.
- Situation 5: Taxpayer Delta buys Stock Y one-year-and-a-day ago for $100,000 and it is now worth $180,000. Sale would result in taxes of $16,000.

You get the idea, the first three situations are economically identical, yet the taxes are different. Worse, there is no actual (real) gain, yet taxes are assessed. This is why using qualified plans/IRAs, Roths, etc. is so vital. That is the *only *way to avoid paying taxes on phantom (inflation) gains. (Assuming all qualified plans/IRAs are exclusively funded with pre-tax dollars.) The last two situations are nearly identical, but the taxes are wildly different.

So here is my modest proposal. All of these should be adopted simultaneously, not in isolation, as they work very well *together*, not nearly as well individually. I’m not trying to minimize (or maximize) taxes, I’m trying to make the economic reality of a situation give rise to appropriate taxes. Anyway:

- All income tax rates for a given taxpayer should be the same marginal rate, no special long-term capital gain or qualified dividend rates. This eliminates the “gaming” that is sometimes done to turn earned income into a capital gain (carried interest for example). This would raise tax liabilities. (But stay with me, it gets better.) A flat tax would be even better, because the sale of large value items (real estate for example) could kick someone into a higher bracket than they would normally be in.

- Companies should get a corporate tax deduction for dividends paid. This removes the tax incentive to use debt rather than equity. It also means that the rationale for a special dividend rate to compensate for double taxation is removed. (Under current rules/rates above a company makes $20, pays 25% in taxes leaving $15, pays it out in a dividend taxed at 20%, the taxpayer nets $12. With my change, the company makes $20, pays it out in a dividend and it is taxed at 40% leaving the taxpayer the same $12.) This would lower tax liabilities to the company. (It would also incent management to distribute earnings rather than horde them and empire-build.)

- Step-up in basis on death should be eliminated. Carry over basis eliminates the economic dislocation from holding property that would otherwise be sold, waiting for the owner to die to avoid tax and leave the heirs more. This would raise tax liabilities. It also, given that we have a progressive tax structure, aligns taxes with the economic situation of the heirs. A “starving artist” heir would pay little or no taxes, a neurosurgeon heir would pay much more. That seems fair.

- Since we have eliminated the step-up in basis, we can eliminate estate taxes now too. This would also free up many very expensive tax attorneys and CPAs to do something socially useful. This would lower tax revenue.

- Investment assets held longer than a year have the basis indexed for inflation. So there is no more tax on growth that isn’t real. The stock bought for $100,000 that grew to $180,000 over 20 years at 3% inflation would have no tax due. A 20-year bond bought for $100,000 with 3% interest (remember inflation is 3% too, so this is zero real return) would have taxes on the 3% paid each year (at 40% rate). But upon maturity, the bonds would have a capital loss equivalent (roughly, you have compounding issues again) to the interest paid. So the taxpayer, having received no real return, pays (roughly) no tax. This structure means that the effective tax rate on stocks is
*still*a little lower than bonds given that dividends are usually lower than interest so you are ahead on the time value of money, particularly on growth stocks, but then the company didn’t get a deduction if they had earnings. This would reduce tax revenue.

- Repeal the $3,000 limit on taking losses against ordinary income. Since all the rates are the same there is no point to this. (And it means the bond buyer in the earlier example, can actually use the real loss upon maturity.) This would reduce tax revenue.

- Section 121 can be repealed (the home sale exclusion of $500,000/$250,000). Since we are indexing to inflation everyone only pays taxes on real appreciation. The current method penalizes people who 1) buy expensive homes (the “free” appreciation is in dollars, not percentages), and/or 2) don’t move. If I buy homes for $1,000,000 and move every five years I will probably never pay taxes on it. If I buy a home for $500,000 and don’t move for 30 years I probably would. That seems … odd. This would probably raise tax revenue, but it could conceivably go the other way. I don’t have data (and behavior would change).

This is just a guess, but I think doing all of that probably wouldn’t materially alter taxes paid (in aggregate) but it would remove a lot of uneconomic behavior that people engage in for tax reasons.

Of course there is zero chance of this being cleaned up logically…