Opinion: How about genuine reform of capital-gains tax rates?

President Joe Biden wants to raise taxes on capital gains but competing with China requires serious reforms neither party has embraced.

For virtually all of the last century, capital gains have been taxed at lower rates than wages and other income. Currently the top capital-gains rate is 23.8%—that includes the Obamacare 3.8% surtax on all investment income.

The tax system makes no allowance for inflation. An asset purchased in 2010 that doubled in nominal value and was sold in 2020 bore an inflationary loss of 18.7% plus a 23.8% tax on the nominal gain. That’s an overall burden of 42.5%.

Chinese subsidies

China massively subsidizes high-tech activities, and industries such as semiconductors and commercial aircraft have been targeted by Western governments. For example, government benefits reduce the cost of new semiconductor facilities in Korea and Singapore by 25% to 30%.

In recent decades, U.S. government support for R&D as a share of gross domestic product has been falling, and Beijing has so many ways of boosting investments in preferred activities—low interest loans, cheap land and the like—it’s difficult to adequately measure.

The World Trade Organization has proved ineffective for combating subsidies for high-tech innovation and exports, because the Chinese, with their mercurial ways, are difficult to prosecute through dispute settlement. And a subsidy-countervailing duty on imports into the United States is minimally effective when the competition in semiconductors, solar panels, airplanes and many other products is driven by global economies of scale and markets.

Many of our big technology companies started out in a garage and under the wings of angels. Engineers and entrepreneurs have promising but speculative ideas, and deep-pocket venture capitalists invest in 10 enterprises hoping one or two will succeed. Then the object is to have a lucrative public share offering or sell to big established technology companies such as Apple
or IBM
Those profits are taxed at the lower capital-gains rate, and that’s how we subsidize R&D to make up for Beijing’s largess.

Might as well surrender

If we taxed capital gains at ordinary rates, we would have a lot less risk-taking, investment in new ideas and essentially abandon the fields of high tech and military innovation to the Chinese Communist Party.

Using the preferential capital-gains rate to compensate for inflation is crude—sometimes it’s too much and other times too little—and the carried interest loophole terribly abuses the system.

Regarding the latter, top corporate leaders and private-equity managers get a good deal of their compensation for managing other people’s assets in stock options. When these shares are sold, this labor income, which should be taxed as wages, is taxed at the preferential capital-gains tax rate. That is hugely unfair to ordinary citizens who don’t earn their 7- and 8-digit incomes.

Biden wants to raise the capital-gains tax to 43.4% but continue to ignore the effects of inflation. In California and New York, on investments made 10 years ago that doubled in value, that would raise the inflation plus tax burden to about 70%. It’s going to be a lot tougher to find angels to capitalize the next Google
or Advanced Micro Devices
with Biden’s proposed rates.

In addition, he wants to tax both unrealized capital gains at death and continue to apply the 40% estate tax. Biden’s double death tax would essentially destroy many family businesses and discourage older Americans from investing to create a legacy for children, but it would boost the sales of yachts and tourist trips into space.

Sensible reform

Sensible reforms would adjust the tax bases of realized capital gains for inflation, close the carried interest loophole and require that the capital-gains rate only apply for investors with real assets at play—stock investors and those who put up their own cash to fund an enterprise. And apply ordinary tax rates to derivatives trades that do not insure the owner of a real asset against loss—for example, crop insurance.

We can set the capital-gains tax too low—a rate of zero would encourage reckless risk taking—or too high—no risk-taking at all. The statutory rate that maximizes tax revenues is 28%—as estimated by the Tax Policy Center and Joint Committee on Taxation. That would approximately maximize productive investment too.

For an asset that doubled in nominal value over the last decade, the inflation-adjusted optimal tax rate would be 22.8%. That’s less than 23.8% under current tax rules.

Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.

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