Should Capital Gains Be Taxed At All?

Rather than tinkering with capital gains inclusion rates or changing which assets qualify for capital gains treatment, should governments reconsider taxing capital gains? Some studies suggest that capital gains are fictitious and any taxes thereon result in an economic burden.  Do you agree?

Bruce Bartlett, Senior Fellow of the National Center for Policy Analysis in Dallas, Texas, did an excellent study in August 2001, providing an overview of the history of capital gains taxation in the US dating back to 1921, as well as jurisprudence on the matter, and arguing that, in principle, capital gains may not be income at all and should likely not be taxed as such.

It’s an argument that has been with us since 1921, when capital gains were first given a tax-preferred status in the US.  They were taxed as ordinary income from 1914 to 1921 and from 1987 to 1990. If they are income, he states, government should adjust for inflation and losses in values. They would find that in contemplating taxable capital gains vs. real gains, however, there is often no income to be taxed at all.

He begins by finding flaws in the universally accepted definition of income by economists Robert M. Haig and Henry Simons: all consumption during the course of a year plus the change in net worth. Under this model, even unrealized gains would be taxed, although offset by losses. Haig and Simons also favored inflation adjustments. Simons in fact conceded in 1938 that most capital gains are fictitious when you adjust for inflation: “Considerations of justice,” he wrote, “demand that changes in monetary conditions be taken into account in the measurement of gain and loss.”

The problem, says Bartlett, is that the definition of capital gains as income, without those adjustments, endorses double-taxation. Capital gains, which occur on an increase in value of income-producing assets, really represent the discounted present value of the future flow of income from rents, interest or dividends associated with the asset, he argues. Taxing both the income from a capital asset and the value of the underlying asset, is like taxing the same income twice. 

Permanent changes in asset valuation, he states, only occur when there are permanent increases in income flows. Therefore, before any gains are taxed as income, they must be adjusted for both inflation and losses in value. When they are, nothing is owed to government. When you think about it, removing capital gains taxation from the tax code would greatly simplify the tax system and reduce expensive court challenges on the subject of valuation.

Bartlett has lots of facts to back up his thesis. He quotes economist Robert Eisner, who noted that from 1946 to 1977, after adjusting for inflation, households suffered a real loss of $321 billion on nominal capital gains of $3 Trillion.

He also notes instances of taxpayers suffering significant economic hardships through onerous taxation, all before the significant bull market of the 1990s. In each case, the failure to index capital gains for inflation have produced punitive taxes:

• In 1973, taxpayers realized nominal gains of $4.5 billion, but a real loss of $1 billion.¹
• In 1977, taxpayers paid taxes on $5.7 billion of nominal gains that actually represented a real loss of $3.5 billion.
• In 1981, taxpayers paid taxes on $17.7 billion of nominal gains that represented a real loss of $5 billion.
• In 1985, nominal gains amounted to $78.8 billion, but real gains came to just $63.5 billion.

He also quotes a key argument against the taxation of capital gains, from Richard Kopcke of the Federal Reserve Bank of Boston, who wrote in that bank’s economic journal:

“According to common financial theories, an asset’s price depends on its prospective income. In applying this description of asset prices, this article concludes that capital gains are not necessarily a proper element of taxable income separate from ordinary income, because these gains (or losses) reflect changes in the prospective income offered by assets. When this income is itself taxed fully, the asset’s price, and any changes in its price, tend to reflect the tax burden on this income. In these circumstances, a capital gains tax imposes an additional levy beyond that of ordinary income, which effectively imposes a relatively high tax on any changes in an asset’s earnings. “

Consequently, Mr. Kopcke concludes, a levy on capital gains is a poor substitute for an income tax. “Only changes in an asset’s earnings generate taxable capital gains, the initial earnings would remain untaxed.”²

What’s your take? Should capital gains be taxable in Canada?

Evelyn Jacks is a best-selling Canadian author of 52 books including her latest, Family Tax Essentials. Evelyn is the Founder and President of Knowledge Bureau, a national educational institute. To learn more about professional tax preparation and tax-efficient wealth management, see www.knowledgebureau.com.

¹Martin Feldstein and Joel Slemrod, “Inflation and the Excess Taxation of Capital Gains on Corporate Stock,” National Tax Journal, Vol. 31, No. 2, June 1978, pp. 107-118. U.S. Treasury Department, Report to Congress on the Capital Gains Tax Reductions of 1978 (Washington: U.S. Government Printing Office, 1985), p. 11; Congressional Budget Office, Indexing Capital Gains (Washington: U.S. Government Printing Office, 1990), p. 24; Leonard Burman and Eric Toder, “Indexing v. Exclusion of Capital Gains: Effects on Income Distribution and Economic Efficiency,” 1992 Proceedings of the 85th Annual Conference on Taxation (Columbus, OH: National Tax Association, 1993), pp. 14-15.
²From Why the Capital Gains Rate Should be Zero, by Bruce Bartlett, Senior Fellow, National Centre for Policy Analysis, Report No. 245 and Richard W. Kopcke, “No Gain, No Pain: Some Consequences of Taxing Capital Gains,” New England Economic Review, March/April 1989, p. 39. For a similar analysis, see Neil A. Stevens, “Taxation of Capital Gains: Principle versus Practice,” Federal Reserve Bank of St. Louis Review, Vol. 60, No. 10, October 1978, pp. 2-8.

Refer a Friend	Research	Calculators	Course Trials