Tax expert – Leonard Burman gave testimony on 9/20/12 to the House Committee on Ways and Means and the Senate Committee on Finance where he made the case for making significant changes to the tax code including increasing the tax on capital gains.  One of the solutions Mr. Burman comes to relative to the tax code is to tax all capital gains at the same rate as regular income.  Taxing capital gains at a lower rate incentivizes manipulation of the tax code pretty significantly and also disproportionately benefits the wealthiest among us.  This is in line with my own thoughts when I wrote an example balanced budget HERE.  You can see his entire testimony HERE.

Very simple solution – we should tax all income equally with a progressive tax code based on how much a person makes.  If you make $20,000 as salary or $20,000 in capital gains – they should fall under the tax code equally.  That does not mean that a person who makes $20,000 should pay the same rate in taxes as a person making $2 million … it just means all income is taxed equally.  That would be the #1 thing conservatives don’t want to do because that’s the #1 priority for their wealthy, wealthy donors.  And I would submit taxing capital gains at a different rate is probably the largest contributor to income inequality in the U.S.

Mr. Burman says:

Whatever its benefits, the difference in tax rates between capital gains and other income is a prime factor behind individual income tax shelters. Since ordinary income is taxed at rates up to 35 percent while long-term capital gains are taxed at a maximum rate of 15 percent, there is a 20 percent reward for every dollar that can be transformed from high-tax compensation, say, to low-tax capital gains.

Mr. Burman gets into the “carried interest” rule and calls it “the biggest shelter”.  The carried interest rule is a loophole that Mitt Romney used to make all of his money.  Mr. Burman says:

In 2012, the biggest tax shelter may arise from the fact that certain forms of compensation are taxed as capital gain. For example, managers of private equity funds hold a “carried interest”—a right to receive a share (typically 20 percent) of the profits produced by an investment fund over and above any share corresponding to their actual cash investment. As a result, a significant portion of their compensation is ultimately taxed as capital gain, rather than ordinary income. Private equity managers also receive fees that are taxed as ordinary income, but if the investments are successful, that is a small portion of their compensation.

Romney went on 60 Minutes this past Sunday and said that he felt it was a good idea to tax capital gains at 15% (or less) even if it meant the middle class paying more in taxes because it was good for economic growth.  You can see that interview HERE.  The video below is an interview with Romney where he was asked if he would eliminate the carried interest rule that he made most of his fortune from – he would not say but he has historically said that he favors the carried interest rule that Mr. Burman calls “the biggest tax shelter”.

But Mr. Burman dives further into treating capital gains the same as other income.  The line in bold below really got my attention.  That’s kind of a wow moment.  He says:

If capital gains were taxed the same as other income, defining them would be fairly straightforward. The prime source of complexity would be the relatively simple matter of defining what events trigger the realization of gain. Classifying income as capital gain or wages or rents would have no tax consequence. However, when capital gains are taxed at much lower rates than other income, the tax code needs complex rules to delimit the boundary between capital gains and other income. In addition, complex anti-tax shelter provisions, such as the passive loss rule, limitations on the deductibility of interest, and a host of other provisions are necessary to deter abuse. Tax lawyers have told me that half of the Internal Revenue Code is devoted to defining the difference between capital gains and ordinary income. If capital gains were taxed as ordinary income, much of that complexity could be eliminated.

In the chart below – you may notice the distribution of capital gains – 65% of them go to the wealthiest 1% of Americans and 47% goes to the top .1% of Americans.

Mr. Burman says:

The benefits of a capital gains tax preference are extremely concentrated among those with very high incomes. In 2010, the highest-income 20 percent realized more than 90 percent of long-term capital gains according to the Tax Policy Center. (See Figure 1.) The top 1 percent realized almost 70 percent of gains and the richest 1 in 1,000 households accrued about 47 percent. It is hard to think of another form of income that is more concentrated by income.

But it gets worse than that – the chart below shows that the 400 wealthiest Americans account for more than double the share of capital gains revenues than 20 years ago.

Mr. Burman points out that capital gains would not be taxed under a consumption tax which is often talked about among people on the conservative side.  A consumption tax would be a horrible idea and would completely exempt capital gains.  He says:

Some argue that the proper tax base is not an income tax but a consumption tax. Under a consumption tax, capital gains and other returns to savings would not be taxed. Therefore, eliminating the tax on capital gains is a step in the direction of a better tax system.

Whether consumption tax or income tax is the appropriate base is obviously a contentious issue, but even accepting the premise that we should have a consumption tax, taking one step in the direction of a consumption tax — by exempting capital gains alone from tax — does not necessarily represent an improvement. The problem, just as in the case with indexing for inflation, is that a low or zero tax rate on capital gains when the rest of the income tax is left alone creates huge incentives for tax sheltering, as discussed above.

Then the coup de grace.  Mr. Burman says the most important thing one can say to explain why it makes no sense to tax capital gains differently; there is no correlation to the taxes on capital gains and economic growth no matter what conservatives will tell you.  He says:

The heated rhetoric notwithstanding, there is no obvious relationship between tax rates on capital gains and economic growth. Figure 4 shows top tax rates on long-term capital gains and real economic growth (measured as the percentage change in real GDP) from 1950 to 2011. If low capital gains tax rates catalyzed economic growth, we’d expect to see a negative relationship–high gains rates, low growth, and vice versa–but there is no apparent relationship between the two time series. The correlation is 0.12, the opposite sign from what capital gains tax cut advocates would expect, and not statistically different from zero. Although not shown, I’ve tried lags up to five years and using moving averages, but there is never a larger or statistically significant relationship.

And Ezra Klein comments on all of this and writes this HERE:

But it’s also worth understanding why more and more tax wonks are wondering if the case holds up under current conditions. For one thing, the low rate on investment income has been an important contributor to rising inequality. In fact, it’s worked so well that if you want to tax the rich without ratcheting their earned income tax rate to extremely high levels, or reform the tax code without massively cutting taxes on the rich, the best option might be to raise capital gains taxes.

Joe Nocera gets at this point by taking a close look at the Forbes 400.

A large number of the Forbes 400 — “roughly 40 percent,” according to a group called United for a Fair Economy — inherited their wealth. Many others on the list — people who started companies that they’ve since left — are classified by Forbes as investors.

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