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February 23, 2012

What is the true tax rate on capital gains?

We are going to have to “Do the math” here folks. So batten down the hatches. Why am I doing this, you might ask? Well, the Obama administration seems to have their hearts set on increasing taxes like this. So I figure that we should know where we are now and be able to compute where any proposal would take us.

First of all, capital gains are directly related to changes in income projected into the future. They are indirectly related to the capitalization rate, the rate that converts future income into its equivalent present value. We have to be a little more particular about describing the income which is directly related to capital gains. It is after tax projected income. There are two tax rates that are relevant here. The explicit capital gains rate and the corporate income tax rate.

So the observed capital gains should be the expected increase in income per year multiplied by the quantity one minus the corporate income tax rate and multiplied by the quantity one minus the explicit capital gains tax rate all divided by the capitalization rate. If we multiply through, we find that the observed capital gains equals the expected change in income divided by the capitalization rate (this is the capital gains that would exist if there were no taxes) multiplied by the quantity one minus the corporate income tax rate minus the explicit capital gains rate plus the product of the corporate income tax rate and the explicit capital gains tax rate. Now we are ready to see the true tax rate on capital gains. It is the corporate income tax rate plus the explicit capital gains rate minus the product of these two tax rates.

So if the corporate income tax rate is 35% and the explicit capital gains rate is 15%, then the true tax rate on capital gains is

.35 + .15 – .35 x .15 = .4475

So the true tax rate at the present time on capital gains is 44.75%. Let me put this differently, when you observe a capital gain, it is diminished by almost 45% from what it would be if gains were not taxed. Is this too much taxation or too little. I leave it to you to decide. Note that I have not addressed state and local taxation in this post.

Now you know how to do this; you can do it for any tax proposal you get a hold of.

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