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.

Romney’s Tax Reform

Apparently, Romney wants to eliminate tax deductions for the rich. This suggests that the non-rich will have the usual deductions. Of course, this adds complexity to the tax code, but this is not the biggest reason that I am against this sort of device. There must be a transition from non-rich to rich. The transition can be abrupt or it can be gradual. If it is gradual as the Earned Income Tax Credit is gradually removed, all it does is increase the marginal tax rate for those in the transitional range of incomes. That is, their marginal rate is higher than that of the rich. If it is abrupt, it makes the marginal tax rate infinite at the point of transition between non-rich and rich. This creates an obstacle to upward mobility. We have this problem between low and middle incomes. I don’t like it there and I won’t like it between middle and high incomes either.

Save Your Local Post Office

The Post Office spends $56.2B per year. But it earns $64.6B per year. Yet we have been hearing that it is losing money. I assume that some PO funds are funneled to other agencies of government. This is hardly a reason to cut PO branches. The PO is a complex network and willy nilly cuts could be a disaster.

Let me explain by way of a metaphor. Suppose that you have a regional bus system. You observe that some routes at the periphery of that system are not paying for themselves. So you determine to cut the unprofitable routes. Suddenly you discover that having cut those feeder routes that some, more central, routes become unprofitable. Should they be cut in turn? Instead, the network must be considered as a whole. Of course, cuts may be necessary, but the question that should be asked is what will be the impact of the cuts on the entire network.

So here is my proposal: 1. Return revenue to the PO from the general fund or wherever. 2. Let’s hold off on PO cuts until we get really good, network-wide analysis of the cuts.

Although not discussed in this post, we should consider what PO functions can be privatized and what cannot be privatized. For example, do we need a PO monopoly?

A Balanced Approach to Balancing the Budget

The Obama administration and their minions in Congress argue for a “balanced approach” to balance the budget. This is code for increasing tax rates on the rich as one supposedly attempts to balance the budget. Why is this unreasonable? Why won’t this work?

In the last 60 years, top tax rates have ranged from 91% to 28%. The list of these top rates is as follows: 91%, 77%, 70%, 50%, 38.5%, 28%, 31%, 39.6%, and 35%. During these 60 years, revenue has not exceeded 20% of GDP for any sustained period regardless of the top tax rates. I conclude that tinkering with the top rate will not in the future do what it has not done in the past. That is, we cannot expect revenues of more than 20% of GDP. In fact, we cannot even expect 20%. What we can expect is that revenues will be between 15% and 20% of GDP.

On the other hand, expenditures are at 25% of GDP and rising. As a result, expenditures must be cut to balance the budget. How big of a cut is needed? It is huge. We must cut about 28% of the federal budget.

As a technical matter, a “balanced approach” to balancing the budget will not work.

A True Flat Tax Versus Now

The purpose of this post is to illustrate a few aspects of current tax/subsidy policy and contrast this complex policy with a true flat tax. It should be understood that there is a lack of precision in the graph, because there are differences in these policies across states and across family circumstances . . . such as the number of children in the family. Income is measured along the horizontal axis. Sorry I didn’t get that on the graph.

The aspects of the current subsidy system that are shown are the Earned Income Tax Credit (EITC), Rent Subsidies (RS), Aid to Families with Dependent Children (AFDC), and Food Stamps (FS). The current tax system is shown with differing marginal tax rates. The overall current policy is shown with the dark line. Pretty complex, isn’t it? The dark line is the vertical summation of all the thin solid lines. That is, it represents the total of the various policies illustrated here.

The dashed line represents what could be done with a true flat tax (TFT) if one were to eliminate all the other subsidies. Pretty simple, isn’t it? Well, simplicity is only one of the advantages of the true flat tax. The major advantage is that you can monitor the marginal tax rate across the entire income spectrum. In no part of this spectrum is there a kink which acts as a disincentive to upward mobility.

Romney Will Plug Holes in the Safety Net

Gov. Romney put his foot in it recently when he said that he isn’t interested in the poor, because they have a safety net and he would plug any holes in the net. He implied that holes in the net might allow the poor to fall out of the net and suffer. Well, he wouldn’t want that to happen, would he?

The central problem with the safety net is not holes in its bottom. Instead, it is that there are no holes in its top. It is difficult to rise above the net. That is, the net is a trap keeping people in poverty. In its place, we need a tax system that smoothly involves all citizens: poor, middle income, and rich. Instead of myriad programs that make up the current safety net, we need a truly flat tax that allows, even encourages, people to increase their incomes. In order to do this, we need a tax rate that can be kept in the range of being reasonable, nowhere near 100%. With the truly flat tax, the poor would receive cash subsidies which would decline gradually as their income rises. At the same time, this means no more food stamps, housing subsidies, unemployment compensation, and so on and on.