The 15% Capital Gains Tax Myth

NEW YORK (TheStreet) -- In his State of The Union Speech, President Obama called for someAmericans to pay a minimum income tax of 30%. Yes, you heard thatright -- a minimum tax. He did NOT propose a maximum tax of, say, $3,000 per person per year, but rather a minimum tax.

Remember the old robber's demand: "Your money or your life!" InObama's new parlance, it's now "30% or jail!" I wonder what GeorgeWashington would have said about this new paradigm.

The fact that Obama is calling for a minimum tax as opposed to amaximum tax tells you all you need to know about this man and his viewof your right to keep the fruits of your time and effort.

But practically speaking, what does Obama mean with his call for aminimum 30% tax? What he is really talking about is to raise thelong-term capital gains tax from 15% to something closer to the topincome tax rate, which is over 30%. Basically, although he doesn'tsay it in those exact words, he is asking for a doubling of thecapital gains tax rate. Some way to talk around the issue!

All this talk about "tax fairness" is political in the context ofWarren Buffett's claim that he pays less tax than his secretary, andof course that it's somehow a problem that Mitt Romney pays close to15% rather than 30%-something. Let's leave aside the discussion ofwhether capital gains should be taxed at all, since the money hasalready been taxed at least once and arguably twice or three timesalready: Is the 15% capital gains rate comparable to an equivalentrate on labor income?

Tax on labor is paid on every paycheck, typically twice a month. Youmake, say, $2,000 pre-tax per pay stub, and you pay 15% tax -- $300 --on that amount. Nothing unusual here. Pretty straightforward.

But how does that 15% capital gains tax work? Let's say that you'resaving for your kid's -- or your grandkids' -- college, and you buy astock for $100. One year later, the stock has surged to $200, and yousell. You pay 15% tax on the $100 profit. That's a 15% rate, right?

No, it's not. You have not accounted for inflation. You're savingfor someone's college benefit. Inflation in college expenses has beenrunning to the tune of at least 7% for many years, so let's use 7%.At the end of that first year, the real value of the $200 share yousold is therefore only 93% of what it seems to be in nominal terms.93% of $200 is $186. The tax you paid was $15, but you're not payingit on a $100 profit. The real profit, adjusted for inflation, was$86. Therefore, $15 / $86 = 17.4%.

So even in the most generous scenario, the long-term capital gains taxrate is not 15%, but 17.4%.

Let's go to year two. You keep that stock for two years instead ofone, until you sell. What's your tax rate if you sell after thesecond year? That real purchasing power of that stock is now worth$186 x 0.93 = $172.98. Your $15 tax is now $15 / $72.98 = 20.6%.After only two years, that "15% tax" is not 15% at all, but really20.6%! Some con job, huh?

Year three: Multiply $172.98 by 0.93 again, for a result of$160.8714. This now means your inflation-adjusted tax rate is $15 /$60.8714 = 24.6%. Some 15% rate -- NOT!

I could go on, showing the impact year after year, but you get thepoint: A 15% capital gains rate is never 15%. It is 17.4% right offthe bat, and increases rapidly for each additional year you've waitedin order to generate your capital gain.

For this reason, hedge funds often sell whatever stocks they've heldfor just over one year. Take the gain as soon as possible, so you'repaying effectively 17.4% instead of the real 20.6% that hits youalready after the second year.

The people who don't get this important principle tend to be "buy andhold" people, often elderly persons who buy a "nifty fifty" stock andhold it forever. If they hold that stock for only a few years, therefore, their real inflation-adjusted tax rate can be well above 100%.

Yes, you read that right: 100% or for that matter any higher number.Do the math: After a few years of holding a stock and making a profit,your "15%" capital gains tax can be an effective rate of over 100%.All you need to do is to keep multiplying with 0.93 for each yearuntil you hit 0.15 and that's when the effective inflation-adjustedlong-term capital gains rate hits 100%.

Some people will object to this analysis by saying that the discountfactor on the gain shouldn't be 7%, but rather a smaller number, suchas 2%. There are two answers to this:
  1. OK, cut it to 2% or whatever, but that doesn't change theprinciple and direction of the analysis at all: The long-term capitalgains rate is never 15%, but rather higher, and it increases for eachyear.
  2. I would argue that saving for particular goals long term,the inflation rate is likely much higher than those "official" 2% or3% numbers. People save for their kids' education and fortheir own health care when they get old. Those educational and healthcare inflation numbers have been far out-pacing the "plastic stuffmade in China" inflation rate that may have been 3% or below -- 7% isactually not a bad number.

What's the conclusion here? The long-term 15% capital gains tax ratecannot be compared on an apples-to-apples basis with a labor incometax rate. Depending on how many years the asset is held, and thediscount rate used (i.e., inflation rate assumption), the 15% capitalgains rate can correspond to any other higher labor income tax rate --30%, 35%, 40% -- or even 100% or much higher than 100%. The ceilingis infinite.

It is simply not possible to compare a labor tax rate with anon-inflation-adjusted capital gains tax rate. You can't say that ifthe latter is a smaller percentage, that it is in reality any smallerthan the former tax rate.

If the capital gains tax rate were adjusted for inflation, theadvocates for increasing the rate from 15% to 30% or higher would atleast have the beginnings of an argument for raising it for thepurposes of "fairness." However, without accounting for inflation,the advocates of "The Buffett Rule" have absolutely not the firstmillimeter of a leg to stand upon.

Of course, once Obama or his fellow proponents of "tax rateequalization" were to concede this critical inflation-adjusted point,there are further hurdles to their case: For starters, if you want toequalize the rates, so that Buffett's secretary doesn't pay more thanBuffett, how about equalizing by lowering the higher labor tax raterather than increasing the lower capital gains tax rate? Why must itautomatically be the opposite? Of course, this goes back to where Istarted this article: Obama is all about imposing a minimum tax --never about protecting us with a maximum tax. Punishment is theprinciple, not protecting your right to keep what you make.

In terms of American tradition, for most of our history we had no taxon capital or labor. For the 137 years before 1913, there was noFederal income tax at all. Coincidentally -- not -- we also hadessentially no Federal budget deficit, no Federal debt and noinvoluntary unemployment for most of the years before the firstFederal taxes were imposed. What DID we have? Record economicgrowth, catapulting this country from an economic backwater in the18th century to the world leader by the early 20th century.

Small wonder that the U.S. government has de-emphasized the teachingof mathematics and American history in its schools. As we said duringthe Cold War, "It's not a coincidence..."

Anton Wahlman was a sell-side equity research analyst covering the communications technology industries from 1996 to 2008: UBS 1996-2002, Needham & Company 2002-2006, and ThinkEquity 2006-2008.

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