The 15% Capital Gains Tax Myth

NEW YORK ( TheStreet) -- In his State of The Union Speech, President Obama called for some Americans to pay a minimum income tax of 30%. Yes, you heard that right -- 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!" In Obama's new parlance, it's now "30% or jail!" I wonder what George Washington would have said about this new paradigm.

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

But practically speaking, what does Obama mean with his call for a minimum 30% tax? What he is really talking about is to raise the long-term capital gains tax from 15% to something closer to the top income tax rate, which is over 30%. Basically, although he doesn't say it in those exact words, he is asking for a doubling of the capital gains tax rate. Some way to talk around the issue!

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

Tax on labor is paid on every paycheck, typically twice a month. You make, 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're saving for your kid's -- or your grandkids' -- college, and you buy a stock for $100. One year later, the stock has surged to $200, and you sell. 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 saving for someone's college benefit. Inflation in college expenses has been running 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 you sold 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 paying it 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 tax rate is not 15%, but 17.4%.

Let's go to year two. You keep that stock for two years instead of one, until you sell. What's your tax rate if you sell after the second 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 really 20.6%! 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 the point: A 15% capital gains rate is never 15%. It is 17.4% right off the bat, and increases rapidly for each additional year you've waited in order to generate your capital gain.

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

The people who don't get this important principle tend to be "buy and hold" people, often elderly persons who buy a "nifty fifty" stock and hold 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 year until you hit 0.15 and that's when the effective inflation-adjusted long-term capital gains rate hits 100%.

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

What's the conclusion here? The long-term 15% capital gains tax rate cannot be compared on an apples-to-apples basis with a labor income tax rate. Depending on how many years the asset is held, and the discount rate used (i.e., inflation rate assumption), the 15% capital gains rate can correspond to any other higher labor income tax rate -- 30%, 35%, 40% -- or even 100% or much higher than 100%. The ceiling is infinite.

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

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

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

In terms of American tradition, for most of our history we had no tax on capital or labor. For the 137 years before 1913, there was no Federal income tax at all. Coincidentally -- not -- we also had essentially no Federal budget deficit, no Federal debt and no involuntary unemployment for most of the years before the first Federal taxes were imposed. What DID we have? Record economic growth, catapulting this country from an economic backwater in the 18th century to the world leader by the early 20th century.

Small wonder that the U.S. government has de-emphasized the teaching of mathematics and American history in its schools. As we said during the 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.