Why Capital Gains Taxes Should Be Lower than Income Tax Rates

A few posts ago in Not Doing a Good Job of Taxing the Rich, I talked about how raising income tax rates would not cause people like Warren Buffett to pay more because most of his wealth is in the form of capital gains from his investment in Berkshire Hathaway and his income from dividends, both of which are not taxed at the standard income tax rate.  With Mitt Romney saying that most of his income was from capital gains, and therefore taxed at 15%, there has been quite a lot of talk about why he and other wealthy people are paying a lower rate than everyone else.  Why not raise capital gains taxes to 30%, or just have gains count as regular income?
One reason often given, which certainly has validity, is that encouraging people to invest their money helps the economy.  Certainly the availability of investment capital helps to create new companies, and helps existing ones expand and eventually hire more people and drive down the cost of goods.  If a person wanted to start a company making board games, for example, she may not be able to because the start-up costs are too high to finance the needed equipment and workforce on her own.  If she were able to form a corporation, however, and sell shares of stock to a willing market, she could raise the needed capital and get the business going.  This would mean more jobs, because she would need people to make and sell the games, and it would mean more competition in the board game market, driving down prices.  Plus consumers would have more choices in games they could purchase and the government would raise more in taxes.
The more compelling reason, however, is that the investor is not usually only paying the 15% on the capital gain.  As a shareholder, he is also seeing his return reduced by the corporate taxes that are paid for each year he owns the company.  Here’s why:
The company must pay corporate taxes on profits.  The top corporate tax rate is 35%.  As a reader pointed out, companies are very good at using the tax laws to reduce their taxes as much as possible, but they still end up paying some corporate taxes even if it does not approach 35%.  If the company were not paying those taxes, it would be able to pay that money to the investor as a dividend each year and still have the same amount of money for operations and growing the company.  Even if the company only ends up paying an effective rate of 10%, the effect is still that the investor saw the earnings he received as dividends taxed at about 25% (10% as corporate taxes and then 15% as a dividend tax on his personal income taxes).  Note that at some times in the past, dividends were sometimes taxed as regular income, so not only was the investor paying full income tax rates, he was paying them after his share of profit in the company was already taxed, and therefore his tax from investments was greater than his tax from wages.
For companies that don’t pay dividends, the extra retained earnings are reinvested to grow the company, which causes the price of the shares to go up.  This assumes that the Price to Earnings ratio (PE) stays at about the same value, which is a fairly good approximation since most stocks trade within a range of PE for long periods of time.  The reason is that even if the company does not pay a dividend, earnings per share represents a possible future dividend, so an effective yield can be determined and compared with the return of other investments like bonds.   If the company were not taxed, and the company was doing a good job of reinvesting the earnings and making acquisitions from the additional money that the company retained, the share price would be higher (because net earnings would be  higher).
Note here that the argument could be made that the price would be lower by the same percentage when the investor bought in as when he sold, and therefore his capital gain would not be affected by the taxes.  The trouble with this argument is that if earnings per share are growing and are taxed at the same percentage, the absolute value of the reduction in earnings due to the taxes (and the reduction in the compounding of that reinvestment) would be larger when the shares are sold than when they were bought.
For example, let’s assume that the earnings for a company grow from $1 per share to $10 per share while an investor holds them.  Let’s also assume that the company has lousy accountants and they are therefore taxed at the full 35% rate. 35% of $10 is $3.50, while 35% of $1 is only 35 cents, so earnings would be reduced by only 35 cents when he bought in, but by $3.50 when he is ready to sell.  With a PE of 10, the shares would be $3.50 less per share when he bought, but $35 less per share when he sold.
Because corporate taxes are taken out each year, if shares are held for a long period of time, a lot of money in taxes will have been paid.  If there is a big capital gain at the end, the investor may be fortunate enough to  have “gotten away” with only paying about a 50% tax.  If the shares have not moved much at all during the time, however, the amount paid in taxes might substantially exceed the capital gain made.
So, as you hear the rhetoric of wealthy investors not “paying their fair share,” and how Warren Buffett pays a lower rate than his secretary, remember that the capital gains tax rate is not the only taxes that are paid when you invest.  The corporate taxes taken out each year reduce the capital gains taken, and the rate can easily well exceed standard income tax rates since the investor will be paying corporate taxes each year.  Fortunately the rewards are well worth the extra taxes.

Please send investment questions to vtsioriginal@yahoo.com or leave them in a comment.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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