Reforming the Tax Code : Capital Gains Tax is Stupid

This post is PART of a larger set of posts on Reforming the Tax Code, an overview of the entire idea can be found here.


How should we tax Investment Earnings?

I am in favor of replacing the current Capital Gains tax with an Investment Exchange tax.


The Capital Gains tax is stupid
The capital gains tax is basically an income tax on investment earnings, and all Income tax is stupid (more on that here).

Some people argue that the Capital Gains tax is a tax on the rich and therefor doesn't affect other people.  But this is false.  This tax is a burden on anyone who buys a home, or intends to save money for retirement.

The Capital Gains tax is one more piece of the disgusting tax code that makes it so that the average american has to hire a financial planner in order to successfully retire.  It is part of the reason we have different kinds of  retirement accounts.  It is part of the reason we have "retirement" accounts at all (rather than just having money invested someplace that we intend to use when we retire.  The existing tax code (including capital gains) is why we take a "hit" when we cash out of our retirement because we run on hard times and need to liquidate our retirement early.

Without the capital gains tax (and payroll tax that it is trying to mimic) there is no difference between withdrawing YOUR money at age 50 than at age 60.  If you have enough to retire at age 40, why should you have to wait until the government retirement age in order to withdraw money from your retirement account. Really, its ludicrous.

That's not to say that investment taxing has to be thrown away, but we are taxing the wrong end of it all.  Instead, we need to go with an Investment Exchange tax (as outlined here).


What is Capital Gains Tax anyway?

Suppose you invested $1,000 in yahoo back in the 1990s.  Then, after holding it for 5 years, sold it for $11,000.  On the surface, you earned $10,000.   But it is not really fair to treat it as a big jolt of income all in the one year because you "earned" it over the course of 5 years.  So, it was more like earning $2000 a year for 5 years, which is a way different tax bracket than what you would be taxed at for making a $10,000 bonus all in one day.

Now, take that and complicate it a little further by assuming that inflation has occurred over those 5 years.  $1000 today is not worth what it was 5 years ago.  So, without going into the details, its not exactly like earning $2000 per year either.  Its ugly.

In order to make it less "ugly" the current tax system just says that any profit you make on aged investments when you cash them in gets taxed at a particular rate (which is lower than the income tax rate for the same amount of money).   In the end, this is more or less "fair", or at least that is the aim of the tax itself.

I am not here to dispute whether or not the current rate charged on capital gains is exactly comparable to the same sort of income tax, for the sake of discussion lets assume that the numbers actually would mean that the capital gains tax somehow equals exactly the same thing you would have paid in income tax if you had paid over time instead of realizing your earnings all at once.