Matt HealeyFriday,7 December 2012

The Snap:

Yesterday, I wrote about a change to the tax code that I think would be a good idea. It involves changing he way that dividends are taxed. I want to follow that up with another idea. It has to do with the way that capital gains are taxed. Similar to dividends, I think they should be taxed as ordinary income, with the base price indexed for inflation.

The Download:

Right now there are a ton of rules associated with long term versus short term capital gains. This leads to different terms, rules, and tax rates. Like the situation with dividends, this can lead to investors making choices for tax reasons rather than investment reasons. As you may have figured out by now, I do not believe that the tax code should be factored into business decisions. And thus, having people make choices based on the tax code is, in my mind, sub-optimal. Taxing capital gains as ordinary income will help alleviate this system. The other reasons to make this change is that you would eliminate the carried interest rule for hedge funds. Under this system, the management fees that hedge funds earn can be classified as capital gains, thus enabling them to claim the lower tax rate. This is how people like Mittens and Buffet have effective tax rates of less than 20%.

But if you are going to do this, then I think you have to make two provisions. The first is that you would have to index the asset purchase price for inflation. It would not be fair to calculate taxes for long term holding without the inflation adjustment. If the value of an asset only increases because of inflation, it is hard to tell me that I have “made money”. The thing is, with current IT, this would be very easy to accomplish. After all we have annual inflation numbers back to well before anyone was alive. The other provision would be to exempt the sale of primary residences from the tax. Given the U.S. focus on home ownership, it would be wrong to tax the sale of primary residences.

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Image Credit: Wikimedia Commons

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