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Capital Gains: Congress’s Immoral, Irrational, and Unconstitutional Tax?

By: Steven Pahuskin, Lawrence Summers

In light of the capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. resetting from its 2003 levels to its pre-Bush levels, Dr. Daniel J. Mitchell and Dr. Richard W. Rahn argued today that capital gains taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es impede economic growth, and are potentially unconstitutional. The talk was hosted by the Cato Institute.

Dr. Mitchell first explained that capital gains taxation discourages savings by favoring consumption of disposable income. People who invest their disposable income, which has already been taxed under the income tax, are taxed through the capital gains tax, the dividends tax, and eventually the death/estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. . These extra taxes encourage taxpayers to use their money quickly rather than saving their money for long-term economic prosperity and growth. Mitchell also argued that the capital gains tax is a form of preemptive double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . When an individual or corporation performs a service or sells a good, the money received is generally considered taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . Any after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. used to invest is taxed again upon realized gains. By taxing the investor's income twice, the government double-dips and potentially deters investment and savings.

Dr. Rahn took Mitchell's analysis a step further. He argued that capital gains taxation is unconstitutional under the 16th Amendment. The 16th Amendment states that "the congress shall have the power to lay and collect taxes on income, from whatever source derived…" [emphasis added]. Rahn pointed out that capital gains are not considered income under any definition of the word, in any dictionary, or any IRS definition. Rahn also argued that capital gains taxes are effectively a tax on inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. ary gains, nominal changes that do not reflect real accumulation of wealth. In the event that the investment does not outperform inflation, the government is taxing twice on a loss instead of a profit. Therefore, imposing a tax on capital gains is an overreaching and unconstitutional exercise of Congress's power to tax.

Both Mitchell and Rahn argued that the government would raise more revenue if it decreased or repealed capital gains taxation. In 1977, capital gains were taxed at 40% and the IRS collected $7.8 billion, compared to $122 billion with a 15% rate in 2007. Even after factoring in inflation and other economic factors, the government collected more revenue with the lower rate. The decrease in rate created incentives for investors to inject more money into the economy, thereby expanding the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . Decreased capital gains tax rates also provide disincentives to wealthy investors in avoiding or evading the tax, increasing the amount of revenue generated by the capital gains tax.