Should a Capital Gain be Considered Income?

July 11, 2014

A capital gain occurs when you purchase an asset—usually a company’s stock—and later sell it at a profit. For example, you purchase a stock at $100 and in a year you sell this stock for $150, your capital gain is $50. Under current law, this capital gain is taxed as income, but at a reduced rate (top rate of 23.8 percent top rate).

The classification and taxation of capital gains as income is based on the “Haig-Simons” definition of income. This defines income as consumption plus change in net worth. While this is a useful accounting identity, using it to define the tax base leads to a tax bias against future consumption. In other words, it double taxes saving and investment while taxing current consumption once. A more economically rational tax base would exempt capital gains.

Income is flow – a regular distribution of payments for services. In other words it represents actual economic activity. Capital is a stock – the sale of an asset is nothing more than converting the capital into cash. Converting an asset into cash does not make the investor any better off in economic terms, the asset has just been recategorized into cash. This is the difference between taxing the fruit picked from a tree and taxing the yearly growth of the tree. The capital gains tax is a tax on asset transformation and reorganization.

The Bureau of Economic Analysis (BEA), one of the principle statistics reporting agencies for the U.S. economy, does not include capital gains or losses in their National Income and Products Accounts (NIPA), from which GDP is calculated. The BEA reasons: “Capital gains and losses are not included in NIPA measures, because they result from the revaluation and sale of existing assets rather than from current production.” In other words, a change in the sale price of an asset does not add or subtract from the goods and services produced in the United States today.

Before 1921, the Supreme Court ruled several times that capital gains were in fact not income. A paper by economist Bruce Bartlett lays out the history of capital gains as described by the Court. Prior to the 1913 enactment of the 16th amendment authorizing the federal income tax, the court held in Gray v. Darlington that: “Mere advance in value in no sense constitutes the gains, profits, or income by the statute. It constitutes and can be treated merely as increase of capital.” In 1919, the Court held in Eisner v. Macomber that stock dividends were not income, stating: “Enrichment through increase in value of capital investment is not income in any proper meaning of the term.”

In 1921 the court overturned previous precedent and ruled in Merchants Loan and Trust Co. v. Smietanka, that capital gains could be included in income. Bartlett posits that this was a political decision, citing WWI debts and other political realities that necessitated the federal revenue.

The economically consistent definition of income is a departure from the commonly used Haig-Simons definition. A more rational tax base would exempt capital gains from taxation and other changes in net worth due to the fact that they do not represent any additional economic activity. A tax system that does this is a consumption-based tax, whether it be a flat tax, retail sales tax, or a personal expenditure tax.

Besides the fact that capital gains do not reflect any increase in economic activity, there are many other rationales to lower or eliminate the capital gains tax: it double taxes capital, it can create an infinite effective tax on gains due to inflation, and it creates a lock-in effect that discourages proactive investment. The repeal of the capital gains tax would increase capital formation and grow the economy.

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