Of Public Interest

Volume 3, Number 17
November, 2001

For months now various economic pundits have been debating whether we are in a recession or just getting close to one. The stock market plunge that followed the terrorist attacks of September 11 has led to heightened calls to provide some fiscal stimulus for our economy. A cut in the present 20 percent tax on capital gains has been advanced as one possible candidate to provide economic stimulation. Proposed cuts in the tax on capital gains seem invariably to arouse controversy, and this time will probably be no different.

To be sure, it is doubtful whether fiscal stimulus is called for in our present situation. Some fall in stock prices is a quite reasonable economic reaction to the death and destruction created on September 11. After all, stock prices reflect people’s evaluations of the future earning prospects of different companies. Some of those companies took substantial hits to their future earning prospects, particularly through their loss of valuable talent.

Moreover, even if such stimulation were called for, it is doubtful that a cut in the capital gains tax would provide much immediate stimulus. A cut in the capital gains tax would do its work by encouraging people to save more and to increase their capital investments. These economic gains take time to obtain, and would not provide much by way of immediate or near-term stimulus.

Still, there is good reason to cut the capital gains tax, indeed even to eliminate it. The plain fact of the matter is that the capital gains tax is an economically harmful and unfair method of taxing the same income twice. The most important thing to note in this respect is that capital gains are not a form of income to be added to other forms of income. To the contrary, they are simply a different measure of the very same income that has already been taxed under the income tax. Capital gains taxation is thus double taxation, a form of double jeopardy for taxpayers.

True enough, our tax code defines capital gains as a form of income to be added to other forms of income. However, no one holds up our tax code as a model of clarity and precision. It is a product of complex political compromises that have been made over many years where political expediency repeatedly and continually trumps clarity and principle.

Consider a family that owns a farm where it raises catfish. Suppose the annual net income generated from harvesting catfish is $50,000. If assets generally earn 10 percent in the economy, this farm will be worth $500,000. Economists use the term capitalization to describe the idea that the value of an asset is just a different way of expressing the annual income that the asset generates. Thus, the value of the farm and the annual income generated by that farm are not two distinct and separate economic magnitudes. Rather they are simply two alternative statements of the same magnitude.

Economically, an asset can be measured by its market value or by the annual return it generates. If one value changes, the other value necessarily changes as well. The two values are locked together through market capitalization. For instance, suppose the market price of catfish rises, so that the annual income generated by the farm rises to $60,000. This rise in the price of catfish and increase in the annual income generated from the catfish farm will be accompanied by an increase in the value of the farm to $600,000. The $10,000 increase in annual income and the $100,000 increase in the value of the farm are simply two different measures of the same thing. You can’t have one without the other.

An income tax is based on the annual return from assets, with people counted as a type of asset, what economists call human capital. When the income from the farm rises to $60,000, tax liability rises as well. The $100,000 increase in the value of the farm is not an additional source of income beyond the $60,000 the farm yields. Rather it is just the capitalized reflection of the increased income. To treat the increase in the value of the farm as a source of income is to tax the same income twice. Any taxation of capital gains is a form of double taxation, so long as there is any taxation of income.

There is much to be said for eliminating any tax on capital gains. Doing this, however, is not a means of providing economic assistance right now. The taxation of capital gains places a double tax on frugality, thrift, and enterprise, thereby discouraging the exercise of these qualities. No reasonable tax system should do this, as these are qualities that, if anything, should be promoted and most certainly not discouraged. Capital gains are not a suitable object of taxation.

Richard E. Wagner is Senior Fellow at the Public Interest Institute and Holbert Harris Professor of Economics at George Mason University.

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