Hillary Clinton’s new proposal for changing the taxation of long-term capital gains prompted me to take a look back to see how capital gains have been taxed over the past 25 years. The tax treatment of long-term capital gains is illustrative of how the tax code grows, and shows why one should not expect tax simplification any time soon.
Back in 1990 the tax rates applied to long-term capital gains were the same as those applied to income derived from wages or dividends. Straightforward enough. And, in addition to its beautiful simplicity, there was no implication that one form of income is any better or worse than another. Income was taxed at the same rate, whether earned by backbreaking labor or because a stock went up in price.
During the period 1991 to 1997 long-term capital gains received a more favored tax treatment, with a tax rate of 15 percent or 28 percent applied depending upon the taxpayer’s total income. This basic approach has been utilized since, although the rates presently used are either 0 percent, 15 percent, or 20 percent (again, depending on income).
Clinton’s proposal last week was to add more tax rates, with the particular rate depending on the length of time the taxpayer holds the asset. Under the Clinton proposal those taxpayers in the highest personal income tax bracket will now face six long-term capital gains rates. For assets held less than two years the rate will be 39.6 percent, for two to three years the rate will be lower at 36 percent, and so forth, on down to a minimum of 20 percent. The low rate of 20 percent is suggested as appropriate for capital gains on those assets held longer than six years.
How Clinton determined the aforementioned rates for optimal social engineering purposes is somewhat unclear. Why 36 percent for assets held over two years, when 34.8 percent might be even better! And, are six rates enough? Perhaps a schedule with 10 or even 20 rates might accomplish the goal with far greater precision.
But arguing what might be the best tax rate schedule is not the purpose of this article. Deciding on the optimal number of long-term capital gains tax rates to most strategically direct investment in the U.S. economy is way too difficult of a problem for me. Thus I will leave those choices to the wise politicians capable of making such important determinations. My point is to illustrate how the tax code expands over time, and to contrast it with the elegant simplicity found in the law of tithing.
Of course, millions of Americans voluntarily pay a 10 percent tithe to their church. There is one and only one rate, and among the faithful there is little cheating. Further, there is no need for armies of lawyers and accountants. The applicable rule is simple: Pay 10 percent on your “increase.”
How come is tithing so straightforward and easily collected, and the tax code so complex and unwieldy? The obvious distinction is that one is voluntarily paid as a matter of personal choice, while the other is involuntarily extracted at the threat of imprisonment.
I am not going to suggest that the expanding and bewildering tax code could be “fixed” and work as smoothly as tithing by enacting a flat tax. Even with a flat tax folks will engage in all sorts of machinations to lower their taxable income. A flat tax might simplify one small piece of the tax code, but the issue of honestly determining and reporting income is the real snag. If people don’t want to pay taxes, there is no amount of IRS tax code that will close all the loopholes.
The conclusion I reach is that simplicity in taxation is only possible in a world where individuals pay taxes honestly and voluntarily. A similar idea can be extended to most forms of business regulation. Free enterprise will flourish if (and only if?) ethical and moral individuals voluntarily exchange one with another. When ethics and morality vanish governmental oversight moves in to fill the void. With regulation comes the threat of imprisonment, the use of force, cronyism, favoritism, and the heavy compliance cost of teams of bureaucrats monitoring mountains of paperwork.
So, can the tax code be simplified? More importantly, can free enterprise be saved? Perhaps, but the solutions may be found in the study of ethics and religion rather than in the social science of economics.