StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between

Tax Reform At The Bottom Of The Cliff

10 Dec 2012
Posted by Clint Stretch

Whatever Congress and the White House do in the next couple of weeks will reinforce the case for tax reform.  The seeming sanctification of low tax rates that occurred with the Tax Reform Act of 1986 has not meant keeping top tax rates low; it has meant only the death of honesty in talking about rates.  The result is a patch work of hidden rates and additional wage taxes that is likely to continue.

Following the 1986 Act, the advertised top marginal tax rate increased from 28 percent to 31 percent in 1990 and to 39.6 percent in 1993 and then decreased to 35 percent in 2001.  But, Congress also added a number of hidden rate increases.  In 1990, it added the phase out of personal exemptions and a haircut on itemized deductions (These were gradually eliminated under the 2001 Act).   In 1993, it removed the cap on wages subject to the Hospital Insurance (HI) Tax and, in 2010, it added an additional HI tax on high-income individuals.
If either the Country goes over the Fiscal Cliff or the President prevails in restoring pre-2001 law for top income taxpayers, then a self-employed high-income taxpayer who earns an extra $1,000 will find $440 of it going to Washington instead of the $396 that the top tax rate discussion might suggest to an ordinary person.  Here’s the math (rounded):
Advertised top tax rate
Effect of 3% haircut on deductions
"Employee" HI Tax
"Employer" HI Tax
Deduction for Employer HI Tax
ACA additional HI Tax
Real marginal rate
 Of course, their spouse’s wages from employment would be taxed effectively at 43.1 percent, their dividends at 44.6 percent and their capital gains at 24.4 percent. 
This system fails some of the fundamental tenants of sound tax policy.   It is not transparent, neutral or simple.  It begs for reform.  I would bet that most high-income individual, confronted with this array of rules and policy fixed at this level of taxation, would prefer a single simple top tax rate on ordinary income of 44 percent and a straight-forward, single capital gains rate or exclusion. 
Unfortunately, I also would bet that, if and when we get to a larger tax reform, politicians will prefer gimmicks that allow them to advertise a lower post-reform tax rate. 

I have long thought that cap

I have long thought that cap gains ought to be treated as regular income, but with a deduction based on portfolio size to account for inflation. I was just reflecting on how a 2% of portfolio deduction would amount to a 20% cut in tax rate on a 10% return, or a 50% cut in tax rate on a 4% return. This seems (to me) like a fairly commonsense way to handle cap gains, but I never see such an idea discussed. Is it a non-starter for some reason? Are there political implications that I haven't thought about?

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