THE TAX PREFERENCE FOR CAPITAL GAINS The U.S. income tax system, and that of most other countries, provides a tax preference to returns to investment that come in the form of capital gains. In the United States, capital gains for individuals are subject to a special lower tax rate structure, are taxed upon realization rather than accrual (which offers deferral of tax liability), and are excused entirely from taxation upon the death of the asset owner because of the basis step-up rule. The U.S. tax treatment of capital gains on a principal residence is even more attractive, exempting $500,000 of gain for a married couple since 1997. Other things equal, then, the tax system favors assets that are expected to appreciate whose return can be classified as capital gains for tax purposes. Did the preferential tax treatment of capital gains encourage investment in assets whose return could come largely in the form of appreciation? In a world with no capital losses, the answer would surely be yes, but a complete answer must address the tax treatment of capital losses. The absence of full loss offset against ordinary individual taxable income means that the expected tax consequences of a risky asset (i.e., one whose value might actually decline) are not as favorable as looking only at the taxation of gains would suggest. This consideration would, of course, not apply to investors who did not consider the possibility of price declines, as anecdotally seems to have characterized many investors. Whether the tax treatment of capital encourages investments whose returns can be characterized for tax purposes as capital gains is a different question than whether the tax treatment encourages riskier investment. The latter follows from the former if the returns to inherently riskier investments are more easily characterized as capital gains; this seems right to me, but I do not have empirical evidence to prove it. (7) The tax preference for capital gains affects not only the relative attractiveness of assets, but also the relative attractiveness of some occupations, depending on whether the compensation can be characterized as capital gains. This can be achieved for those who apply their effort to fixing up, or "flipping," houses because the effort results in a higher sale price. It can also be achieved by the general partners of private equity funds or hedge funds to the extent that the compensation for their effort is characterized as carried interest and therefore treated for tax purposes as capital gains. By granting preferential tax treatment, the capital gains preference thereby further encourages relatively risky activities. (8) Finally, the realization-based tax on capital gains causes a "lock-in" incentive for investors to hold on to assets with appreciation (especially for older investors closer to the step-up of basis at death) and a "lock-out" inducement to sell assets with losses. Given the limitation on taking capital losses against ordinary income, the lock-out effect applies with most effect to those who also have realized gains in the same year, which may apply more to 2008 than 2009, and therefore was arguably a factor in the decline of stock prices in the latter part of 2008. Note also that the advantage of stepping up the tax basis for inherited assets at the time of death for the owner provides a tax break only with regard to assets with appreciation. In the post-crisis world riddled with assets that have accrued losses, for tax purposes it is better to sell assets before death to take advantage of the capital loss that will not be available to whoever inherits the asset.
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