June 1995 No. 7
Capital Gains: A Tax on the Middle Class
Those who oppose reducing the capital gains tax argue that it would be a “tax cut for the rich.” But in truth, the capital gains tax falls most heavily on middle-class business people and investors. The wealthier an investor, the easier it is to structure investments so as to avoid capital gains taxes. The techniques that investors employ to avoid the tax are so common that the National Association of Securities Dealers includes them on its exam for trainee brokers. Some of the largest institutional money managers catering to wealthy investors advertise investment strategies that use computer models to avoid capital gains taxes. Indeed, wealthy rentiers living on income from traded securities can effectively avoid capital gains taxes altogether.
Taxing the Middle Class
An investor pays the capital gains tax only when he liquidates his investment. In practice, investors liquidate taxable securities and incur the capital gains tax only if they must do so in order to meet large, non-recurring expenses. Wealthy investors often hold onto assets that have appreciated in value until they die, passing them to their heirs and avoiding the capital gains tax (though not the estate tax) altogether.
In contrast, middle-class families who have either invested in securities or built small businesses typically must sell a large portion of their investment at the peak of their savings, in order to pay for a large expense like retirement, a child’s education, or the purchase of a home. At that time, these investors have no choice but to pay tax on their capital gains.
Consider the case of a Pakistani immigrant who saved for years to buy a New York City taxi medallion for $75,000 in 1984. The value of the medallion doubled to $150,000 by 1994, at which point the immigrant sold it, showing a capital gain of $75,000, on which he pays 28 percent in capital gains taxes.
Another hypothetical example: A married couple, a policeman and a nurse, have seen their combined annual income go up from $40,000 at age 21 to $90,000 at age 46. During the past 14 years, during which their income averaged $72,425, they have invested 8 percent of their savings, or $6,000 per year, in an investment fund indexed to the Standard & Poor’s 500; the value of their portfolio now stands at $96,600. This year their oldest child enters a university, so they liquidate 15 percent of their portfolio, giving them a taxable capital gain of $13,455. Again, they must pay the full 28 percent tax rate on this gain.
These cases illustrate two important points about the capital gains tax. First, studies that purport to show that most capital gains taxes are paid by wealthy individuals reflect a fundamental error: They treat individuals as “high-income” because of a one-time increase in earnings the year they realize capital gains. In both our hypothetical cases, the individuals probably earn over $100,000 in the year in question, but their normal incomes put them well within the middle class.
Second, the capital gains tax is a tax on nominal earnings—it is not adjusted for inflation. Much of the increase in the value of a taxi medallion, for example, reflects a decade’s inflation, not an increase in the real value of the medallion. To take a more extreme example, consider an investor who bought a small business for $100,000 in 1962 and sold it for $300,000 in 1995. In real terms, the value of his business is unchanged: $300,000 in 1995 dollars is worth about the same as $100,000 in 1962 dollars. Yet the businessman would pay $56,000 in capital gains taxes, leaving him with a negative real after-tax return on his investment.
Avoiding the Tax
The capital gains tax is applied to the net profit on investments sold in a given year. Therefore, an investor who sells profitable securities may offset his gains by also selling securities that have lost money. The owner of a small business or the small investor in a conservative mutual fund will not have such offsetting losses. But a wealthy investor is more likely to have access to sophisticated advice on how to manage his portfolio to avoid taxes.
Moreover, the wealthy investor has natural advantages in avoiding taxes. Because he has a larger portfolio, he will have to liquidate a much smaller percentage of it in a typical year than a middle-class investor would. Further, because he has more capital to begin with, he will have more flexibility to buy high-risk securities. That means more of the individual securities he buys will lose money—even though the overall return on his portfolio will be just as high as, or higher than, that of a middle-class investor.
When the wealthy investor liquidates a portion of his portfolio, he will be able to sell securities that have declined in value along with some that have been profitable, using the losses from the former to offset the gains from the latter and thereby reducing his tax liability. Yet even though he avoids paying capital gains taxes, the overall return on his portfolio will still be quite high, because his profitable investments have a high rate of return.
Testing the Model
We developed a computer model to simulate how much capital gains taxes three investors would pay if they employed optimal trading strategies designed to avoid capital gains taxes:
1) A small business owner who must sell his firm, which represents his entire net worth;
2) A middle-class investor who must liquidate 40 percent of his portfolio each year; and
3) A wealthy investor who must liquidate 20 percent of his portfolio each year.
The first investor’s case is simple: as in the example above, he pays 28 percent of his nominal gain.
The second investor diversifies his portfolio, buying 20 stocks, which, over 20 years, have the characteristics of the Standard & Poor’s index: average annual “volatility” (a measure of the fluctuation in the price of stocks) of 16 percent and average annual price appreciation of 15 percent.
Pursuing this optimal tax-driven investment strategy, the second investor seeks to offset the tax liability of his gains by selling stocks that have lost money. Our computer simulation shows that this investor is likely to pay an effective capital gains tax of 20 percent on the nominal gains from the profitable stocks he sells. His total after-tax profit is 12 percent. (An actual middle-class investor is unlikely to pursue an optimal tax-driven investment strategy. More likely, he would purchase shares of a mutual fund and pay the full tax on his profit.)
The wealthy investor also pursues an optimal tax-driven investment strategy, but he is at an advantage. Because his wealth is greater and his cash needs smaller relative to his total investments, he can invest in high-risk securities—those with high volatility. Because his portfolio is larger, the wealthy investor is likely to have the motivation and the professional support to adopt an optimal tax-driven strategy. In our simulation, he purchases 20 stocks with average volatility of 25 percent (as opposed to 16 percent for the S&P 500) and average annual price appreciation of 15 percent (identical to the S&P 500).
In this scenario, we found, the investor is likely to have sufficient tax losses every year to offset all the capital gains he needs to realize—with exactly the same pre-tax return on the investment in his portfolio. After taxes, he earns a total annual profit of 15 percent.
To sum up, in our simulation, the small businessman pays the full 28 percent tax on his profits; the middle-class investor pays 20 percent; and the wealthy investor pays zero.
In practical terms, it is likely that a wealthy investor would buy high-volatility stocks that also have a higher rate of return than the S&P 500. In this case, he would have a relatively higher proportion of gainers to losers, and may not have enough capital losses to offset all his gains. To test what would happen under such circumstances, we ran the model again, this time assuming the wealthy investor bought stocks with an average volatility of 25 percent and an average return of 20 percent. In this case, the effective tax rate is about 17 percent—still lower than that of the middle-class investor. His after-tax profit is 17 percent—higher than the S&P average.
The conclusion is startling: To the extent that wealthy investors must pay capital gains taxes at all, it is because they have earned pre-tax returns superior to those generated by the broad stock indices such as the S&P 500.
Abolish the Capital Gains Tax
The capital gains tax falls overwhelmingly on the middle class—specifically, on savers and entrepreneurs, the most thrifty and industrious members of the middle class. It is not a means of redistributing wealth from the rich to the poor: the wealthy may for the most part avoid the tax through well-known and commonly used techniques. Because the upward-striving middle class is the key to economic growth, the capital gains tax harms the economy by creating a disincentive to thrift and investment. The capital gains tax should be cut substantially—or, better, abolished altogether.
—David Goldman and Evan Kalimtgis
About the Authors
David Goldman is a Managing Director of Bear Stearns and Co. Inc. in the Financial Analytics Structured Transactions Group and is responsible for Fixed Income Strategy. He writes a monthly column for Forbes magazine, and has contributed to The Wall Street Journal, The Journal of Applied Corporate Finance, The Public Interest, The Washington Times and other publications.
Evan Kalimtgis is a Vice President in the Financial Analytics Structured Transactions Group at Bear Stearns and Co. Inc. He is completing a Ph.D. in Finance at Columbia University.