Why the Capital Gains Tax Rate Should Be Zero

Policy Reports | Taxes

No. 245
Friday, August 31, 2001
by Bruce Bartlett

Are Capital Gains Income?

The issue of capital gains taxation was of no importance during most of our nation's history because there was no income tax and therefore no effort to tax capital gains by the federal government. It became a problem when an income tax was imposed for the first time during the Civil War.3 During the time this legislation was in effect, the government taxed capital gains as ordinary income.

Supreme Court Decision in Darlington. After the war, a case came before the Supreme Court in which it was argued that capital gains did not constitute income within the meaning of the law because, unlike wages or other forms of income, capital gains often accrued over many years. It was incorrect, therefore, to tax such gains as if they arose entirely within the course of a single year. The Court agreed with this argument, concluding that capital gains are not, in fact, income. In the case of Gray v. Darlington the Court ruled as follows:

The question presented is whether the advance in the value of the bonds, during this period of four years, over their cost, realized by their sale, was subject to taxation as gains, profits, or income of the plaintiff for the year in which the bonds were sold. The answer which should be given to this question does not, in our judgment, admit of any doubt. The advance in the value of property during a series of years can, in no sense, be considered the gains, profits, or income of any particular year of the series, although the entire amount of the advance be at one time turned into money by sale of the property....

The mere fact that property has advanced in value between the date of its acquisition and sale does not authorize the imposition of the tax on the amount of the advance. Mere advance in value in no sense constitutes the gains, profits, or income by the statute. It constitutes and can be treated merely as increase of capital.4

The case had no practical effect, however, because the same year the decision was handed down Congress refused to reauthorize the income tax and it ceased to exist. Nevertheless, an important precedent was established.

In 1894, another income tax became law, but before any capital gains cases could be heard, it was declared unconstitutional in the case of Pollock v. Farmers' Loan and Trust Co.5 This case concluded that an income tax was a direct tax and thus must be apportioned among the states according to Article I of the Constitution.

"The issue of capital gains taxation was of no importance during the most of the nation's history because there was no income tax."

Supreme Court Decisions under the 16th Amendment. Passage of the 16th Amendment to the Constitution in 1913 opened the way for enactment of the present income tax.6 It was not long before a capital gains case was brought to the Supreme Court. In 1918, the Court heard a case identical to Darlington, Hays v. Gauley Mountain Coal Co. It concluded that capital gains by a corporation were taxable under the corporate income tax, but only by making a very fine distinction between the precise wording of the current law and the previous law.

"Gains, profits, and income for the year ending the thirty-first day of December next preceding" (Act of 1867) conveys a different meaning from "the entire net income...received by it...during such year" (Act of 1909). The former expression, as this court held (15 Wall. 65), denoted "such gains or profits as may be realized from a business transaction begun and completed during the preceding year" with the exceptions already mentioned. The expression "income received during such year," employed in the Act of 1909, looks to the time of realization rather than the period of accruement, except as the taking effect of the act on a specified date (January 1, 1909), excludes income that accrued before that date.7

A commentator at the time said that the Court had dealt with Darlington in a "high-handed manner," and "redefined income" in Gauley Mountain.8 A more recent commentator has noted, "The distinction between income 'for' a year ending on a certain date and income received 'during' the year seems extremely technical as there is no income at all 'for' a year unless some conversion of increased value to cash, or its equivalent, has occurred."9

Adding to the confusion, just a few days after the Gauley Mountain decision, the Supreme Court handed down another decision going in almost the opposite direction. In Lynch v. Turrish, the Court decided that realizing a capital gain did not constitute income because it was merely an asset conversion from one form to another, from unrealized gain to cash. "Indeed," the Court said, "the case decides that such advance in value is not income at all, but merely increase of capital and not subject to tax."10

This ruling seems to uphold the earlier decision in Darlington that capital gains are not income. In the words of a recent commentator, "Turrish thus provided strong support for the belief that Darlington was valid precedent and that capital gains occurring outside the business context were not income."11

The following year, 1919, the Supreme Court again revisited the capital gains question. In Eisner v. Macomber, the Court was asked to decide whether a stock dividend constituted taxable income. It concluded that such dividends are not income. "Enrichment through increase in value of capital investment is not income in any proper meaning of the term," the Court held.12

"In a series of flip-flops, the Supreme Court held that capital gains are income, then that they are not, and then again that they are."

Despite these rulings, the federal government continued to collect income taxes on capital gains. This gave rise to a Federal District Court case in 1920, Brewster v. Walsh. Following the logic of the earlier Supreme Court cases, the District Court held that capital gains are not income. As Judge Thomas wrote:

The sale of capital results only in changing its form and, like the mere issue of a stock dividend, makes the recipient no richer than before....Therefore, under the authority of Gray v. Darlington, which is approved in Lynch v. Turrish, I feel constrained to hold that the appreciation in value of the plaintiff's bonds, even though realized by sale, is not income taxable as such.13

Commenting on this case, the New York Times agreed wholeheartedly with the philosophy. Capital gains, it stated firmly, are not income.

Income is an addition to capital value, something which may be severed from it and still leave the capital undiminished, like a crop from land. Income is a flow. Capital is a fountain. Profit from a sale is not a flow. It cannot be repeated, the transaction being final. An income tax is a recurring tax, and ought to be confined to the tax period....The economic distinctions between capital and income is one of natural law, independent of either statutes or Constitutions. The Constitution controls the procedure of Congress, but the Constitution and Congress together would find difficulty in defeating natural law.14

Supreme Court Decides Gains Are Taxable. Finally, the Supreme Court moved to resolve the question of whether capital gains were taxable once and for all.15 In a series of cases, the leading one being Merchants Loan and Trust Co. v. Smietanka, the Court stated definitively that capital gains are taxable under the income tax.16 At this point, in 1921, the capital gains question ceased to be one for the courts and entered the realm of politics and economic analysis, which have governed the debate ever since.

"In 1921, the capital gains question ceased to be one for the courts and entered the realm of politics and economic analysis."

This is not to say that the Court decided the case correctly. At the time, the Court was criticized for not taking economic analysis into account when defining the term "income." Said one commentator, "The Supreme Court has evinced slight regard for the science of economics when solving purely constitutional problems. Just as they refused in differentiating direct and indirect taxes to apply the economic tests of shiftability, incidence, and consciousness of paying, so in determining meaning of income, they will have none of the economists' analogies to 'tree and fruit,' 'fund and flow.'"17 Fred Rogers Fairchild of Yale probably spoke for most economists of the day when he said, "the weight of economic authority supports the theory that mere growth in value of capital is not income."18

More recent commentators have been equally critical of the Court's reasoning. In the words of Van Mayhall:

A clear case may be made for the proposition that in the early development of our capital gains tax structure, this country chose the wrong path, from which no return has been possible. In short, it may be argued that the country adopted an incorrect approach to the taxation of capital transactions, resulting in a needlessly complex taxation system.19

Marjorie Kornhauser believes that the Court's precedents would have supported a decision against taxing capital gains under the income tax. What tipped the balance was not logic or precedent, but the political, economic, administrative and constitutional concerns of 1921. The nation had just come out of World War I, the debt was large and the economy in a recession. Depriving the government of its ability to tax capital gains would have reduced federal revenue at a time when it was needed and put the Court at odds with the Congress on an issue - taxation - to which it has historically deferred.20

"During the period from 1917 to 1921, the federal government had negative revenue from the capital gains tax, since capital losses were fully deductible from ordinary income."

Deductibility of Capital Losses. In truth, eliminating capital gains from the tax base might not have deprived the government of any revenue at all. Indeed, during the period from 1917 to 1921, the federal government had negative revenue from the capital gains tax, since capital losses exceeded gains by $213 million.21 It is important to remember that at this time capital losses were fully deductible from ordinary income. Thus it is not surprising that investors simply held onto their gains free of tax, while realizing all of their losses for tax purposes, resulting in a net revenue loss for the government.

Full taxation of gains as ordinary income - at rates that went as high as 73 percent in 1921 - combined with full deductibility of losses also created a massive lock-in effect.22 Investors were stuck in their investments, unable to trade or reinvest their gains because of the punitive tax situation. This is what led Congress to establish a preference for capital gains for the first time. In the 1921 tax act, Congress provided that net gains over losses on assets held at least two years could be taxed at a flat rate of 12.5 percent. This led to a very sharp increase in capital gains realizations, with the government unquestionably taking in more revenue at the new, low rate than at the old, high rates. The data are presented above.[ Table 1 ]

"After 1924, there was a preferential rate for gains, and a limit on deductibility of losses."

The 1921 legislation was unsatisfactory, however, owing to the asymmetrical treatment of capital gains and losses. Losses could still be deducted against ordinary income at rates that went as high as 58 percent in 1922 and 1923, while gains were taxed at a maximum of 12.5 percent. Treasury Secretary Andrew Mellon, therefore, asked Congress to resolve this asymmetry and either treat gains and losses alike or stop taxing capital gains altogether. Mellon made it clear that the latter was his preference:

It is believed that it would be sounder taxation policy generally not to recognize either capital gain or capital loss for purposes of income tax. This is the policy adopted in practically all other countries having income tax laws, but it has not been the policy in the United States. In all probability, more revenue has been lost to the government by permitting the deduction of capital losses than has been realized by including capital gains as income.23

In the 1924 tax act, Congress moved to fix the problem by allowing only 12.5 percent of net capital losses against ordinary income. Unfortunately, no serious consideration was given to removing capital gains from the tax base - then or since.24 Indeed, even many of those favoring preferential treatment for capital gains refuse to take seriously the argument that they should not be taxed at all.25

"In Britain, most capital gains originally were not considered income and not taxed."

The British View of Capital Gains. Mellon alludes to the fact that capital gains historically were not taxed in other countries and this is true, especially in Britain and many former British colonies such as Canada, Australia and New Zealand.26 The reason for not taxing capital gains in Britain mainly derived from a different concept of income. In Britain, income for tax purposes emphasized its regular or annual nature. Consequently, occasional, extraordinary, or temporary sources of income were not considered income for tax purposes. Thus such things as lottery winnings, one-time payments for a book or article, or occasional capital gains on the sale of stocks or land were not considered taxable income and were not taxed.

It is hard to say how this concept arose. It may have arisen from the fact that for many years the income tax in Britain was considered a temporary measure. It was first imposed in 1799, but expired in 1802. It was reintroduced in 1803 and repealed in 1816. In 1842 another income tax was imposed. Like earlier income taxes, it was widely viewed as a temporary measure. In fact, Prime Minister Robert Peel suggested at the time the tax was introduced that it would be needed for just three to five years.27

Although the 1842 income tax proved, ultimately, to be a permanent feature of British law, many of its features, as they developed, were based on the assumption that it was temporary. Consequently, there was a concern for people who realized temporary income during the time the income tax was in effect, such as the sale of an asset which had appreciated for many years before the tax existed. It was felt that it would be unfair to tax such one-time income sources the same way that regular incomes, such as wages, rent or interest, were taxed.

The British tax system had separate tax schedules for different types of income. Capital gains fell under Schedule D. However, for income to be taxable under this schedule it needed to arise on an annual basis. A 1920 Royal Commission report explains why this requirement excluded capital gains from taxation:

It will be noticed that the word annual is prominent, and although "annual" sometimes means no more than "calculated by reference to a year," yet in fact this use of the term "annual profits" in the charging words of Schedule D has had in general the effect of excluding from Income Tax liability all profits that are not annual profits in the sense of being likely to recur annually. Casual, non-recurring or occasional profits arising from transactions that do not form part of the ordinary business of the person who makes them are accordingly held not to be within the scope of the Income Tax, and consequently escape taxation.28

Of course, the distinction between casual and annual profits would extend to other forms of income in addition to occasional capital gains. It also means that individuals who made their income primarily from capital gains on a regular basis would pay tax on such gains, since for them such income would be considered regular in nature. The result was great confusion and controversy about what was taxable income and what was not. U.S. tax reformers frequently called attention to these problems in the British practice to argue against special treatment for capital gains in the U.S.29

Nevertheless, the British practice of not taxing occasional capital gains survived for 120 years. As recently as 1955, another Royal Commission recommended retention of the system, despite heavy criticism from tax reformers.30 In the 1960s, however, the Labor Party finally abolished the tax-free status of capital gains and introduced a U.S.-style tax system.31 Canada soon followed.32

"Before 1921, lower U.S. courts also ruled that regularoty was an essential quality of 'income', a quality that capital gains necessarily do not have."

Still, the point raised by the historical British practice is a valid one: Do occasional, unexpected gains constitute "income" in a meaningful sense? Does not the concept of "income" imply regularity and consistency? This was certainly the view of many economists at the time the Supreme Court decided that capital gains were "income." For example, in his presidential address to the American Economic Association in 1923, Carl Plehn of the University of California stated that, "Income is essentially wealth available for recurrent consumption, recurrently (or periodically) received. Its three essential characteristics are: receipt, recurrence and expendability."33

Before 1921, lower courts also ruled that regularity was an essential quality of "income" that capital gains necessarily do not have. For example, in a 1918 case, Judge Learned Hand ruled that the discharge of a debt did not constitute taxable income because it lacked regularity. The term "income," he wrote, "unquestionably imports, at least so it seems to us, the current distinction between what is commonly treated as the increase or increment from the exercise of some economically productive power of one sort or another, and the power itself, and should not include such wealth as is honestly appropriated to what would customarily be regarded as the capital of the corporation taxed."34

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