Why capital gains tax isn’t too low

Allister Heath
RARELY have I seen such a nauseating US presidential election. All the candidates are poor, especially on the Republican side; but it is what passes for debate that is truly pathetic. Particularly depressing has been the vitriol directed at Mitt Romney, one of the two top Republican candidates, for deriving much of his income through capital gains (which are taxed at a low rate). There are lots of reasons why Romney deserves to be criticised – many of his policies are half-baked – but the tax story isn’t one of them.

At first sight, it sounds crazy and a scandal that Romney faces a lower tax rate than his cleaner. In reality, however, he probably doesn’t, and this is why. Income comes either from capital (in the form of dividends, interest, rents or share buy-backs) or from labour (in the form of wages and bonuses). Companies as such don’t really exist; they are a legal fiction, a mechanism by which capital and labour income is created and distributed. Only people exist; they eventually receive all the income and pay all the tax. All the nonsense about how much or how little companies pay in tax is just that – nonsense. Only their employees or owners can genuinely be said to pay tax.

At the moment, people who own capital (such as shares in a company) see their income taxed up to three times: first, corporation tax on profits; then tax on paid-out dividends; and then tax on their capital gains if they decide to sell the shares. People who sell their labour get taxed once via income tax and national insurance (including employers’ NIs, which are in fact a hidden tax on workers). Everybody then gets taxed again when they spend the money on goods and services (Vat, petrol duty) or some assets (stamp duty).

It is easy to see why capital gains tax is a form of triple taxation on capital income. Share prices are determined by the discounted value of expected future dividends; (taxed) capital gains are thus driven by changes to (taxed) profits and (taxed) dividends. All of this often leads to a very high effective tax rate on every pound of profit.

In Romney’s case, it may look as if he is paying just 15 per cent tax on capital gains and nothing else – but in reality his shareholdings would be worth much more in the absence of corporation tax and dividend tax. Both these are ultimately hidden taxes on him as a part owner of corporations, even though they don’t show up in his tax form. The US tax system is hitting him and reducing his wealth in ways that are not obvious; economists call this the difference between the actual incidence of a tax – who bears its true burden – and how it is collected – who hands over cash.

Take a theoretical UK company. In extremis, its £100 of profit will be taxed at up to 26 per cent per cent; its remaining £74 could be taxed at up to 42.5 per cent if distributed as a dividend, leaving just £42; and then gains on the sale of the shares in the company (which capitalise future profits) will be taxed at 28 per cent. This is an extreme example; average corporation tax rates are lower. But it shows why so many countries tax capital gains less than employment income: it is to prevent the total tax rate on capital income being absurdly high.

It is a shame that those involved, including most unforgivably Warren Buffett, ordinarily a genius in matters financial but oddly an advocate of higher capital gains tax, either don’t understand this, or pretend not to.

Follow me on Twitter: @allisterheath