With so much talk about the government’s plans to raise capital gains tax – and our argument that hiking CGT is actually likely to lose the exchequer revenue – it is easy to forget that in an ideal world, we wouldn’t tax capital gains at all. The reason is that taxing capital gains is usually double taxation – that is, taxing the same income stream more than once. As Stephen Moore explains on EconLib:
Take, for example, the capital gains tax paid on a pharmaceutical stock. The value of that stock equals the discounted present value of all of the company’s future proceeds. If the company is expected to earn $100,000 a year for the next twenty years, the sales price of the stock will reflect those returns. The “gain” the seller realizes from the sale of the stock will reflect those future returns, and thus the seller will pay capital gains tax on the future stream of income. But the company’s future $100,000 annual returns will also be taxed when they are earned. So the $100,000 in profits is taxed twice—when the owners sell their shares of stock and when the company actually earns the income. That is why many tax analysts argue that the most equitable rate of tax on capital gains is zero.
Moreover, this double taxation is one of the reasons why modern economies tend to be overly reliant on debt rather than equity – with all the problems that brings along with it. Put simply, investment is severely discriminated against in the tax system, and that distorts the co-ordinating function of the free market.
In the short term, I’m sticking to my guns: the government’s planned CGT rise is bad policy that is likely to hit both revenues and economic growth. In the long run though, we need to get past aiming to get down to the revenue-maximizing rate and try to reform the tax system so that we get rid of double taxation.
As I see it, there are two options here: one would be to continue taxing investment income at the individual level, but to get rid of corporate taxes. The other option is to treat corporation tax like a withholding tax, which taxes investment income at source, and only tax individuals on their wages, salaries and pension income. That’s the option Hall and Rabushka advocated in their classic flat tax proposal, but I’d be happy either way.