Recently I posted here and ordered my list of candidates from most prefereable to least. After finishing, I had noticed that I placed Edwards last (at least of the five serious candidates). His constant class warfare rhetoric actually scares me, and this is not just rich versus poor class warfare, but the classic Marxist scenario of capital owners versus workers. Given how much people here seem to like Edwards, I would like to pleed my case for capital and the importance of it to creating wealth in all brackets.
"When I left graduate school, in 1963, I believed that the single most desirable change in the U.S. tax structure would be the taxation of capital gains as ordinary income. I now believe that neither capital gains nor any of the income from capital should be taxed at all. [...] Under what I view as conservative assumptions, I estimated that eliminating capital income taxation would increase the capital stock by about 35 percent." -- Nobel laureate Robert Lucas
Capital in its broadest sense is savings. It is used to produce, but it is not wealth in itself. It takes a combination of labor and capital to produce wealth. And the worker is most valuable when he is swamped with capital. A man in a warehouse moving boxes with only his hands is worth little. A man with a dolly is worth more. But the man with a forklift is worth far more than either of them. Just because somebody doesn't own the capital, doesn't mean they do not prosper from it. Capital requires labor to be useful, so to make labor more valuable you want it scarce relative to capital. The only way to do this is to flood the economy with capital -- so much that there isn't even enough labor to use all of it.
One of the biggest difference between labor and capital investment is that investments can be lost. It is a risk, something that labor does not have associated with it. My salary is my salary, but when I invest in somebody else, I shoulder some of their risk for them. I may get nothing back and lose my entire investment. With a high capital gains tax, investors become risk averse, but all great economic booms are a result of risk taking that paid off. We would like to get out of the way of people wanting to take risks that create new industries and jobs.
The pratical reason to be against the taxation of capital gains is that these gains are unlike other forms of income. Income from labor must be realized when the work is done, however capital gains can be realized at any time. This makes high rates of capital gains taxes actually produce less income than lower rates since people and companies will instead chose to delay the sale of capital that has appreciated in value. However, this effect of keeping capital tied up in an inefficient location is called lock-in. Since capital is useless without labor, often this means that capital is prevented from finding an efficient match with labor, hurting labor in the process.
A good example is a company that decided to make part of their own inputs. It builds a factory to produce part of their product. Demand for their product falls, and after a while they are only running the factory at 40% capacity. It would be nice if they could sell the factory to somebody else, but the capital appreciation and inflation has created a situation where it is still slightly better to just keep the current situation. Then, the capital gains tax is cut, and the situation changes. It is now slightly better to sell the factory, so they sell it to another company that can use it more efficiently. The original company now buys the input from the new owner of the factory, and the new owner can run the factory at full capacity selling the extra 60% of product off to other places. More workers are now needed to keep up with the increased production, and there are winners all around. This isn't a hypothetical example either. There was a couple of stories running in the newpapers last year about this same scenario, although few of them understood how the capital gains tax cut created this activity, and the few that did, I don't think fully understood the impact.
Back up to where I said that "capital appreciation and inflation" were creating the tax burden. Inflation has a perverse way of interacting with capital taxation. An investment of $100,000 could grow to $120,000 after five years, growing only from inflation without any increase in real value. Upon sale, the government would see a nominal gain of $20,000 and tax it. The solution often proposed is to index capital gains for inflation using the Consumer Price Index (CPI). This would definitely be a good step, however the CPI is a very slow moving statistic that tends to overstate inflation. The value of the dollar can slide, yet upwards consumer prices may not be seen for a couple years, and equity markets are effected much quicker. Overall, indexing is a poor fix for a problem that shouldn't even exist.
Besides, since capital is useless without labor and if labor is taxed, then capital is already taxed. The capital gains tax is actually compounded with the income tax. First, let me just show that it doesn't matter where the income tax is applied, either before the capital investment (front-loading) or after the return is realized (back-loading):
I'll say I have an income of $20,000. Front-loading the income tax before I invest it at a rate of 30% leaves me with $14,000. Then I invest it in some smoking hot blogging stock that earned a 50% rate of return. That $14,000 would grow to $21,000. Now, I'll try back-loading the income tax. My $20,000 gets invested and comes out as $30,000. I pay my income tax on that amount, paying a whopping $9,000 and giving me in the end $21,000. So to me, it doesn't matter where that income tax is applied. I end up with the same $21,000 after tax amount.
However, notice that when I front-loaded the tax, the income tax took away from my potential return. I was only able to invest $14,000 instead of $20,000. The income tax eats into my investment by reducing the amount I can invest. Now, we'll see how this works out with a front-loaded tax with the addition of a capital gains tax.
I'll still have the same income of $20,000. After tax that leaves with $14,000. I invest it into the same white-hot stock, returning me $21,000. However, on that $7,000 capital gain I will now pay a 20% tax on it. That cuts my gain down to $5,600 and adding that to the investment gives me $19,600. My effective rate of taxation has climbed to 35%, far higher than the 20% that the capital gains rate is set at.
Imagine returning to a top marginal tax rate of 39.6% and also taxing capital at the same amount. This comes to two 39.6% taxes being applied in sequence. Take a $350,000 income from a small business. After taxes that is $211,400. With a 25% return on investment that nets $52,850 but after the capital gains tax that comes down to $31,921 for a total of $243,321 making the effective tax rate of 42%. After including inflation, half of the capital of this business is going to be sucked away creating a serious impediment to success.
Removing the capital gains tax would increase economic activity in all sectors, especially the capital intensive, high-tech, good paying, next generation sectors. It would unlock capital to flow freely and find efficient matches with labor and encourage risk taking. This new economic activity would increase the taxes acrued in other forms -- like sales, corporate, and personal income taxes -- erasing state deficits around the country (especially for California which taxes capital at a top rate of 9%).
The chief failure of small business is undercapitalization. They are hurt the most by levies on capital. Those who have already invested in their capital expenditures and have a sizeable bank account are still harmed, but to a lesser extent since they are not trying to grow as agressively as a younger company. While removing the capital gains tax cut is not a final solution to economic problems, it is a needed step in any serious way of improving the standard of living in America.