A friend called me the other day asking for some financial advice. While I was flattered, I'm not a financial planner and I don't particularly care to discuss money matters with friends. So instead I offered to be a good listener and sounding post to make some observations.
My friend had purchased some stock earlier this year and had done very well in price appreciation – I mean, really well. But now they were getting nervous that the run up in price had been too great, too fast and was thinking about cashing out. Fortunately they understood there would be taxes on the sale, but how much?
Congress decided that there should be a difference in the the way short-term and long-term capital gains should be taxed and the IRS administers that law:
Capital gains and losses are classified as long-term or short-term. If you hold the asset for more than one year before you dispose of it, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term. To determine how long you held the asset, count from the day after the day you acquired the asset up to and including the day you disposed of the asset ... Note: net short-term capital gains [sale price less purchase price] are subject to taxation at your ordinary income tax rate.So if you sell an asset 364 days after you buy it, the gain is subject to the full income tax rate (although not payroll taxes, but that's another story). However if you hold onto it for two more days you get a tax break.
My guess is that Congress imposed the short-term/long-term separation to dissuade investors from making a quick buck and encourage them to hold individual issues for a longer period, thereby making a distinction between "trading" and "investing". Yeah, whatever.
What Congress did instead was to make the stock transactions and the tax code more complex with greater opportunity to game the system. So instead of selling the asset when it's favorable and desirable to me, I have to make another decision on whether to time the sale. That decision may require input from a financial planner or accountant, adding to the cost of the transaction and resulting in less money in my pocket.
The distinction between trading and investing is carried a step further by some people: investment income is not "income" at all since they already paid taxes on the principle earned through wage income. I touch on this in a blog post earlier this year. And since I'm not averse to bludgeoning a topic here we go again.
Investment in oneself via education or training returns long-term wage income that is subject to the 15.3 percent FICA tax as well as income tax. By contrast long-term investment income is exempt from FICA taxes and gets a break on income taxes. The result is inequitable, that is, two incomes that are the same save for the source of income are treated disparately. According to recent data from the IRS, the 400 highest earning Americans made a combined $106 billion in 2010. But just $5 billion was wage income compared to $59 billion in capital gains income. As a result of relief from FICA and favorable treatment of long-term investment income, the average tax rate paid by this group was 18 percent.
The policy change needed is straightforward: keep it simple and equitable by treating the entire investment gain as ordinary income. Removing the arbitrary one-year distinction between short-term and long-term gains provides greater freedom for the investor to make the transaction when it's most advantageous – without Congressional tinkering.
If you have read this blog previously you know I'm not gonna get on a "soak the rich" tirade. But you also know I loathe favoritism of any kind. Income is income is income regardless of source or time horizon.
Make the tax code fair, then let's talk about rates.