For 35 years American taxpayers have been subjected to a cynically one-sided levy on capital gains.
Prior to the stock market collapse and depression of 1929-33, capital gains were taxed as income, and at the same rates. And capital losses were fully deductible against income. But one day J. P. Morgan revealed before a Congressional committee that he had paid no income tax for the preceding year, because his capital losses exceeded his ordinary income.
The statement caused great moral indignation. Yet if capital gains are equivalent to and should be fully taxable as income, then by the same logic capital losses should be fully deductible against income. But Congress preferred indignation (and more revenues) to logic (and fairness) and one-sidedly "rectified" matters by refusing to allow anybody to deduct more than $1,000 a year in short-term capital losses against income, though it continued to tax short-term capital gains in full as if they were income.
Congress and successive administrations then launched upon a career of inflation. This has paid the government handsomely at the expense of the taxpayer. The inflationary rise in prices has made nominal money incomes rise. This rise in money incomes has kept putting people all along the line in higher tax brackets where they are automatically subject to higher and higher rates, whether or not their real incomes in purchasing power are any higher.
Inflation has had the further result that people since 1933 have often been paying taxes on capital "gains" that have no real existence.
Suppose you bought stock or real estate for $10,000 in 1939 and sold it for $25,600 today. You would be taxed on a capital gain of $15,600. Actually, as the cost of living has also risen 156 per cent in this period, you would have achieved no real capital gain at all. Your $25,600 would buy no more than $10,000 bought in 1939. If you sold your real estate or stock for $21,000, you would be taxed on a capital gain of $11,000, though you would have suffered an actual loss in real terms.
Under past and prospective inflation, the present capital-gains tax amounts to a large extent to capital confiscation.
Its harmfulness does not end there. By taxing net money gains in full, and short-term gains at rates up to 77 per cent, with loss deductions only against gains (except for a token deduction against income) the present system of capital-gains taxation discourages investment, particularly of risk capital. It "locks in" capital. It penalizes investors heavily for transferring investments into new ventures and so retards economic growth.
There are at least a dozen different possible reforms of the capital-gains tax, any one of which would make it less one-sided. I suggest we begin with this one: When a taxpayer sells shares or a piece of property held over a long period, he should be permitted to calculate his real gain (or loss) by deflating his nominal money gain against the increase in the official consumer price index since the year in which he originally acquired the property.
The justice of this way of calculating real capital gains should be obvious. At least the advocacy of such a reform would help to make clear the injustice of the present heavy taxes on grossly inflated or nonexistent capital gains. The government might no longer be able to profiteer so flagrantly, either in capital-gains revenues or in higher income tax rates, from its own inflationary policies.
Copyright 1969, Los Angeles Times. Reprinted by permission.
Henry Hazlitt
Henry Hazlitt (1894-1993) was the great economic journalist of the 20th century. He is the author of Economics in One Lesson among 20 other books. See his complete bibliography. He was chief editorial writer for the New York Times, and wrote weekly for Newsweek. He served in an editorial capacity at The Freeman and was a board member of the Foundation for Economic Education.