Profit or No Profit?

Did you know that you sometimes pay taxes on profit that isn’t profit at all? The government might be taxing you on inflation.

Pretend I’m saving for a new violin. Yes, this entire post will be a “pretend” because I bought a violin a year ago, and I love it.

What if I find an instrument I like for $8,000? I only have $3,000 saved. I buy gold with my $3,000 and keep saving. Or rather trying to save. You know how it goes. Emergencies keep coming up, and I just can’t squirrel away any more money.

Finally, I check the value of my original investment and see it has doubled. Now my gold is worth $6,000. I’m excited until I find out that the price of the violin has also doubled. It costs $16,000.

I’m no closer to my goal. And when I sell my gold, I have to pay capital gains taxes on its “increased” value. If the capital gains tax rate is 15%, I’ll be sending $450 to the government.

Alan Blinder, a former member of the Federal Reserve Board, admitted that up until 1980 most capital gains taxes were paid on increased prices due to inflation and not on true increase in value. See "Capital Gains Taxes" by Stephen Moore.

The Economic Effects of Capital Gains Taxation makes a similar point. The table at the top of page eleven shows how much investors would pay in capital gains taxes due to inflation if they bought stock in certain years and sold it in 1994.

When the price of everything goes up, it isn’t profit. It’s inflation. Don’t tax it.

Capital Gains Taxes – Part 2

I will now prove how good I am at debate. I am so good that I can argue both sides of an issue. I will proceed to argue against my last post.

It is sometimes true that capital gains taxes are double taxation. Corporations pay high taxes on their profits. This negatively affects the price of their stock. The little bit that the stock increases in value is taxed again if the investor sells it and reports capital gain.

But not all capital gains are from stocks. If someone invests in gold and sells it at a profit, it’s pure profit. No corporate taxes have been paid.

Or is it pure profit? There is that awful word inflation, but I’ll leave that for my next post.

Capital Gains Taxes

Is the capital gains tax rate too low? Not if you look at the whole picture. Pretend you risk your money by investing in a new company. With your money, the business manages to make $100 profit (after expenses, employee's wages, etc.).

"Yay!" you think. You didn't lose your investment. You made money instead. But you forgot one important thing – the corporate tax rate. That business has to pay approximately 40% of its earnings in taxes (state and federal) before it can give any money to you.

So this new business that you supported sends $40 to the government. “Oh, well,” you think, “I still get $60.” Not quite. Once the company sends the $60 to you, you have to pay taxes on it again. Granted it’s only 15% since it’s capital gains. But 15% of your $60 is still $9.

You send the $9 to the government. You figure it’s a rough deal, but at least you got to keep $51 of the $100 that the business made with your money. But then your neighbor complains that you didn’t pay enough taxes – he has to pay 35% income tax.

Ugh! Forty-nine percent of your profit went to the government, and someone is complaining. Well, that’s his problem. You have a different problem. You’re staring at that $51 in your hand and wondering if it’s worth investing it again. Investments are a little risky. Maybe you should hide it under your mattress.