- US economy adds 196k jobs in March
- Oregon Senator proposes taxing unrealized capital gains
Stocks responded positively to today’s jobs report. The US economy added 196k net new jobs in March, a strong bounce back after February saw an increase of only 20k new jobs. The unemployment rate held steady at 3.8%. Wage growth slowed slighly, but remained above 3% year-over-year. In an economy with low inflation, 3%+ wage growth feels pretty good to me. This report shouldn’t change anything with the Fed’s plan to keep interest rates unchanged through the rest of 2019. For the week, the Dow increased 1.9% while the S&P 500 gained 2.1%.
Oregon Senator Ron Wyden revived an idea this week to tax unrealized capital gains on an annual basis. Long-term capital gains have long been taxed at a lower rate than regular income. Wealthy individuals often generate a large portion of their income from capital gains versus W-2 income, leading to a lower overall tax rate than many ordinary Americans pay. The current capital gains rate for wealthy Americans is 20%. This is below the 22% tax bracket for income between $39k and $77k. On the surface, this is an unfair system that flies in the face of an otherwise progressive income tax structure.
Capital gains have always been taxed when an asset was sold. There are many reasons for this. When investing in a business, buying a house or other capital intensive investments, all the cash might be tied up and not available to pay taxes on an annual basis. Additionally, as long as an investment is still owned, the ultimate gain or loss isn’t known. Many investments collapse in value in any given year. Only when sold is the true gain/loss known. On that basis, it makes sense to wait to tax a gain until the gain is finalized. Because of this feature, higher tax rates on capital have been shown to generate less revenue for the government because, on the margin, investors will choose to delay selling an asset to push the taxes into the future. It’s economically rational to retain an asset longer if the capital gains tax is 40% versus 20% for example. Of course people will still sell assets for a variety of reasons, but a lower tax rates reduces the incentive to continuing owning something for tax reasons. The question then becomes, do we want a ‘fair’ tax rate for wealthy Americans or do we want to maximize tax revenue. Over the last 30 years, US policy has been to keep a lower rate to encourage people to realize gains therefore creating a tax liability.
Senator Wyden’s proposal attempts to remove the incentive to not sell an asset to avoid paying taxes. Removing this option means the capital gains rate could easily be raised to equal to, or in excess of, the top marginal income tax rate. One major problem I see with a plan like this is how to treat capital losses. It doesn’t make sense to tax capital gains unless you also get a tax benefit for capital losses. Let’s say an investor buys $100,000 in stock that increases in value to $150,000 in one year. Under the Wyden plan, the $50k unrealized gain would be taxed. Now in year 2, the investment falls to $120k in value. The investor should get a tax deduction of $30k because of the unrealized loss. In the current system, that all happens because only the final realized gain/loss is used for tax purposes. This would cause huge swings in government revenue as investors piled on losses in bad years. A real world example that demonstrates how this would work in practice is the former CEO of Lehman Brothers, Dick Fuld. Before the financial crisis and Lehman’s bankruptcy, Fuld held Lehman stock valued over $1 billion. He never paid taxes on any of the gains associated with that position. Then Lehman filed for bankruptcy and his position was worth nothing. Under a system that taxes unrealized gains, Dick Fuld, Wall Street CEO, would have been entitled to a huge refund check from the government after his investment went to zero. He would get a check equal to all the taxes he paid on unrealized gains, probably in excess of $100 million. It would essentially serve as a government guarantee that no rich person could ever go broke. That doesn’t make sense to me.
Another major problem is the treatment of illiquid investments. If a homeowner sees appreciation in their house, do they owe taxes on the capital gain every year? Who values the house every year? If a business owner sees their company grow, even though all the profits are needed to be reinvested in the business, do they owe taxes on the gain? Where will they get the money to pay the taxes? I’m all for talking about ways to ensure that wealthy Americans pay taxes, but this idea has too many flaws to make sense to me.
Oil increased 5.2% this week to close at $63.29/barrel. The yield on the 10-yr Treasury moved higher, closing at 2.49% from 2.41% last week. The average rate on a 30-yr fixed rate mortgage moved up slightly, to 4.08% from 4.06% a week ago.