By Thomas Sowell
Wednesday, October 03, 2012
One of the many false talking points of the Obama
administration is that a rich man like Warren Buffett should not be paying a
lower tax rate than his secretary. But anyone whose earnings come from capital
gains usually pays a lower tax rate.
How are capital gains different from ordinary income?
Ordinary income is usually guaranteed. If you work a
certain amount of time, you are legally entitled to the pay that you were
offered when you took the job. Capital gains involve risk. They are not
guaranteed. You can invest your money and lose it all. Moreover, the year when
you receive capital gains may not be the same as the years when they were
earned.
Suppose I spend ten years writing a book, making not one
cent from it in all that time. Then, in the tenth year, when the book is
finished, I may sell it to a publisher who pays me $100,000 in advance
royalties.
Am I the same as someone who has a salary of $100,000
that year? Or am I earning $10,000 a year for ten years’ work?
It so happens that the government will tax me the same as
someone who earns $100,000 that year, because my decade of work on the book cannot
be documented. But the point here is that it is really a capital gain, and it
illustrates the difference between a capital gain and ordinary income.
Then there is the risk factor. There is no guarantee to
me that a publisher will actually accept the book that I have worked on for ten
years — and there is no guarantee to the publisher that the public will buy
enough copies of the book to repay whatever I might be paid when the contract
is signed.
Even the $10,000 a year — which is less than anyone would
earn in an entry-level job — is not guaranteed. If my years of work produced an
unpublished manuscript, I would not even have been among the first thousand
writers who met this fate.
Very similar principles apply to businesses. We pay
attention to businesses after they have succeeded. But most new businesses do
not succeed. Even those businesses that eventually turn out to be enormously
successful may go through years of losing money before they have their first
year of earning a profit.
Amazon spent years losing money before turning a profit
for the first time in 2001. McDonald’s teetered on the edge of bankruptcy more
than once in its early years. The people who ran McDonald’s resorted to
desperate expedients just to keep their noses above the water while hoping for
better days.
At one time, you could have bought half interest in
McDonald’s for $25,000 — and there were no takers. Anyone who would have risked
$25,000 at that time would be a billionaire today. But there was no guarantee
at the time that they wouldn’t just be throwing 25 grand down a rat hole.
Where a capital gain can be documented — when a builder
spends ten years creating a housing development, for example — then whatever
that builder earns in the tenth year is a capital gain, not ordinary income.
There is no guarantee in advance that the builder will ever recover his
expenses, much less make a profit.
There are whole industries where no one can expect to
make a profit the first year — publishing a newspaper for example. Virtually
every major American airline has lost money in some years, and some of the
biggest and most famous airlines have ended up going bankrupt.
If a country wants investors to invest, it cannot tax
their resulting capital gains at the same rate as the incomes of people whose
incomes were guaranteed in advance when they took the job.
It is not just a question of “fairness” to investors.
Ultimately, it is investors who guarantee other people’s incomes in a market
economy, even though the investors’ own incomes are by no means guaranteed.
Reducing investors’ incentives to take risks is reducing the jobs their
investments are likely to create.
Business income is different from employees’ income in
another way. The profit that a business makes is first taxed as profit and the
remainder is then taxed again as the incomes of people who receive dividends.
The biggest losers from politicians who jack up tax rates
are likely to be people who are looking for jobs that will not be there,
because investments will not be there to create the jobs.
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