Are Capital Gains Income?

The history of taxing capital gains as income stems from a dubious, and at the time much criticized, Supreme Court decision that reversed prior Supreme Court decisions holding capital gains not to be income. Job changes are not “income” transactions. Nor, are changes in capital. Income is what “comes in” from having the job, just as it’s what “comes in” from having the investment of capital; e.g., dividends, interest, rents, and including business income. Indeed, capital gains are not considered to be income by economists, who exclude them from their computations of GDP. The exclusion is because capital gains are not income in the economic sense.

SFPPR_NewsandAnalysis_Red By James K. Jeanblanc l October 24, 2016

capital

Are capital gains income? Abraham Lincoln might be heard, “If you call a horse’s tail a ‘leg,’ how many legs does it have?” You know his answer. “Four. Calling a tail a leg doesn’t make it a leg.”

Nevertheless, capital gains are commonly called “income.” This is the accepted truth of most people, a belief justified by the following level of thought:

That man sold his family farm, and look at all of that cash he now has (Harking to the notion of ability-to-pay). That’s more than I make in a year (Envy Politics). He should pay an income tax on that gain just as I do on my earnings (Fairness).

But, Are Capital Gains Really Income?

Looking at a horse, it’s easy to spot the tail to be different from a leg. However, in other cases, differences don’t always stand out. Try this thought experiment:

Suppose you have an “is” basket, and all the “ises” in the basket are similar in nature. The addition of another “is” won’t change the overall commonality – unless that “is” is an “isn’t.”

Now, think of the Tax Code as a basket, a basket of various incomes to be taxed as income. Note the capital-gains addition seems to be the addition of a something else. Its inclusion is accompanied with special rules to give these “gains” a semblance of income-basket compatibility, as illustrated below –

    Case (1). Suppose you own stock in a company that splits its stock into twice as many shares and pays out the additional shares, doubling your share count. Despite your having received property which can be sold for cash, your new shares are not treated as “income” because the total value of your capital investment remains the same as it was immediately before the stock payment.

Case (2)(a). Suppose your company merges into a large mega-cap company and you trade your shares for shares in that large company – any taxable capital-gain “income” from that? No. Despite the change in your capital investment mix, you are regarded as invested in a carryover of the same thing.

(b). Now, suppose there’s no merger transaction, but instead you trade your shares with another investor for his shares in that same large company. This investment exchange is treated as an “income” transaction, despite your ending in essentially the same economic position as in (a) above.

Case (3)(a). Suppose you trade your family farm for an office building. Despite that significant change in the nature of your capital investment, this exchange is classified as a “like-kind exchange,” and there is no taxable capital-gain “income.”

(b). Suppose instead you make a cash sale of the farm and, in a separate transaction, purchase that office building. The cash sale here gives rise to capital-gain “income.” This is the result despite your ending in the very same economic position as in (a) above. (Actually, that’s not so – your economic position is worse, just as in case (2)(b) above. Your total capital has been diminished by the tax owed on the deemed capital-gains “income.”)

There are further equivocations on the inclusion of capital gains as “income” –

    (1) In the tax parlance, the term “ordinary income” has been coined to mean generic income with capital gains excluded.
(2) Regarding the taxable-income-aggregation rules, capital losses are not permitted to offset more than $3,000 of ordinary income. But, there is no dollar-loss limit on the deduction of ordinary losses from ordinary income.
(3) And, the income-tax rates on capital gains typically are lower than the rates on ordinary income. This reflects a clear ambivalence whether capital gains should be included in the Tax Code basket as “income.”

So, could it be that capital gains are an “isn’t?”

The Answer

In reality, capital gains are not income. They are due to an increase in the value of property already owned, before its being sold or exchanged for other property of the same value (the so-called taxable event). The sale or exchange transaction, itself, does not increase the owner’s wealth nor does it amount to an in-flow of income. Taxing capital gains is akin to property taxation of one’s assets and wealth.

The history of taxing capital gains as income stems from a dubious, and at the time much criticized, Supreme Court decision, Merchants Loan and Trust Co. v. Smietanke, 255 U.S. 509 (1921). This decision reversed prior Supreme Court decisions holding capital gains not to be income. [See Bruce Bartlett, Why the Capital Gains Rate Should Be Zero, NCPA Policy Report No. 245 (August 2001), at: www.ncpa.org/studies/s245/s245.html]

Indeed, capital gains are not considered to be income by economists, who exclude them from their computations of GDP. The exclusion is because capital gains are not income in the economic sense. [See: https://www.quora.com/Why are capital gains not included-in GDP] Analogous to the taxation of capital gains as income, would be the taxing of the increased earning power of a worker changing to a higher paying job. His “job gain” from the change would be measured by the extent the value of his earning power from his new job value exceeds the value of his earning power from his old job.

Job changes are not “income” transactions. Nor, are changes in capital. Income is what “comes in” from having the job, just as it’s what “comes in” from having the investment of capital; e.g., dividends, interest, rents, and including business income.