stocks, flows, and capital gains

Disclaimer: I am not an economist. Really, really not. Any comments as to why I am wrong here would be welcome!

There is a common meme in the discussion of capital-gains taxes that the income from capital gains has “already been taxed” when it was business income, taxing it when it becomes increased value in investments is unfair or at least double taxation. You can find this claim all over the place; one typical example is here:

…wealthy tax filers make most of their income from investments. Such income is taxed once at the corporate rate of 35% and again when it is passed through to the individual as a capital gain or dividend at 15%, for a highest marginal tax rate of about 44.75%.

Various commentators have noted that this distinction means little to “average Americans,” and that it shows just how disconnected the very wealthy are from the rest of us. I largely agree.

However, I think there’s a good analytical case to be made (separate from the political case) that the double-taxation thesis misunderstands the nature of capital and taxes. That’s because it conceptualizes the funds being taxed as a stock[1] when they are really a flow. Income taxes, sales taxes, etc. (but not property taxes) are imposed on flows: essentially, on the transfer of money from one party to another.  When a company pays a worker a salary for her work, the money it uses to pay her has also already been taxed, either as prior profit for the company, or as income from sales before, etc.  So if we conceptualize that money as a stock, liable to be taxed once and only once, the same argument applies to regular income taxes as to capital gains taxes.

On the other hand, if we recognize that income taxes are imposed on the transfer of money from one party to another, capital gains is no more double taxation than is any other form of income tax. Investors realize profits from capital gains as income from a distant source; indeed that’s why the IRS defines it as “passive gains!”  It’s perfectly reasonable to understand the company as paying taxes on its profits, and the stockholders as paying taxes on their income, because most elements of the economy, emphatically including this one, are best understood as flows, not stocks.

The same misunderstanding is, I believe, involved in the meme that claims that focused government spending is like “moving money around in the ocean” (I can’t find a reference online but I’ve heard it orally). The simile works because anybody can understand that moving money in an ocean doesn’t change the stock of water. But economic growth is actually about increasing the flow of money, not the stock;  so moving “water” around may[2] actually contribute to economic growth because moving money around increases the likelihood that it will flow further.

[1] As you probably figured out, I mean stock as opposed to flow, not in the sense of a piece of paper conferring share ownership in a corporation.

[2] Note that I wrote “may”, not “will.”

Author: andrewperrin

University of North Carolina, Chapel Hill

3 thoughts on “stocks, flows, and capital gains”

  1. I think the distinction between stock and flow is an important one and I’m glad you’re bringing it to people’s attention.

    I also agree that the corporate income tax and tax on capital gains shouldn’t be described as “double taxation” as if they were identical. It is complicated though, and I don’t have it all figured out but I’d like to recommend Rajiv Sethi on this topic:

    http://rajivsethi.blogspot.com/2012/01/double-taxation.html

    http://rajivsethi.blogspot.com/2012/01/returns-to-information-and-returns-to.html

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  2. Michael, thanks for the links – Sethi’s posts and the discussions that follow are quite interesting and develop a different reason to be skeptical of the “double taxation” meme.

    brubineau’s posted cartoon strikes me as spot on, though. Passive investments are one way people make money. They are therefore sources of income, and should appropriately be taxed as such as a matter of fairness. This is justified because income taxes tax flows, not stocks.

    Like

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