Can the 15% tax rate on capital gains and dividends be justified?

The disparity in tax rates between earned income and investment income is making a lot of news these days due to Mitt Romney’s admission that his effective rate is around 15% with most of his money coming from investments and just the other day Jim Cramer’s twitter rant on “carried interest” which enables hedge fund managers to treat their incentive compensation as capital gains rates (15%) rather than ordinary income rates which for most hedge managers would be at 33%.

The two main reasons for justifying lower taxes on investment income are that it encourages long term investments and that it is equitable to ease the burden of double taxation. The first problem with these arguments is that double taxation is not always an issue. Income earned through a partnership like Bain or most hedge funds. is a pass through, it does not get hit with first a corporate income tax. Even the issue of double taxation should be addressed by eliminating the corporate income tax, but more on that later. The other rationale for the lower rate on capital gains and dividends that it encourages long term investments that benefit the economy falls short held up to sunlight. The average holding period for stocks in now around four months. In the early 1960, the average holding period was eight years and the maximum long term capital gains rate was then 25%.  Now the top marginal tax rate then was 91%, but nobody really paid that because of loopholes. But the holding period of stocks tracked over time, would strongly indicate holding periods are most closely tied to the lowering of trading commissions overtime than tax rates.

The only place where one can really justify a lower capital gains tax break is on private investments made with fresh capital. Now while some will say that is Bain, it is only part of Bain. To the extent, Bain principals invested their own cash in private illiquid investments they should get a tax break for taking high risk and a lack of liquidity is one of the reason it is high risk. I actually think the tax rate on such investments should start at 15% one year from investment and gradually reduce to zero after five years. But to the extent their “basis’ came in the form of equity stripped away from their clients in the form of fees, incentive or otherwise, they should be taxed at ordinary income.

This leaves us back at the double taxation issue. The best way of doing this is eliminating the corporate income tax itself. This assumes we can get an international agreement amongst the major economies of the world to do the same, so we can rid overselves of all the inefficiencies and gamesmanship of country allocations that only makes tax lawyers and accountants wealthy and produces little revenue for most governments.   Google cut its taxes by over $3 billion in three years by shifting income to places like Ireland, not that it paid the statutory rate in Ireland either, because it found a way around that as accounted in this Bloomberg story:

Just tax the owners. Part of the problem here is that many of the owners are tax exempt themselves such as corporate pension programs and this tax exemption is questionable itself as not all Americans are fortunate to work for companies or governmental entities that offer and fund these retirement plans . The problem is eliminating this loophole would immediately make many defined benefit programs underfunded or even more underfunded than they are now. But the focus should be on taxing the owners which is more efficient as they pay taxes in only one country generally than trying to tax multinational companies with complex depreciation and depletion allowances who constantly are in the business of playing international shell games with profits which are impossible to reform so long as they are subject to different tax codes in multiple countries.