It makes no sense because you're choosing to not think about it.
Person A works in a factory. He works hard all year building products and at the end of the year he has earned $50,000.
Person B sits in front of his computer at home and moves money around in the stock market. One day he gets lucky and makes $50,000. He then decides he doesn't need to do anything more the rest of the year.
Under our current system, Person B is rewarded with a lower tax rate and Person A is punished with a higher one. Person A is punished for working hard all year and building products.
How long before Person A stops doing that?
Actually, in most cases where someone was relying on capital gains for income (if we assume Person B is trading often), both would pay the exact same rate; the capital gains rate is only available if you have held the stock for more than one year. And in any case, fairness is only one consideration in the capital gains tax discussion, and not a particularly useful one (although I do think it’s fair to tax capital gains at a lower rate – despite arguments to the contrary, most increases in stock price are a result of income earned by the company that has already been taxed once). The difference between capital gains and other forms of income is how easily the former can be avoided by simply choosing not to sell an asset. Studies have shown over and over that high capital gains rates are accompanied by low capital gains tax collections, and vice versa. If I own a building that I bought for $1,000 30 years ago and it is now worth $10 million, I might be more likely to hang on to it rather than pay the tax on the $9,999,000 gain; the market may not pay enough of a premium for me to decide it’s worth selling, especially if the rate is 35-40% ($3.5-4 million). However, that analysis is likely to change if the rate is only 15% and I would only pay $1.5 million. So the question is – would you rather collect $1.5 million today or perhaps $4 million 20 years from now?
In 1977, the capital gains tax rate was almost 40%. Over the next several years, the rate was both lowered and raised; the effects on collections were predictable; while rates were hovering near 40%, capital gains realized (resulting in tax income) was only 1.5% of GDP. However, when the rates were reduced to 20% in 1982, the gains increased to 4.1% of GDP. When they were raised back to 28% in 1988, the gains decreased to 2.3%. When they were again reduced to 21% in 1998, the gains increased again to 4.3%.
It seems pretty clear that investors are highly influenced by tax rates, and that they will be more likely to follow the economics of a transaction and create taxable gains if tax policy does not exert an undue influence. This actually increases the amount of revenue generated. So chances are, raising capital gains rates will not have the desired effect of raising revenues, and short term traders do not get the benefit of those rates. However, we can all feel better about “getting” those darn rich people.
TDP - Tax Rates vs. Revenues
