Double Taxation, by Rajiv Sethi: The release of Mitt Romney's tax returns has drawn attention yet again to the disparity between the rates paid on ordinary income and those paid on capital gains. It is being argued in some quarters that the 15% rate on capital gains vastly underestimates the effective tax rate paid by those whose income comes largely from financial investments, on the grounds that corporations pay a rate of 35% on profits. Were it not for this tax, it is argued, dividends and capital gains would be higher, and so would the after-tax receipts of those (such as Romney and Warren Buffett) who derive the bulk of their income from such sources.
Romney himself has made this argument recently, claiming that his effective tax rate is closer to 50%:
One of the reasons why we have a lower tax rate on capital gains is because capital gains are also being taxed at the corporate level. So as businesses earn profits, that's taxed at 35 percent. Then as they distribute those profits in dividends, that's taxed at 15 percent more. So all total, the tax rate is really closer to 45 or 50 percent.
The absurdity of this claim is clearly revealed if one considers capital gains that accrue to short sellers, who pay rather than receive dividends while their positions are open. Following the logic of the argument, one would be forced to conclude that short sellers are taxed at an effective rate of negative 20%, thereby receiving a significant subsidy due to the existence of the corporate tax. The flaw in this reasoning is apparent when one recognizes that asset prices are lower (relative to the zero corporate tax benchmark) not only when a short position is covered, but also when it is entered. ...[continue reading]...