One of the principles of good tax policy and fundamental tax reform is that there should be no double taxation of income that is saved and invested. Such a policy promotes current consumption at the expense of future consumption, which is simply an econo-geek way of saying that it penalizes capital formation.
This isn’t very prudent or wise since every economic theory agrees that capital formation is key to long-run growth and higher living standards. Even Marxist and socialist theory is based on this notion (they want government to be in charge of investing, so they want to do the right thing in a very wrong way – think Solyndra on steroids).
To help explain this issue, the Wall Street Journal today published a very good primer on taxing capital gains.
The editors begin with an uncontroversial proposition.
The current Democratic obsession with raising the capital gains tax comes from a mistaken belief that the preferential rate applied to the sale of a family business, farm or financial asset is a “loophole” that mainly benefits the rich.
They offer three reasons why this view is wrong, starting with a basic inequity in the tax code.
Far from being a loophole, the low tax rate applied to capital gains is beneficial and fair for several reasons. First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses.
Next, the editors highlight the unfairness of not letting investors take inflation into account when calculating capital gains. As explained in this video, this can lead to tax rates of more than 100 percent on real gains.