Why are capital gains taxed? Aren't gains/losses a zero-sum game?

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longinvest
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Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by longinvest »

From the point of view of the government, don't gains and losses more or less offset each other? Why tax capital gains, if it is so?

Let me explain.

Note: To keep things simple, let's ignore registered accounts.

Let's start with a simply type of financial security, with a well-defined lifetime, and a maturity at par. Let's pick a (non-defaulting) bond. At issue, buyer A pays $X. At some point, A sells the bond to buyer B for $Y, where Y > X. As a result, A experiences a gain of $(Y - X) and pays tax on it. B keeps the bond until maturity and experiences a capital loss of $(X - Y), which he can use to offset taxes on an equivalent capital gain. From the government's point of view, it's a zero sum game: got tax on $(Y - X) but also gave credit on $(Y - X) for a total of zero, except for a possible (positive or negative) arbitrage due to different tax brackets for A and B.

So, with bonds, the government never makes money off the gains (other than, possibly, through to tax bracket arbitrage, if the government is lucky; I'm sure smart investors try to keep the government unlucky, though). Actually, the government loses money when there is a default on a bond, as this leads to a loss credit without an offsetting gain tax.

Let's continue with a more complex security: a stock. From a capital gains perspective, a stock is like an indefinite maturity bond. But, still, eventually, most companies die (go bankrupt, get merged, whatever, causing a final gain or loss to its last investors). Over its lifetime, most of the capital gain taxes and loss credits, for all its buyers and sellers, will offset each other. In the end, the government will have given a net capital gain credit if the company goes bust (because of the initial $X investment in stock which has a $0 value in the end). If the company grows, the government will get a net capital gain tax on $(FinalValue - X).

OK, yes, the government gets some money out of stocks, as long a the stock market keeps increasing in value, in the aggregate. Yet, these gains are way smaller than the total of all taxes and credits given each year to tax payers trading these stocks. Given the cumulative overhead of all this paper and money shuffling, is it really worth it for the government?
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by ghariton »

I think that one problem is that it is relatively easy to convert other sorts of income into capital gains and vice versa.

An example that comes immediately to mind: A corporation can convert dividends to its shareholders into capital gains (more or less) by distributing extra cash via share buybacks rather than dividends.

Or if I have a CCPC, I can choose to pay no dividends (or salaries) to myself, instead building up retained earnings. When I sell the company, the retained earnings will be converted into a capital gain (more or less equivalent amounts -- there are frictions along the way).

If you don't want to live in that condo any more, sell it rather than renting it out.

And I can only imagine the fun that could be had with callable bonds, options, and so on.

That's on the practical side. On the tax policy side, it is generally seen to be desirable to make taxation neutral to different kinds of fiscal arrangements -- you only want to tax real income or real increases in wealth, regardless of the financial instruments used. For example, you don't want to bias entrepreneurs' decisions towards financing with debt rather than equity -- or vice versa.

Finally there is a fairness principle at play: As the Carter Commission said some fifty years ago, a dollar is a dollar is a dollar. As your financial wellbeing increases, whatever the source, you should contribute to meeting society's needs.

The flaw in my argument, of course is that, if all this is true, why aren't capital gains taxed at the same rate as other income? Well, it should, provided that inflation is explicitly accounted for when calculating the capital gain. And that's a problem right there. How do you adjust asset prices to account for inflation? Do you use economy-wide inflation, e.g. the GDP deflation? A consumption-based measure such as the CPI? Or a measure specific to the asset class you are dealing with, e.g. a real estate index for that condominium of yours? A telecommunications price index for your BCE shares? Or perhaps something in between?

I think that it was to avoid calculation of inflation (which Joe Blow would find mind-bogglingly difficult anyway, whatever the definition) that the government decided to use a partial inclusion rate as a substitute. I think you can actually find that justification in some of the discussions just prior to 1972.

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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by adrian2 »

Total stock market cap keeps increasing.
Total fixed income market keeps increasing.
Total real estate market keeps increasing.
I fail to observe a zero sum.
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by Shakespeare »

I think that it was to avoid calculation of inflation (which Joe Blow would find mind-bogglingly difficult anyway, whatever the definition) that the government decided to use a partial inclusion rate as a substitute. I think you can actually find that justification in some of the discussions just prior to 1972.
Although I don't expect to see it, it would be pretty simple now to ratio the Dec. 31 CPI's of the year of purchase and the year of sale to get an adjustment factor.

In fact, CRA could produce a table of factors, one for each year of purchase, assuming sale in the prior year (to be reported on income tax.).

DRIPs would be messy, though. :wink:
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by longinvest »

adrian2 wrote: 06 May 2017 23:19 Total stock market cap keeps increasing.
Total fixed income market keeps increasing.
Total real estate market keeps increasing.
I fail to observe a zero sum.
For (non-callable non-convertible) bonds, capital gains are a zero (or below-zero) sum game for the government, as each bond matures at par or defaults below par. But, don't worry, the government gets its pound of flesh from fully taxing coupons! The increase in size of the bond market is mostly due to the issue of more bonds.
Last edited by longinvest on 07 May 2017 01:15, edited 1 time in total.
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by longinvest »

George,
ghariton wrote: 06 May 2017 23:11 I think that one problem is that it is relatively easy to convert other sorts of income into capital gains and vice versa.
OK, I see the problem.
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by adrian2 »

longinvest wrote: 07 May 2017 01:00
adrian2 wrote: 06 May 2017 23:19 Total stock market cap keeps increasing.
Total fixed income market keeps increasing.
Total real estate market keeps increasing.
I fail to observe a zero sum.
For (non-callable non-convertible) bonds, capital gains are a zero (or below-zero) sum game for the government, as each bond matures at par or defaults below par. But, don't worry, the government gets its pound of flesh from fully taxing coupons! The increase in size of the bond market is mostly due to the issue of more bonds.
US bond market dwarfs the Canadian one. A Canadian buyer of a 10 year US bond a decade ago would have been collecting his US$ principal at par together with a 30%+ capital gain due to currency movements. It's not a zero-sum game for the CRA.
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by adrian2 »

Also, don't forget that not all buyers and sellers of securities are taxable by the CRA: there are foreign buyers as well as non-taxable entities.
Not all the terms are in the sum.
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by longinvest »

Adrian,
adrian2 wrote: 07 May 2017 08:49 US bond market dwarfs the Canadian one. A Canadian buyer of a 10 year US bond a decade ago would have been collecting his US$ principal at par together with a 30%+ capital gain due to currency movements. It's not a zero-sum game for the CRA.
Wasn't it kind of obvious that I was discussing domestic bonds? :|
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Re: Why are capital gains taxed? Aren't gains/losses a zero-sum game?

Post by longinvest »

Adrian,
adrian2 wrote: 07 May 2017 08:51 Also, don't forget that not all buyers and sellers of securities are taxable by the CRA: there are foreign buyers as well as non-taxable entities.
Not all the terms are in the sum.
I know that. I didn't spell out all the little details, but I did hint to these effects:
longinvest wrote: 06 May 2017 22:14 Note: To keep things simple, let's ignore registered accounts.
longinvest wrote: 06 May 2017 22:14 From the government's point of view, it's a zero sum game: got tax on $(Y - X) but also gave credit on $(Y - X) for a total of zero, except for a possible (positive or negative) arbitrage due to different tax brackets for A and B.

So, with bonds, the government never makes money off the gains (other than, possibly, through to tax bracket arbitrage, if the government is lucky; I'm sure smart investors try to keep the government unlucky, though). Actually, the government loses money when there is a default on a bond, as this leads to a loss credit without an offsetting gain tax.
Over the lifetime of a bond maturing at par, all the cumulative gains come from coupons. A smart investor would buy a bond at issue in a non-registered account and sell it to himself at a premium (once maximized) to buy it back into a registered account. This way, the investor will have held the bond from issue to maturity, but part of the total interest income will have been converted into capital gains (in addition to the tax sheltering in the second part of the lifetime of the bond).

This reminds me of a question I had asked long ago: Who are the buyers of 1-year bonds? As you said, on that thread, the buyers are possibly non-taxable entities (such as money-market funds for registered accounts). That would represent a nice tax arbitrage.


George has it right:
ghariton wrote: 06 May 2017 23:11 I think that one problem is that it is relatively easy to convert other sorts of income into capital gains and vice versa.
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