Capital Gains Taxes

Corporate income taxes are not the only taxes that corporations in the United States are expected to pay. They are also expected to pay capital gains taxes when they realize a gain in their capital investments that they have made.

In this article, we will have a closer look at what capital gains taxes are as well as how they affect the economy in general.

What are Capital Gains Taxes?

Companies purchase capital assets in due course of their business operations. Then, they keep making adjustments to the value of these capital assets.

For instance, if improvements are made, or installation charges are incurred, then the value of the asset is marked up. On the other hand, depreciation charges are used to reduce the value of the asset. This keeps on happening over time. The value of the asset after all these adjustments are made is called its book value.

When an asset is sold, its selling price is compared with its book value. If the selling price exceeds the book value, then there has been a capital gain. The capital gain so determined is taxed at different rates.

Just like real assets, capital gains also arise when financial assets are purchased or sold. In the case of financial assets, the values are adjusted for inflation. This is done via a process called indexing. The sales price is then compared with the indexed value to determine the capital gain.

Most governments around the world have different tax rates for short term capital gains and long term capital gains. If the asset being sold is purchased less than one year before being sold, it is charged short term capital gains tax.

On the other hand, if the asset is held for more than one year, it is charged a long term capital gains tax. Generally, in the case of short term capital gains tax, the income is added to the regular income and taxed at regular rates. Short term capital gains accrue to companies who buy and sell shares at short intervals i.e., day trading.

However, in the case of long term capital gains tax, the income is taxed at a preferential lower rate. This rate is close to half of the corporate income tax rate. This is done in order to encourage people to hold on to their investments for longer periods of time.

Just like capital gains occur, there is also a possibility of capital losses occurring. These losses can be used to set off the gains made. The set-off of the gains is not restricted to one year but can be carried forward over several years.

How do Capital Gain Taxes Affect Corporate Behavior?

Capital gains tax rates have always been lower as compared to corporate tax rates. This has been the case because many economists believe that it benefits the economy in the long run. Some of the reasons have been listed below:

  • Capital gains taxes are paid in addition to income taxes. Hence, if they too are charged at very high rates, there will not be much incentive for corporations to invest their own money.

  • Capital investments are necessary for entrepreneurship. Hence, if a government starts rigorously taxing capital investments, it will be removing the incentives to make capital investments.

  • Lastly, if the capital gains tax is too high, it will result in corporations holding on to their investments for too long. There will be a strong disincentive to sell and make bigger investments. Hence, lower tax rates actually result in higher tax revenue.

Who Benefits from Lower Capital Gains Taxes?

There are many economists who have been vehemently opposing lower capital gains taxes. This is because they believe that the benefits of such taxes are disproportionately taken by the rich.

For instance, many studies have concluded that when capital gains taxes are reduced, the lion’s share of the savings is done by people with very high incomes. It has been estimated that over 70% of the people benefitting from such schemes have an income of more than $1 million dollars. These are not the people that governments intend to support.

Also, lower capital gains tax create situations wherein people are incentivized to scam the system. For instance, it is common practice for many citizens to convert their normal income i.e., wages and rental income, into capital gains in order to tale advantages of the lower tax rates.

Another disadvantage of a lower long terms capital gains tax is that a lot of work has to put in towards administrative tasks. As already mentioned above, people have strong incentives to change the type of income.

Hence, a lot of tax officials have to be appointed to ensure that such cheating does not happen. This costs a lot of money and effort. Many times it wipes out the gains that are made by having a lower tax in the first place.

The bottom line is that capital gains tax is not really a major factor in determining the economic growth of a nation. Hence, as long as the value is not too high or too low, it is generally immaterial.

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