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taxation of earned income vs investment income‏


ERICOPOLY
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My chief worry that is the source of all this grumbling about taxes is being able to invest conservatively while keeping up with inflation.

 

Let's say I have a bond earning 4% and I get taxed at 46% rate (in California).  Hmm...  I only have 2.16% after tax.  That's roughly a return of 0% after inflation.  So that's the first reason why I believe fixed income should be taxed at a lower rate than earned income.

 

Because of this 0% real return, I must invest in shares of businesses that steadily grow their earnings.

 

Compare that to your earned income as an employee.  You have a salary that rises every now and then to adjust for inflation.  The rise in the present value of your future earnings is a form of imputed capital gain.

 

Just like if I own shares of BAC, if they raise earnings steadily over time the shares will rise.  There is a capital gain there associated with the rise in earnings.

 

Same for the wage earner -- the present value of his future earnings stream rises as he is given wage increases.

 

Thus, the capital gains tax could be abolished to put wage earners on a level playing field with investors.

 

People are calling capital gains "income", but they are not recognizing that when their own wages go up the same type of "income" is occurring (if you took the present value of all future earnings and expressed it as a capital value).  Do you want to be assessed a special "income" tax on the imputed value of your future earnings stream whenever you switch from one employer to the next?  Because that's pretty much exactly what happens when I switch from BAC into WFC.

 

So pretty much everyone (except for investors) is enjoying tax-free capital gains, in a sense.

 

Granted, I know Buffett throws off this argument a bit because he has opted for capital gains in lieu of taxable dividends, but there is some component of capital gains that is strictly due to the steady rise in earnings over time.  Investors are in the unique position of owing a tax when they switch from one income source to the next, even when the "gain" is merely the present value of the increase in earnings.  But employees never get hit with that when they change jobs -- however they too have a increase in present value of future earnings.

 

Okay, this was a little tongue in cheek but I think there is a point to be made about the capital gains tax.  It's not really a "gain" -- when you pay the tax you are losing a share of a future earnings stream -- and often it's just an inflationary rise in future earnings and thus not really a gain at all.

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