A Century of Flip-Flopping – A Brief History of the Capital Gains Tax

Remember the 2004 presidential debates when George W Bush said of John Kerry that “first he voted for it and then he voted against it” (Kerry’s votes to fund the Iraq war).  The media loved it and since then, with the help of PACs and special interest groups and the so-called pundits who people C-Span and AM radio, have turned “flip-flopping” into something of a political crime.  Any politician with the audacity to change his mind now risks his career.  Flip-flopping isn’t quite as bad as engaging in Twitter sex with a woman in Texas or disappearing for a week to Argentina, but it’s a whole lot worse than voting for a bridge to nowhere.  Mitt Romney, it seems, is the latest culprit (I’m writing this during the primary season).  Poor Mitt (pun intended) did it twice, changed his mind about health care reform and about abortion too.  God forbid.

In light of the national war on flip-flopping, and now that we’re getting ready to celebrate (if that’s the right word) the centennial of the first Internal Revenue Code, I thought it would be fun to put together a brief history of capital gains legislation.  No issue, it seems to me, has caused more congressmen to change their minds more often than has the capital gains tax.  If you look at my brief history you’ll see that capital gains tax rates have been as low as 0% and as high as 75% (counting the AMT effect) and everywhere in between.  During that time the required holding period for capital assets has ranged from 6 months to 10 years.  Capital loss deductions have come and gone and come and gone and then come again.  The exclusion amount (a portion of gain excluded from tax) moved back and forth between 6 different rates until 1986, when it was eliminated altogether.  The one and only consistent thing about capital gains law during its first hundred years has been the progressively liberal treatment of homeowners.  Steadily, step by step, the amount of tax paid on gains from the sale of personal residences decreased until 1997; that’s when the exclusion hit $500,000 and all but a small handful of homeowners were liable for any tax at all.

Notice my use of the word “brief”.  My short history only lists major legislation affecting most individual taxpayers (1040 filers). I haven’t included legislation concerning the sale of business or rental assets, corporate capital gains, gains on inherited or gifted assets or laws aimed at one type of asset, like timber, movie rights, agricultural land, etc.  Such a history would be 10 times longer.

Revenue Act of 1913 –  Capital gains taxed at ordinary income rates of 1 to 7 percent.  Capital losses were not deductible.

 Revenue Act of 1916 – Capital losses deductible to the extent of capital gains..

Revenue Act of 1918 – Net capital losses in excess of gains were deductible.

Revenue Act of 1921 – A holding period of 2 years established for capital assets.  Maximum capital gains tax of 12.5% was established.

Revenue Act of 1932 – Net capital losses were not deductible, but carried forward for one year..

Revenue Act of 1934 – Capital gains exclusion at rates of 20, 40 and 60 percent for holding periods of 2, 5 and 10 years respectively. Net capital losses of $2000 deductible.

Revenue Act of 1938 – Exclusion changed to 33 1/3 and 50 percent for holding periods of 18 months and 2 years respectively. Maximum capital gains tax rate increased to 30%.  No limit on net capital losses.

Revenue Act of 1942 – Exclusion changed to 50% and holding period to 6 months.  Maximum capital gains tax rate increased to 50%.  Only 50% of capital losses were allowed, Net capital loss limit decreased to $1,000 with a 5-year carryover.

Revenue Act of 1951 – 50% limit on capital losses abolished.

Revenue Act of 1964 – Time limit for capital loss carryovers eliminated.

Tax Reform Act of 1969 – Maximum tax eliminated for gains in excess of $50,000.  The capital gains exclusion became a “preference item” for the new “alternative minimum tax” rate of 10%, which effectively raised capital gains tax for some taxpayers.

Tax Reform Act of 1976 – Holding period increased to 12 months.  AMT was raised to 15%.  Net capital loss limit raise to $2,000 and to $3,000 starting in 1977.

Revenue Act of 1978 – Maximum tax totally eliminated.  Exclusion increased to 60%.  AMT raised to 25%,

Deficit Reduction Act of 1984 – Holding period decreased to 6 months until 1988.

Tax Reform Act of 1986 – Exclusion eliminated.  With no exclusion the AMT effect on capital gains was effectively eliminated.  With no exclusion and no maximum tax, capital gains were taxed as ordinary income.

Revenue Reconciliation Act of 1990 – Maximum tax rate on capital gains re-established at 28%.

Taxpayer Relief Act of 1997 – Maximum tax rate decreased to 20 and 10 percent for holding periods of 18 months and 5 years respectively. Tax rates would drop to 18 and 8 percent starting in 2000.  A new class of assets called “collectibles” (paintings, coins, etc) would be taxed at 28%.

Internal Revenue Service Restructuring and Reform Act of 1998  – The 18-month holding period changed to 12 months.  The 18% tax rate scheduled for 2000 eliminated.

Jobs and Growth Tax Relief Reconciliation Act of 2003 – New capital gains tax rates of 5% and 15% were tied to a taxpayer’s AGI.  A 0% rate would start in 2008.

Tax Increase Prevention and Reconciliation Act of 2005 – Extended 2003 capital gains rates, set to expire in 2008, through 2010.

Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010 – Extended 2003 capital gains rates through 2012.

Back to the Future

 The 2003 capital gains rates, the so-called Bush tax cuts, are set to expire at the end of this year, having already been extended twice.  President Obama has said that, going forward into the next tax century, at a minimum the capital gains tax should increase to 20%, and ideally, that capital gains should be taxed at ordinary income rates.  He’s also suggested that capital gains should be subject to payroll taxes just like earned income if.  As an investor I find his ideas appalling.  To my mind, investment, which involved risking my hard earned money, is an entirely different activity from punching a time clock, and the tax system should recognize the difference and acknowledge the risk.  The president doesn’t agree.  For him, income is income.  He has plenty of company; any number of congressmen and a large part of the American public, perhaps most of it, are on his side.

We’ve been here before.  In 1913, when the IRC was written, and again in 1986, after Reagan’s so-called tax revolution, investment income and earned income were taxed alike.  In both cases, within 3 years, tax law began to evolve towards recognizing capital gains.  But this time around there are two new issues muddying the legislative waters, one of which is “carried interest”, a loophole which allows hedge fund and private equity managers to treat large portions of income as investment income.  It’s a smokescreen.  Hedge funds invest and risk other people’s money, not their own, which mean that their income is earned.  To me it’s that simple.  Unfortunately, half of Congress wants to do away with all capital gains in order to tackle the carried interest problem and the other half defends carried interest in the defense of all capital gains law.

The other issue is “employee benefits”.  Based on BEA numbers, benefits topped 1.5 trillion dollars in 2010.  That’s 20 cents for every dollar of payroll.  The number of 401k and cafeteria plans, not to mention the cost of health insurance, has grown by leaps and bounds since 1986.  These benefits are virtually all tax free (many of them are also payroll tax free), which means that the typical American worker gets a 20% income exclusion on his/her tax return without even realizing it.  Since 1986 the number of tax credits has also grown by leaps and bounds.  Most credits, the most generous ones – the EIC, Child Tax Credit, Making Work Pay Credit and Dependent Care Credit – can be applied only to tax resulting from earned income.  In 2009 (latest IRS figures available) these credits reduced total tax liability by almost 15%; for working people with children the reduction was over 40%.  It’s not hard to see why many investors think it’s actually earned income which gets the preferential treatment.  That’s not far from the truth.

Going forward into the next century it’s hard to see how capital gains legislation could be more sensible than it was in the last.  Our tax law will surely continue as a muddle, a mish-mash of largely politically motivated, re-hashed proposals which come and go and come again.  The situation is probably worse than in 1913, of even 1986, because now any politician who’s ever weighed in on the carried interest or employee benefit questions or on any aspect of capital gains law couldn’t change his mind even if he wanted to.