Under Biden’s program, taxes and inflation could claim 100% of certain capital gains

A common misconception is that the US federal corporate tax rate of 21% means business owners keep 79 cents on the dollar.

This, however, ignores the many layers of taxation they face. In fact, if President Joe Biden’s 5% to 8% “High Income Surtax” is passed, after accounting for inflation, some investors could face a marginal tax of over 100%. on the business profits generated by their investments.

To demonstrate this, let’s take an example involving a high-income person with a regular income of at least $ 25 million each year and who is subject to Biden’s maximum 8% surtax.

In addition to this passive income, which includes rents, royalties and some dividends that do not require active involvement, this person also receives a high salary. On wage income, the individual pays federal income tax, the 8% surtax, payroll taxes, and state and local income taxes. After all of that, suppose the person earns an after-tax salary of $ 10 million.

The individual can spend the salary of $ 10 million or invest it. Suppose he or she invests the after-tax salary in shares of the company and that company uses the $ 10 million in capital to fund a 10-year project that ultimately brings in $ 20 million by the end of the decade. The company earns $ 10 million in income subject to corporate tax.

First, the federal government taxes corporate income at a rate of 21%, then the median state adds an additional corporate tax of 6.5%. After allowing state and local tax deductions, governments are claiming about $ 2.58 million at the company level.

After paying corporate taxes, suppose the company distributes a pre-tax dividend of $ 7.42 million to the individual, paid 10 years after the initial investment. The individual investor then pays a federal capital gains tax of 20%, Biden’s 8% surtax (note that this is the second time the surtax has appeared), a net income tax of 3.8. % and an average state and local capital gains tax of 5.2%.

Among the various taxes, governments are claiming $ 5.33 million in taxes on the $ 10 million in income from the investment. Only $ 4.67 million in investment earnings remains at the time the individual pays the capital gains and related taxes. The total value after 10 years is $ 14.67 million, compared to the initial investment of $ 10 million.

However, as 2021 has demonstrated, prices after 10 years will almost certainly be higher than they were when they started. Based on inflation, $ 14.67 million over 10 years could be worth much less.

Even at the low inflation rates of 2% over the past two decades, the investor in the example would only have 20% more purchasing power after 10 years of investment if he had immediately spent 10 million. of salary dollars.

At 4% inflation over the 10-year period, the investor’s purchasing power would be lower than if he had immediately spent his salary.

At the current inflation rate of 5.4%, the investor would effectively end up with a negative return on investment of 13%, due to the combination of taxes and inflation.

This underlines the importance of controlling inflation. Galloping federal spending on new taxes proposed by Biden is not helping matters.

The example also illustrates why excessive taxation of investment income is counterproductive, not only to the economy, but also to federal tax revenues.

At a certain level of taxation, people stop investing in taxable assets. Capital is notoriously mobile. In the face of high taxation, a large amount of capital moves to untaxed assets or to countries offering investments with higher after-tax returns.

Reports show that the Joint Committee on Taxation and the Treasury Department estimate the federal income-maximizing capital gains tax rate to be between 28% and 32%. The Tax Foundation and the Tax Policy Center use estimates that imply that long-term capital gains are maximized when the maximum rate is set at around 28%.

The new surtax brings the top federal rate on capital gains to 31.8%, likely high enough to start costing federal government revenues.

In high tax states, the situation would be worse. Take California, for example, where the top capital gains tax rate is 13.3%. Biden’s new taxes would push the combined capital gains tax rates in the Golden State to 45%. Such capital gains tax rates for high-income people will punish the rich, but will not help finance the Democrats’ extravagant spending proposals.

Regarding his plans to tax the rich, Biden said, “I don’t want to punish anyone.” However, if it raises the taxes of some individuals beyond the point of generating additional income, what does it do other than punish the rich?

Exorbitant capital gains taxes are certainly not helping the economy. Capital investments are an essential engine of economic growth. If the government removes the incentives for people to finance the operations of businesses, the obvious result is that some business operations will stop. The demand for labor will decline, which will drive down the real wages of the lower and middle class Americans that the Build Back Better plan claims to help.

Instead of superimposing tax after tax on investments, Congress should strive to craft a tax code that encourages investment and thus encourages long-term growth.

Making the full charge-off provisions of the 2017 Tax Cuts and Jobs Act permanent would be a positive step. Under full expensing rules, taxpayers can deduct capital investments in the year the costs are incurred.

Unfortunately, in 2023, the U.S. tax code is expected to revert to a system in which companies have to wait several years to deduct capital investments using a complicated amortization schedule. A system that effectively requires taxpayers to pay taxes on the profits of investments before they are earned is particularly problematic when businesses fear continued inflation.

With inflation, the tax code artificially devalues ​​these deductions that are delayed for years after a taxpayer has incurred an expense. As in the example above, taxpayers can end up paying taxes on phantom profits.

Investment stimulates long-term economic growth. The US tax system is already skewed against saving and investing. Biden’s tax plans compound the problem.

Worse yet, Biden is resorting to inefficient and counterproductive taxes that are unable to fund even half of his new welfare spending which could amount to $ 4 trillion after factoring in budget tips.

This will only worsen deficits, further crowding out investment and slowing economic growth.

This piece originally appeared in The Daily Signal