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Reuters reported yesterday that a bill about to be considered would raise taxes on investment fund managers, by treating some of their investment income like "regular" income. Will this raise a lot more money in the grand scheme of things? No. Why do it? Politics. It's a way to look "tough on" Wall Street.

This week the unpopular people are the investment fund managers, so we are going to tax them extra, and not let them eat lunch at the cool kids' table.

One of the reasons our tax system is so insanely complex is that it's not designed to be about raising needed money, it's not particularly "designed" at all in the sense that there's some overreaching vision that has created a coherent system.

The tax system is our legislature's favorite plaything. They take away money from whomever isn't cool this week, and give it to whomever is. Meanwhile, in their great concern that we all be a little cooler, they tax ugly shoes (or whatever else they deem uncool) a little extra and provide tax credits for funky wallpaper (or whatever they think is cool). Since, like ditzy teenage mallrats, congress can't be bothered to think for a minute about the fact that trends change constantly, and it really isn't their business to try to rid the world of ugly shoes (or -- gasp -- that they may have horrific taste to begin with), the tax code is a pile of unrelated and sometimes contradictory snippets of fleeting fashion sure to rival any sixteen-year-old girl's clothes closet.

Did you know that federal income taxes haven't always existed in America? It was not until the Revenue Act of 1861 was signed into law by Abraham Lincoln, to raise money for the Civil War, that we had an income tax. We did fine without one for nearly 100 years.

You may be wondering why "capital gains" are treated differently than other types of income when it comes to paying taxes. We hear a lot about "capital gains" from the talking heads on TV, who seem to agree that there is some vague evilness about "capital gains", but never talk about what it is or how it got that way.

Article I, Section 2, paragraph 3 of our constitution says, in part, "...direct Taxes shall be apportioned among the several States...according to their respective Numbers..." "Direct taxes", in a constitutional sense, are basically taxes on things you already own. So, if the federal government wants to tax things people already own, it must be done by taxing each state according to its population. The idea is that once you have worked hard and finally bought your family a home, the federal government can't say "give us this much money every year or we'll take away your home". (States and localities have no problem doing this to you, of course.)

Now, what happens if something you own causes you to have more assets (stuff, money, anything worth anything)? This can be an "on paper" sort of income, such as if your house becomes more valuable over time or some knicknack you bought becomes a valuable collector's item -- you don't actually have more money, because you aren't selling your home or your knicknack, but in a legal sense it is income -- or actual money coming into your hands, such as if you rent out a house you own, or if a farmer pays you to cultivate some of your property. If the federal government taxes that, is it taxing something you already own (a direct tax), or is it taxing new stuff you are getting (an indirect tax)?

In 1895, in a case called Pollock v. Farmers' Loan & Trust Co., the Supreme Court said that income from things you already own (such as when those things become more valuable, or someone rents them) is a direct tax. That special income -- income from things you already own -- is today most often referred to as "capital gains". Congress, because it doesn't like being told it can't tax things, soon passed the Sixteenth Amendment, which changed the constitution to allow Congress to tax individuals for all kinds of income, including what we now call "capital gains".

There's a political theory that says "we don't like people who don't work for their money, so we need to tax capital gains more". It sounds good on TV! Unfortunately, it really hurts people. If you own a house, raise your children there, and want to keep raising your children there, but your neighborhood suddenly becomes more desirable, you may find that the house you bought for $120,000 ten years ago is now worth $200,000. That is an $80,000 capital gain! Do you want to pay taxes on $80,000? Is it fair to lose your home over it? Is it fair to go to jail over it? Remember, it's "income" you "didn't work for".

Now, here's the kicker: even if we did pretend that capital gains are all evil, and should be taxed like crazy, WHY should they be taxed differently for people with one job description than for people with another? That's like saying "there was a plane accident this week, so we're down on pilots, everyone who is a pilot will now pay extra income tax". This week people are freaking out about Wall Street, and we understand what those people do less than we understand what pilots do, so it's easier to make the argument while sounding good on TV.

At least the tax preparers, accountants, financial advisors, tax consultants, IRS auditors, and government beurocrats are all making lots of money trying to sort through all these exceptions and special cases.

Also posted to Political Illiteracy.

HedgeMage's blog

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