Question & Answer: The question of whether capital gains should be subject to the federal income tax has long been a subjec…..

The question of whether capital gains should be subject to the federal income tax has long been a subject of debate. Today, however, the issue has become less abstract and theoretical, because many Congress people (and pundits and commentators, etc.) are openly advocating substantial reductions in or outright abolition of all such taxes. Explore the Internet sites for commentary on this issue, and consider the arguments in light of what you know about capital gains taxes. To what extent is the capital gains tax a good tax? Why or why not? In making your decision (and explaining your answer), make sure that you consider some of the fundamental requirements of a good tax that we explored in Week 1, such as fairness, efficacy in raising funds, and relative ease of administration. Please provide citations that will support your arguments.

Expert Answer

Background – A capital gains tax is a type of tax levied on capital gains, profits an investor realizes when he sells a capital asset for a price that is higher than the purchase price. Capital gains taxes are only triggered when an asset is realized, not while it is held by an investor.

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Reduction in Capital Gain –

Cutting capital gains taxes would increase the difference between capital gains and other income and boost the tax sheltering industry. They also drain revenues from the Treasury. Advocates like to assert that capital gains tax revenue rises when capital gains tax rates are cut. The result, even if it were true, is misleading. The point of shelters is precisely to shift income from highly taxed to lowly taxed forms. For example, when lower taxes on capital gains cause an executive to shelter income by switching the form of compensation from wages to stock options (which generate capital gains), revenues from capital gains taxes increase, but tax revenues from wages fall by even more, so overall revenues fall.

Capital gains tax cuts would provide a windfall for the wealthy. Advocates often claim that tax cuts are fair because most of the people who would get tax breaks have modest incomes. That’s like saying that income is equitably distributed because almost everybody has some. About three-quarters of capital gains are realized by the 3 percent of households with incomes over $100,000.
Yes, capital gains cuts would raise saving and investment, but not by much. Capital gains taxes are a small part of all taxes on saving and investment, and the effective rate on gains is already low. Much investment would be unaffected because it is financed with debt or supplied by pension funds, non-profit institutions, and foreigners who do not pay capital gains taxes in the first place. And saving is not very responsive to changes in its return. As a result, conventional estimates suggest that cutting the top gains rate to 20 percent would raise private investment by less than 0.1 percent of GDP. Even that modest gain could be erased if the tax cut increases the deficit, causing interest rates to rise.

Advantages and disadvantages –

1.Tax Deferment
One advantage of capital-gains taxes is that tax payments are deferred until the asset is sold.
2. Tax Rates – The amount of taxes you must pay on a capital gain depends on the length of time you owned the asset prior to selling and can either be a benefit or detriment to the taxpayer. If you owned the asset longer than 12 months and realize a profit, you have a long-term capital gain, which is taxed at a lower rate. If you own an asset less than 12 months and sell it for a profit, you have a short term capital gain, which is taxed at a higher rate. Long-term ca+C8pital-gains taxes are more advantageous than short-term capital-gains taxes because its rate typically produces savings.

3. Profit Reduction
According to the Internal Revenue Service, nearly everything you own for personal use or investment purposes is a capital asset. A drawback to owning capital assets is that if they are sold for profit, the IRS requires that you report gains as income. The disadvantage of this tax is that it can reduce the overall profits realized from the sale of the asset.

Conclusion – A cynic might conclude that capital gains tax cuts are simply a sop to rich campaign contributors. It could be better than that, though. The proposals made here could improve economic incentives and simplify taxes at relatively little budgetary cost.

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