- The Washington Times - Wednesday, August 15, 2001

Press reports indicate that there is growing support in Congress for cutting the capital gains tax rate. If history is any guide, the debate will pit those who believe that a lower capital gains rate will stimulate economic growth against those who say it is unfair to reduce a tax primarily paid by the wealthy.
In fact, taxing capital gains at all is among the most unfair features of the tax code, because capital gains are not income. The fairest thing Congress could do is abolish the capital gains tax altogether.
Because capital gains have been taxed continuously since enactment of the current income tax, few people realize that this was the result of historical accident, rather than congressional intent. When Congress passed the income tax, there was no mention of including capital gains in taxable income, and strong reason to believe capital gains would not be included.
At the time Congress created today's income tax in 1913, the legal precedent in place was that capital gains were not considered to be income for tax purposes. In Gray vs. Darlington in 1872, the Supreme Court ruled on a capital gains case arising from the Civil War income tax, which was in place from 1861 to 1871. It held that capital gains did not constitute taxable income because, unlike wages, interest, dividends and other forms of income that accrue entirely within a single tax year, capital gains could accrue over many years. Hence, it was wrong to tax them as if they had arisen within a single year.
Many commentators at the time the 16th Amendment was enacted assumed that this precedent would carry forward, leaving capital gains untaxed. And in fact, the Supreme Court ruled as such in Lynch vs. Turrish in 1918. The court decided that realizing a capital gain did not constitute income, since it was merely an asset conversion from one form to another, from unrealized gain to cash. "Indeed," the court said, "the case decides that such advance in value is not income at all, but merely increase of capital and not subject to tax."
The Internal Revenue Service, however, simply refused to follow the court's ruling and taxed capital gains as if they were ordinary income. This led to further court cases in which the principle of not taxing capital gains was upheld. For example, in 1919 the Supreme Court ruled that stock dividends are not income in Eisner vs. Macomber. In 1920, a federal district court ruled against taxing capital gains in Brewster vs. Walsh, citing the Supreme Court's earlier rulings.
Nevertheless, the IRS continued to tax capital gains. This led to yet another Supreme Court case in 1921. But this time the court did not follow precedent, and reversed its earlier rulings.
In the case of Merchants Loan and Trust Co. vs. Smietanka the court decided that capital gains are in fact income after all.
Apparently, the deciding factor in the court's about-face was not logic or the law, but a fear that the federal government would not be able to service its huge World War I debt without revenue from taxing capital gains.
The theoretical question of whether capital gains constitute income was resolved not just by the Supreme Court's definitive ruling in 1921, but by the wide acceptance among tax theorists of the Haig-Simons definition of income. This holds that "income" consists of consumption plus the change in net worth within a tax year.
Obviously, such a broad definition fully encompasses all capital gains, whether realized or unrealized. Yet, interestingly, capital gains are not included in the broadest definition of income of all — the gross domestic product.
There are many other reason, of course, why it is a bad idea to tax capital gains. Most gains only represent inflation or the present value of corporate profits that are already taxed twice, first at the corporate level and again by stockholders. High, effective capital gains rates reduce the capital stock and lower growth and productivity. And capital gains taxes encourage a "lock-in" effect that discourages investors from selling their assets, which reduces economic efficiency by putting too much capital in older investments at the expense of newer opportunities.
Congress may well be persuaded to cut the capital gains tax this year. But it would be better if there were a debate about whether capital gains should be taxed at all, as a matter of principle. Such a debate over the estate tax has led a majority of Congress to conclude that it is not a legitimate form of taxation. The same logic says there should be no taxation of capital gains, either.



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