Maybe We’ll Cool It on Thought Experiments for a While, Because I’m Tired

Listen, Rich People, something you should know about me is that my brain is owned and operated by a trio of opposing, hustling forces (the Three Grind Mice, if you will), constantly grappling with one another for control. 

The first mouse is Curiosity, genuinely open-minded and steering me in the direction of truth, no matter how inconvenient to my preexisting beliefs. 

The second is Greed, tracing her grubby little paws through the tax code line by line on April 14 wondering just how frowned upon it is to fib about what constitutes business travel. 

And the third is Pride, who—regardless of evidence presented to the contrary—will steer my attention to whatever validates my point of view.

So you can imagine the chaos amidst my little cerebrum rodents when Curiosity was like, “What if we challenged our thinking about capital gains taxes and incentives?” while Greed put a hex on a tiny IRS voodoo doll under the table and Pride was like, “Girl, have you seen this chick’s YouTube channel? She calls tax avoidance ‘her Superbowl.’ We can’t start poking holes in capital gains. The readers will revolt.”

Three Grind Mice HQ after hitting “publish” last week:

And revolt the readers did, which inspired even more melee for my head hamsters, who had already reshuffled to accommodate their new positions: Pride ready to defend the new conclusion (it might make sense to tax capital gains like labor), Greed relieved of its regular duty and taking a breather in the back seat, and Curiosity half-asleep at the wheel. Get in, losers, we’ve got bias to confirm.

But I shook Curiosity awake and strapped Greed and Pride to the spinning wheel of terror, so I’m ready to chat about your feedback. Many of you raised points I either hadn’t considered or had considered, but ultimately dismissed. For example, one reader wrote that they’d expect to be rewarded for the risk of investment (in the form of a tax break).

“Is the risk I take worth the advantages I have with capital gains (vs. ordinary income)?” This sentiment came up a few times—that is, It’s a risk/reward calculus. I’m taking risk by investing, so I should be rewarded with a tax advantage. 

As your friendly neighborhood 401(k) advocate who will be the first to tell you that you should avail yourself of a tax deduction eight days a week, the more I think about this line of reasoning, the more I wonder if it’s a flawed application of our understanding of risk and reward in capital markets.

“The more I think about this line of reasoning, the more I wonder if it’s a flawed application of our understanding of risk and reward in capital markets.”

The risk you’re taking is already being rewarded (maybe) by the return you’re receiving in the market, irrespective of how light (or heavy) the government touch is, right?

Perhaps it’s useful to return to the capital gains tax’s beginnings to understand the original intention: In the late 1800s, when the United States was just getting comfy for the first time with taxation, political economist Henry Carter Adams (you should see the mutton chops on this man) argued that income derived from labor was truly “earned,” while income from capital represented the “unearned” returns from the “accumulated wealth of the idle rich,” and should be taxed differently. One point for Curiosity! Or is it Pride?

At the time, though, the rates were so low and exemptions so generous that basically nobody paid taxes (a few readers who make frequent appearances in my inbox who would enjoy a vacation to this time period)—only 2% in 1913, and up to 20% by 1919, thanks to World War I. 

The idea to treat earned income and investment gains differently originated with a dude by the name of Frederick Kellogg (perhaps an early ancestor of Big Cereal fame), who was a hot shot corporate lawyer in the early twentieth century. In 1920 and 1921, he testified before Congress that all Americans “refrained from transacting” in the face of high taxes. They weren’t going to buy or sell assets, and this was allegedly constipating the economy. 

After the war, lawmakers struck a compromise with disgruntled businessmen who were grumbling that taxes were too high: They’d retain a progressive income tax, but throw the boys a bone and grant capital gains a preferential rate. 

In that sense, it had next to nothing to do with rewarding or incentivizing risk at all, but rather, the “fluidity” of money. 

Relatedly, one reader brought up inflation: “One thing that’s never pointed out is that long-term capital gains are not adjusted for inflation. It’s possible to pay heavy taxes on an investment that didn’t keep up with inflation. If capital gains taxes are raised, they should be adjusted for inflation.”

In other words, because gains aren’t indexed to inflation, it’s possible that what looks like a gain on paper still has the same or less purchasing power than it did before—creating what feels like an unnecessary taxable event. 

“Because gains aren’t indexed to inflation, it’s possible that what looks like a gain on paper still has the same or less purchasing power than it did before.”

I wonder if this isn’t a funky little portal to a larger question more broadly: The 4% interest you generate in a savings account this year might merely help your savings preserve purchasing power amidst 4% inflation…but it’s still going to be taxed (like ordinary income). Your income might be raised by 4% to keep pace, too—but that doesn’t mean the increase won’t be taxed. All the tax brackets do, however, adjust upward for inflation every year, so that helps offset this effect to some degree.

(As fate would have it, that litigious king Kellogg argued this, too: “Income from capital gains also deserved preferential treatment because inflation reduced the real value of capital gains, even before taxes were paid.”)

Other readers were quicker to accept that maybe the argument was potent, but hey, what about all those damned real estate investors? Were we planning to come for their lavishly tax-advantaged, levered-up winnings, too?

“With all these talks about capital gains tax, how come I don’t hear people talking about eliminating things like the section 121 exclusion or 1031 exchanges? If people really want to make things ‘more equal,’ they should be okay with paying these taxes, too, because if I’m punished for investing my capital successfully, why shouldn’t someone who makes money on a house pay up? I mean, a $250,000 or $500,000 exemption on a personal residence…is that really necessary?”

It’s worth noting that, actually, the new proposal for the 2025 budget does propose getting rid of the 1031 exchange. For the uninitiated, this is a piece of the tax code that advantages real estate investment in a way that no other asset class benefits from. 

“Maybe radical simplicity is the real (and least objectionable) answer.”

The use of the word “punishment” interests me (here, I am going to psychoanalyze this poor, dear reader). Maybe the problem is that the tax code is so dang complicated and summons loophole exploiters so readily. Maybe radical simplicity is the real (and least objectionable) answer.

In a 2012 episode of Planet Money, they interviewed a team of economists all over the political spectrum, and regardless of where they landed, they were all in agreement that the best way to standardize things was to…eliminate all the deductions. Yup, simplify it. No standard deduction, no itemized deductions, no nothin’—just revisit the brackets and treat all income from any source the same way. For obvious reasons, you can imagine how that would go over politically: with a sound barrier-disrupting thud. It would also put people like me out of work, so let’s wrap this thing up before Greed untethers herself from the exercise wheel and steers this draft to the trash bin.

Another reader pointed out that the investor in my hypothetical is still paying net-more in taxes than the laborer: “I think your Amazon example is incorrect. What did the Amazon investor do for the intervening 20 years [after they graduated and invested their $10,000 gift]? They worked, and were taxed on that income. All the while, their $10,000 investment was used by Amazon to invest in their operations and to pay those who took an unguaranteed chance and invested in the company and used to offset salaries with stock options. If we assume both workers paid the same income tax, the investor paid more in actual taxes and also as a percentage. Should they be punished for that?”

There’s that word again! “Taxes as punishment” strikes me as a uniquely American perspective, almost as though there’s a tiny Boston Harbor tea-tosser inside each one of us. I can’t imagine a Swede or a Norwegian describing their taxes as punishment. (Scandinavians, weigh in.)

“Is it because, in order to invest at all, one must sacrifice, and labor in a new, different way?”

I can see this reader’s point of view, though, much to Pride’s chagrin—that any incremental tax money paid on capital gains will be “new,” so to speak, so in this case, the investor has paid $30,000 more into the tax system than their only-laboring counterpart. My core curiosity remains, though: Why do we tax income derived from financial capital more preferentially than income derived from human capital?

Is it because, in order to invest at all, one must sacrifice, and labor in a new, different way? The words I write on this page are technically “work,” but when I receive my paycheck and choose to do the hard work of saving a portion such that it may be invested and go on to more productive use, that’s more laborious, more productive, than blowing it on, say, strippers and cocaine? 

Still, the phrase “idle rich” feels inescapably relevant. As we’re all well aware, there comes a point where your money is multiplying faster than you can use it (like the households the government is proposing we tax at parity with ordinary income: those with $1 million or more in realized capital gains per year). What of them, Kellogg? Who’s constipated now?!

I’ll close with thoughts from a reader who took umbrage at the idea that any of us should be forking over more of our Chuck-E-Cheese tokens to the rusty animatronic band of our federal government:

“While bailing out the sinking ship might feel like decidedly not our job, the alternative is going down with it.”

“What are we adding to the deficit at this point? A trillion every 100 days or so? Our interest on our debt is closing in on what, a trillion a year? The argument that the most productive [people] should try to bail out this sinking ship is a bit of a stretch. There is a systemic issue that needs to be addressed first, at the top, before trying to pass the buck on to us individuals.” 

Reader, I don’t disagree. But it’s worth remembering that while bailing out the sinking ship might not be our job, the alternative is going down with it. 

Maybe we’ll cool it with thought experiments for a while—my mice are tired.