David Post: Investment tax rates can be tricky stuff

Remember that entertainer who puts a sponge ball under one of three cups? You watch closely as he moves them around. He stops, picks up the cup with the ball under it, and you’re proud for not having been tricked.

He does it again, but this time his hands and the cups are a blur. When he stops, you have no idea where the ball is. Someone guesses, points to a cup and misses. The cup magician raises another cup, and there’s the ball. The crowd claps, and some leave money in his hat.

The cup magician, a small-business job creator, has a tax question. How much tax should he pay on the money in his hat? Is it earned income with a possible 35 percent rate? Or can an imaginative tax guru figure a way to characterize this process as investment income, perhaps as a dividend from the capital investment in the cups and sponge ball, resulting in the lower 15 percent rate?

Suppose that instead of using a sponge ball, the magician put stock certificates under the cup and moved them around. That’s good tax planning. Moving money and investments around is clearly an investment activity. Hence, he would be entitled to the lower 15 percent rate.

The logic behind lower capital gain rates is that patient capital creates jobs, and the investor incurs the risk of loss. The investor also has the advantage of when to sell and therefore when to pay the tax, or to not sell and owe no tax. Employees don’t enjoy that luxury of determining when they pay their tax.

The tax rate on dividends is also 15 percent because they are generated by the capital investment. Because dividends are paid to shareholders from corporate earnings that have been taxed, Republicans want to eliminate all taxes on dividends.

Lower tax rates on investment income are among the largest loopholes in the tax code and have been the centerpiece of Republican economic policy for years. So, the big question is whether lower taxes on investment income spur economic activity and create jobs.

Here is a 30-year tax history in a nutshell:

Reagan reduced rates on earned income, increased rates on capital gains, increased deficits and generated 11 million jobs.

Clinton increased rates, reduced deficits, and generated 22 million jobs.

George W. reduced tax rates, doubled the national debt, and created no jobs.

That’s right: President Reagan raised rates on capital gains. During his second term, Reagan reduced tax rates on earned income and increased (yes — increased!) rates on investment income from 20 percent to 28 percent.

President George W. Bush lowered taxes on investment income to 15 percent, the lowest in U.S. history. That tax cut created no jobs (arguably lost jobs), reduced revenues and doubled the national debt. Would someone — anyone — explain why more tax cuts will work now?

On a personal level, I bought some Apple stock last year for $325 per share. It’s now worth $425. I also earned dividends from Microsoft. The tax rate on my Apple and Microsoft investment income is half the rate on my salary income. Did that income generate twice as many jobs as my salary income?

The Republican presidential candidates think so.

On a large scale, Mitt Romney paid $6 million tax on $41 million income over the past two years. Lower taxes on his investment income saved him $7 million. Did those tax savings — some of it parked off shore and some in Switzerland (until he ran for president) — create tons of jobs?

The Republican presidential candidates think so.

History has proven otherwise, but bidding taxes down attracts votes.

Until rates get to zero — which happens to be Ron Paul’s proposal — what’s a tax savvy cup magician to do? Replace those sponge balls under their cups with stock certificates. That will cut their taxes in half. And maybe put more cup magicians to work.

• • •

David Post is a co-owner of the Salisbury Pharmacy and an adjunct professor at Georgetown University.