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Capital gains are income. Incomes are capital gains.
We can transform one into the other with accounting tricks.
When an individual owns an asset, like a company share, asset value changes are known as capital gains or losses.
These are treated as a special type of economic return in the tax system.
Australia, for example, provides a 50% capital gains tax discount on income for capital gains realised after owning an asset for 12 months.
If you make a capital gain you only trigger a tax on that gain if you swap the asset for another asset, like cash, during the tax year. Don’t do the asset swap and the gain is yours to keep. If you swap the asset for cash but get less back than the amount of cash you swapped cash for the asset in the first place, you create a loss that can be deducted from other capital gains income.
There is one exception.
When an individual owns a particular asset called a bank deposit account, changes in the value of this asset due to their sweat equity are known as income. These are treated uniquely as taxable every time there is a gain. Any loss in the asset value cannot be deducted against future gains to reduce tax liability.
You never need to swap this bank deposit asset for a different asset to be liable for tax. Any gain is continuously taxed and losses are always ignored.
What would equal tax treatment look like?
We can make our system of taxing gains in asset values consistent in two ways:
Treat bank deposit asset value gains the same as other asset value gains, or
Treat other asset value gains the same as bank deposit asset value gains.
The first way would involve treating every individual as their own company. Their bank account is now treated like a company account that goes up with revenue, and down when living expenses needed to “run the company” are purchased. Any bank deposits left over at the end of an accounting period represent part of the value of equity in your personal company.
There would not be “wages”, just revenue. There would not be “living expenses”, just costs.
Only if you swapped those bank deposit accounts assets (a share of your personal equity) to buy other assets would a taxable capital gain be triggered.
The second way is to treat all assets like the bank deposit assets of individuals. After all, balance sheets are fungible. Any asset, be it property, shares, or another financial instrument, can be swapped for bank deposits at any time. The choice to hold the same asset over time is no different to swapping the asset at its current value for a bank deposit, then deciding that the asset is still worth owning at the current price and swapping back. You just save the transaction cost.
When your assets increase in value over a tax period, this is treated as if you worked to earn that value in cash and then used that cash to buy assets equal to the value gain.
Losses in asset value would have so special tax meaning. They would be treated the same as if I spent more than I earnt from my job in a year.
This might all sound a bit weird to you. But it is important to always keep in mind that our tax settings and economic thinking on these matters are just conventions.
We are creating the world through these rules, not mimicking something natural about the world. Most of the analyses you will read about what are “good” and “bad” taxes are simply stories told by vested interests, like the idea that we shouldn’t tax “real” capital losses even where there are nominal gains.
The very idea that you could tax every earner’s wage income is only a little over a century old. Prior to that, taxes were predominantly on imports and exports, royalties on production, and property holdings.
It is all accounting tricks
To show that incomes and capital gains are the same, look no further than the United States carried interest tax loophole whereby incomes from providing management services are redefined as a share of capital gains for certain types of money managers.
In fact, all incomes, including wages, could be accounted for as shares of capital gains.
Just call it “sweat equity”. As so beautifully noted in the NYT.
Carried interest is just another term for sweat equity or founder’s equity, a concept that is widely accepted in every type of traditional partnership, private equity or not.
Alternatively, all capital gains could be turned into wages by simply realising the gains in another company structure and paying all the revenue from that trading company as wages.
The distinction between capital gains and labour incomes is an accounting choice, not an underlying physical economic reality.
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