How Burdensome are Capital Gains Taxes?

Several recent and provocative studies have described portfolio trading strategies which permit investors to avoid all taxes on capital gains and to shelter a substantial part of their ordinary income as well. Other studies adopt the more traditional view that the capital gains tax raises the effective tax burden on capital income. This paper uses capital gain realization data from the 1982 IRS Individual Tax Model in an effort to distinguish between these views. It shows that for about one-fifth of the investors who realize gains or losses, the ordinary income loss-offset limitations are binding constraints. Since additional gain realizations do not affect these investors' current tax liability, they may be effectively untaxed on capital gains. Another significant group escapes taxation by not reporting realized gains. However, the largest group of investors trades in a less elaborate and more honest manner, realizing and reporting gains without offsetting losses. The capital gains tax may reduce the after-tax return earned by these investors.