Why isn’t gambling considered capital gains? Deconstructing the conversation about capital formation and taxation

Mr. Burns is the 1%.

Long before the 1% meme, we had Mr. Burns. I wasn't able to trace this to the source. I am linking to the largest one I could find.

The conversation about capital gains taxes, a higher income tax for higher incomes and capital formation needs to be broken down.

First, not all forms of investment are equal. Some are about growing the economy by growing a business and some are about growing a pile of money. The “don’t tax the rich” crowd deliberately fail to make this distinction because they want you to believe that both forms of investment deserve to be treated the same way. They shouldn’t be treated the same way and historically, we have not treated them the same way.

There are two ways people use money to make money. The traditional way is to invest in a business, either a start-up or a business that is expanding. The business does well and you get your money back as a dividend, as income or you cash in your stock. The goal is to make money by providing a widget or a services that people want and one of the outcomes is that you grow the economy by adding wealth. If the business prospers, the business, the old and/or new employees and the investor makes money. This is using money to build something to make money.

Historically, the newer way is to invest in financial instruments such as options or derivatives or to use stocks as a financial instrument through what I call day trading, the practice of buying and selling stock simply to accumulate money. No money goes directly back to the business nothing new is added to the economy, one person definitely gets richer (the person handling the transaction) and if it is a profitable investment, the investor makes money. This is using money to make money. Functionally, this is no different than gambling, with a bookie handling the transaction and the investor putting his or her money on Fancy Dancer in the fifth.  More importantly, the net effect to the economy is zero. Money changes hands and the person doing the exchanges makes their transaction fee, but no new services are offered and no new widgets are manufactured. There are no new jobs. There is no economic growth. There is no new wealth.

In short, investing in a start-up or expanding business grows wealth. Investing in a financial instrument grows money.

Interestingly, it was the collapse of financial bubbles created by unregulated trading in financial instruments that created the Great Depression and the Bush Recession. But that is a different topic.

So, the cut taxes on the rich argument treats investing in a business and investing in a financial instrument equally by saying they both stimulate the economy. But since investing in financial instruments does not stimulate the economy, capital gains or income from these investments should not be treated the same way as investments in a business. Historically, we have tried to draw that line. Examples include reinvestment credits and the tax distinction between short and long term capital gains.

So, if someone tells you that cutting taxes on the rich grows the economy, call them on it. Ask them how betting on whether or not a stock goes up or down (puts and calls) is different from betting on whether or not the local high school basketball team will win or lose by five points. Where are the jobs? Where is the wealth? More importantly, why is gambling on the local high school team illegal but puts and calls are legal? And why is it okay to tax gambling winnings but not capital gains from options?

Tax cuts for investments that grow the economy? Sure, all for it. But we should be raising taxes on capital gains from financial instruments that make money without making wealth without adding value.

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