Capital Gains

What is a "capital gain"? and why is it taxed at a rate lower than than of ordinary income?

The textbook answer to the first of those questions: a capital gain is the amount by which proceeds from the sale of an asset exceed the original cost.

Further, there is at least one obvious and intuitive reason for treating capital gains differently. The income from the sale of an asset that a taxpayer has held for several years realizes the accretion of value over each of those years, whereas his/her salary, wages, tips etc.(paradigms of "ordinary income") represent the return on labor expended in the taxable year involved. This means that if the income from the sale of a house were taxed as ordinary income the year of the sale, the homeowner would experience an enormous hit that year. This is called the "bunching effect," i.e. taxable events from several years bunched into the year of realization. That, in turn, would freeze up assets -- everyone would become afraid to sell anything valuable for fear of the tax hit -- with disastrous economic effect.

So far, so good. But there are also short-term intra-year capital gains. Why aren't they taxed as ordinary income? Suppose I bought a house in February 2006 for purpose of flipping it. Did so in April 2006. Why shouldn't my profit be treated as ordinary income? The best argument against doing so is that there would still be a "lock-in effect" even without any bunching. We (policy makers or others putting ourselves in their shoes) want people to be able to flip house, because they contribute to the liquidity of the marketplace -- to the ease with which non-speculators too can find something to buy or sell when the time is right.

But the intuitive appeal of that argument is weaker, it would seem, than the appeal of the bunching argument for longer-term investments.

And since we're thinking about it ... there might be better ways of dealing with the "bunching effect" in the case of long term investments too. Conceivably, the accretion of value to my house could be taxed each year as it happens, so that the final sale would have no or only a very slight significance for tax purposes. (Yes, there would be obvious practical difficulties there.)

Aside from the bunching and lock-in effects, the only significant remaining argument for differential treatment of capital gains is this: taxing such gains discourages investment or (what is the same) discourages savings, encouraging immediate consumption and indebtedness.

Does it, though? The late Milton Friedman always used to maintain that fiscal policy is much less efficacious at shaping behavior than policy-makers flatter themselves it is. I wonder about this one.

Also, there seem to be a number of areas defined by law as "capital gains" arbitrarily, or simply as a response to lobbying power and cronyism, where the definition isn't warranted by any of these arguments. But more of that another time perhaps.