There is an immense amount of value in the U.S. stock markets. U.S. stocks are worth more than $17 trillion dollars, even more incredibly the World Bank estimates that $35 trillion is traded on U.S. stock markets every year. But despite all of the money trading hands, the U.S. government receives only $350 billion annually from capital gains taxes, meaning that on average the U.S. government only has a 1% tax rate on stock trades.
If most stocks are owned by the super wealthy and they have a 20% capital gains rate, how can the Federal Government get so little in taxes from the stock market? The stock market has been doing very well since the passage of the 2017 tax cut bill, so why hasn’t the amount of tax revenue collected by the U.S. government increased?
Who owns the stock market?
The stock market can be broken down into three buckets of ownership. The biggest bucket is tax advantaged accounts, which own 39% of the stock market. These are things like IRAs, 401(k)s, HSAs, and 529 plans. It’s possible that these stocks can be owned for years without being taxed and some accounts (like HSAs) are never taxed at all. Additionally, if you follow the rules of tax advantaged accounts the proceeds who earn are taxed as income and not capital gains.
The next bucket is stocks owned by U.S. individuals, who own 33% of the stock market. There are estimates that the richest 1% of Americans own 50% of the stocks owned by U.S. individuals. While 50% of Americans don’t own a single stock. When someone in the 1% sells a stock, they are subject to the 20% capital gains rate. But as long as they don’t sell the stocks, they can keep their money in the stock market, increasing in value and completely un-taxed. Further, an investor can lower their tax bill by selling stocks that lost value to offset stocks that gained in value and take advantage of government programs to get out of tax completely, like the new Opportunity Zones program that was part of the 2017 tax bill but because of their complexity can only be used by ultra wealthy individuals.
The remaining bucket of the stock market is owned by foreigners, a whopping 28%. Foreign investors pay zero U.S. taxes when they sell a U.S. stock, although they may owe capital gains in their home country.
Only one of the three buckets of stock ownership has to pay capital gains taxes and only when they sell the stock, and then factoring in the numerous laws that allow wealthy individuals to avoid capital gains taxation, demonstrates why the U.S. government only gets a 1% tax rate on the value of all the stocks traded in a year.
How the U.S. Government Receives Funding
On average, the Federal Government gets 10% of its tax revenues from capital gains, 40% from individual income taxes, 30% from payroll taxes such as Social Security, 10% from corporate income taxes, and the rest from a variety of sources such as excise fees on cigarettes and alcohol. Since the 2017 tax cuts bill, the Federal Government’s revenues have fallen and the budget deficit (debt) has steadily increased. For instance, corporate revenues in 2018 was just above 6% of the Federal Government’s total revenues.
U.S. citizens own a large amount of stocks in foreign stock markets. However, there are more incentives for foreign investors to buy into U.S. stocks. Among the developed countries, the U.S. gets one of the smallest amounts of its revenues, as a percentage of GDP, from corporate taxation because other countries allow fewer deductions and have a form of a federal sales tax using a value-added tax (VAT). Governments in other developed countries focus on what corporations can do to better their population instead of only ensuring corporation’s earn high returns for their shareholders. One of the best examples is Germany, where laws mandate that 50% of the board of directors for corporations are made up of employees, also called “co-determination.” This pushes businesses in a country to be more responsible citizens within their country.
Despite Stock Market Increases Capital Gain Taxes Stay the Same
The 2017 tax cut bill mandated that U.S. companies bring back trillions of dollars in overseas earnings that companies had been waiting to bring back to avoid paying U.S. taxes, but the law also gave the companies a significant tax break on those earnings. At the same time the tax law dramatically lowered the U.S. corporate rate from 35% to 21%. Some companies invested in new equipment and upgraded facilities but far more spent their tax reduction on stock buybacks. When a company has large profits that it wants to return to investors instead of reinvesting in the business, it has one of two options: 1) the company can increase its dividend, which is a payment to every stock owner, or 2) the company can buy back its own shares. When a company buys back its own shares, the company is driving up the percent of the company one share owns. Simple supply and demand, the less availability of stocks the more the price should increase.
Many investors prefer stock buybacks over dividends because it drives long-term value of the stock and reduces taxes for the investor. For instance, if I own a share in company X that’s currently valued at $10 and the company gives me a $.50 dividend, I have to pay capital gains tax of 20% on that dividend, meaning the dividend is only worth $.40 to me. However, if the company does a stock buyback instead of a dividend and the value of the stock goes up by $.50 I don’t have to pay any tax and I can keep that value growing in the stock market until I sell the stock, worth even more to me.
Stock buybacks are generally good for U.S. investors, but they are even better for foreign investors. Foreign investors who live outside the U.S. generally don’t have to pay any capital gains tax when they sell a stock, but they are subject to a 30% tax on dividends. With the spree of stock buybacks, the market has been pushing ever higher, providing a windfall for wealthy foreign investors who have invested in U.S. stocks. It’s important to note that many foreign countries tax the capital gains their citizens receive from U.S. stocks, just as the U.S. does for when U.S. investors have income from foreign stocks.
However, when Congress passed the 2017 tax law and lowered the corporate tax rate and the cost to bring back trillions of dollars in overseas cash, it led to the dramatic increase in the stock price of U.S. companies. While this has helped the half of Americans who own stocks, nearly one third of our stock market is owned by foreign investors and receive an even bigger benefit. You see, the U.S. government won’t see any tax revenue when the foreign investors sell their stocks, instead that will go to the foreign investor’s home country, helping them build roads, bridges, and dams. While the U.S. stock market is doing very well, revenue from capital gains taxes are not up and corporate tax revenue is down, the U.S. debt is increasing, and Congress can’t reach a deal on how to pay for our own badly needed repairs to roads, bridges, and dams. While the U.S. Government collects capital gains when an American sells a foreign stock, because few countries focus on corporate profitability to the same extent as U.S. companies the benefit is rarely as large.
Ways the U.S. Can Get More Taxes From Stocks
There are several ways that the U.S. Federal Government can get more tax revenue from corporations and their stock owners that will benefit all Americans and not just foreign investors and Americans who can afford stocks. The first would be to create a VAT, similar to most other developed countries. The problem with this proposal is that it will impact everyone, even those who don’t own stocks and this form of taxation is regressive. The second solution would be a carbon tax, which suffers from many of the flaws of a VAT, in that it is regressive so to make it work at least some of the income should be returned to lower-income Americans.
The third proposal is to create a financial transaction tax. This has been proposed by several of the Democratic Candidates for President in 2020 and would tax a small percentage of every stock trade, something that even Michael Bloomberg and Bernie Sanders both agree is a good tax.
Most of the proposals are for the tax to be .1% of all financial transactions. A .1% tax doesn’t seem like much but when you are taxing $35 trillion in financial transactions that means an additional $35 billion in tax revenue to fund vital projects. One of the arguments against this tax is that it would impact retirement accounts, reducing their value, which is a valid argument. However, they would also tax foreign investors who are getting the advantage of the extremely friendly business environment in the U.S. A financial transaction tax also doesn’t tax consumers, like a VAT or carbon tax would, meaning that poorer Americans who buy products but don’t own and stock wouldn’t shoulder the burden of the new tax.
If you can afford it, you should be putting some money into the stock market. The best advice, is to setup a monthly contribution and increase it at set intervals (biannually or annually).
Here are a few more stories about investing:
- This story explains how to Get a Tax Break For Selling Your Stocks
- I wrote a post called Rich People Don’t Keep Money in a Bank Account, You Shouldn’t Either
- Another is called Taxes on Savings are Unfair, Here’s How to Fix it
- 401(k)s are the Worst form of Saving, Except for All the Others
- Lastly, here is an important one called Did you Receive a Smaller Tax Return? Next Year Will be Worse