Stock market crashing, capital losses and tax reform

So yesterday, while I was returning from Denver (elevation 5,280) to Dallas (elevation 430 feet), the stock market decided to make a similar journey.

In case you didn’t know it, you can deduct your losses on tax return (Form 1040) to the extent of  $3,000, less any gains.

I think I already told you in a prior blog that they haven’t indexed that $3,000 for inflation in nearly 35 years (if they had, it would be worth around $10,000 now).

Today Obama again mentioned hopes of tax reform.  One way he could do this is to make this deduction “fairer” – and by fairer, I mean more helpful to the small investor that has lower taxable income.

The absence of the small investor right now (outside of retirement accounts) is partly to blame for the wild swings in the stock market during the past few years – many trades are being made either by hedge funds or big brokerage firms, who enter and exit the market much faster and more often than the small investor.

But the small investor has little reason to come back – including the fact that the $3000 loss deduction is seriously benefiting high income taxpayers and not "middle" America.

The reason why is that the tax costs of the gains versus the tax benefits of the losses are not symmetrical. Because of that, high income taxpayers get a much better deal on their losses than low income taxpayers.

Let’s start with the first item – symmetry.  If your taxable income is $500,000 per year, you’re in the 35% bracket.  If you have an additional gain on sale of stock – say a $3,000 gain – it is taxed at 15%.  So you pay $450 more.

Now suppose instead you have a loss of $3000 at 35%.  You end up paying $1050 less in taxes. 

That’s right – UP and you owe $450 to the government, DOWN and you get back $1050.

Suppose your taxable income is $30,000.  You get a gain of $3,000 – you pay tax on it at 10% - $300.  Down and you pay $300 less in taxes as well.

Let’s see – UP and you owe $300 to the government, DOWN and the government owes you $300.

Just another reason why you would rather make $500,000 a year than $30,000.

Instead of correcting disparities like this, presidential candidates (former Governor and 2008 Presidential candidate Mike Huckabee of Arkansas comes to mind) become obsessed with these “pie in the sky” ideas like FLAT TAX (!!) (as if the Flat tax is going to fix all the problems – but I will cover that in a future blog).