From the course: Accounting Foundations

Capital gains vs. ordinary income

From the course: Accounting Foundations

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Capital gains vs. ordinary income

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- Let's talk about two different kinds of income. There's ordinary income and there's capital gains income. Ordinary income is just what it sounds like, ordinary income, such as wages, salary and interest on your bank account. Capital gains income arises when you make an investment and the value of the investment increases. Let's say you buy a stock portfolio, hopefully you're going to buy low and sell high. Let's say I buy at $1,000 and sell at $1,300. That $300 increase is called capital gains income. So there's ordinary income, wages, salaries, interest on bank accounts, and there's capital gains income, income from the increase in the value of investments. Worldwide, and particularly in the United States, capital gains income is typically taxed at a lower rate than is ordinary income. Now, we could get in a long philosophical discussion about whether this is right or wrong. Let me just give you the rationale on both sides of the argument. The reason that capital gains income is typically taxed at a lower rate is that governments want to encourage people to invest. In addition, people say, "Listen, if I'm going to invest money in a stock portfolio, I already paid tax on that investment money when I originally made it, you're going to tax me again when I invest it?" On the other side, a very reasonable view is that income is income. There's no difference between ordinary and capital gains income, it's just a different way to make income. Capital gains income should be taxed at the same rate as ordinary income. Well, those are the arguments on both sides. The fact is that in most jurisdictions around the world, capital gains income is taxed at a lower rate. In fact, in some places, capital gains income is not taxed at all. In the United States, ordinary income is taxed at one rate, capital gains income is taxed at a lower rate. Let's go back to our simple tax system. For income from $0 to $50, you don't pay any tax at all. That's the first tax bracket. For income above $50, the tax rate differs depending on the type of income. If it's ordinary income, the rate is 20%. If the income is capital gains income, the rate is 10%. Okay, how much income tax would you pay if you made $100? If the $100 is ordinary income, meaning that you just went to your job and that's your wage, the tax is $10 as we have computed before. If, on the other hand, this $100 in income is capital gains income, the first $50 is not taxed at all, and the second $50 would be taxed at the lower capital gains rate of 10%. You would only pay $5 in taxes. So if somebody gives you your choice, do you want to classify this income as ordinary income and pay $10 in tax or capital gains income and pay $5 in tax? Well, if it's legal, you'd prefer to pay the lower $5 tax on capital gains income. And here is where a lot of complex tax shelter arrangements arise. Tax shelters take on many forms. One form is structuring your affairs so that the income can be classified as capital gains income rather than ordinary income. Lots of things, both legitimate and shady, have been done to create tax shelters to change the nature of income from ordinary income to capital gains income. People prefer to have any income they make classified as capital gains income, if at all possible, so that the income is taxed at the lower capital gains rate.

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