- Let's talk about the 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,
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, salary,
interest on bank accounts,
and there's capital gains income,
income from the increase in value of investments.
Well, 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 the government wants to encourage people to invest.
In addition, people say, listen,
if I'm going to invest my money in a stock portfolio
I already paid tax on that investment money
when I originally made it as income.
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 the same rate
as ordinary income.
Now 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.
Well, let's go back into our simple tax system.
For income from zero 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 50%.
If the income is capital gains income,
we'll say that the rate is 20%.
Okay, how much income tax would you pay if you made $100?
Well, if the $100 is ordinary income,
meaning you just went to your job and that's your wage,
the tax is $25, we've computed that before.
If on the other hand this $100 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 20%.
You only pay $10 in tax.
So if somebody gives you your choice,
do you want to classify your income as ordinary income
and pay $25 tax,
or capital gains income and pay $10 tax,
which would you choose?
Well, if it's legal you'd prefer to pay the lower $10 tax
on capital gains income.
Here is where a lot of the complex
tax shelter arrangements arise.
Tax shelters take on many forms.
One form is structuring your affairs
so that 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 income they make
classified as capital gains income, if at all possible,
so that the income is taxed at the lower capital gains rate.