- It's a double tax, as money that was invested had already been previously taxed.
- It does not account for inflation. If an investment grows only with inflation, capital gains taxes still need to be paid on that growth.
A capital gains tax is not intended to account for inflation--the persons that pay the capital gains tax (companies and wealthy individuals) are least subject to inflation. The lower rate was intended as an incentive to make capital investments in businesses. Unfortunately, due to the way capital assets are defined (or rather, is not defined) in the tax code, the lower rate has instead resulted in excessive investment in real properties, illusory assets (i.e., derivatives), and other passive investments rather than in businesses.
That's what double taxation means. You paid taxes twice on the earnings of $100k.
[edit: it might shock some of you to discover that this is a simplified example to illustrate the point.]
(Cash distributed by a corporation but which is not earned, i.e.,if the corporation has negative earnings at the time of the distribution, would reduce the shareholder's basis.)
If you were dealing with a partnership/LLC, the $65k would generally increase its partners' basis in the partnership/LLC. However, in such case you wouldn't be dealing with double taxation in the first place.
You paid 48% on the $100K, and that is all that matters in the end - the fact that it was a two step process, and that different steps have different credit/exemptions consideration is not really important.
And you generally can pay just your marginal rate - don't set up a corporation, and list everything on your own return - singular taxation goodness!.
However, no one likes to do that, because it makes them personally liable. So actually the higher rate (which people like to call "double taxation" even though that's not informative) turns out to be the fee you have to pay to separate your finances and legal status from the business - and by the fact that the vast majority of businesses choose it indicates that, in general, it's not expensive and might even be too cheap for what it provides.
You own a company, X. It earns income of 100 doing whatever. That income is taxed. This is the first level of taxation. The company then distributes that income as a dividend to its shareholder, you. That dividend is income to you. Thus, it is subject to tax again. This is the second level of taxation. If you had performed the income-generating activity directly (i.e., not through the company), it would not be subject to this second level of tax. However, at the same time, the use of the corporate entity provides significant legal and tax benefits. Thus, the double taxation is mitigated but not eliminated.
Another example: Company X, based in the U.S., does some business in France. France taxes that income. That is the first level of taxation. The U.S. also taxes that income, due to its worldwide taxation system. That is the second level of tax on the same income. In this particular instance, we have a treaty with tax to eliminate the double taxation of that same income. (This is not true of all countries, for example, we don't have a tax treaty with Taiwan.)
In your example, you ignore the basic system of US and EU capital gains taxation. When you sell a business, you are generally taxed based on the difference between [sale price] subtract [your "cost basis"] in the business. (Cost basis generally means the amount you paid to acquire the shares, or which you contributed to the business.) It is irrelevant that your business was worth $100k before it made another $100k--the tax code doesn't look at intermediary valuations, and it doesn't care about earnings when determining the tax on the sale of a capital asset. What matters is whether you have a "cost basis" in your shares of the business. If you acquired your shares for $0 (for example, you contributed your labor to earn those shares), then upon selling the business in your example you would recognize capital gains of $165k, not $65k. Usually, capital gain from the sale of a business relates to "goodwill" (i.e., brand value) rather than cash from earnings (and for property or other capital assets, capital gains are usually due to simple appreciation.) Double taxation is not usually a problem with capital assets, so the capital gains rate does not reflect a discount to remedy double taxation. Rather, capital gains rates are discounted to encourage investment in capital assets.
Yes, I was assuming you purchased at $100k to illustrate the cost basis. I should have been more clear on that point.
If you want to argue that double taxation is justified as the price of limited liability, go ahead. But it's silly to compare the capital gains rate to the income tax and then ignore the corporate tax rate. Combined they amount to a lot more than personal income taxes. This is why the wealthy contribute such a disproportionate amount to the US treasury.
Overall US taxes (from all sources) are approximately flat taxes, if considered relative to wealth, as you seem to be doing. The wealthy contribute roughly the same share of their wealth to the treasury as the less wealthy do. The 90th-percentile-and-above of richest Americans own about 75% of the country's assets in aggregate, and pay about 75% of the country's taxes in aggregate.
Furthermore, HF managers pay less taxes on their earnings than their investors do b/c HF investment gains are short term capital gains but the fees collected for managing such short term gains get taxed at the lower long term rate.
There is no fairness, or logic in that scenario.
Everything has, in some form of another, been previously taxed. "Double taxation" is a good sound bite, but it doesn't actually say anything. yummyfajitas gives a computation below that shows the overall tax rate is higher (48%). That is an actual argument (which I will respond to there). But other than that, "double taxation" means nothing other than "different rates", which is generally always the case.