Why Capital Gains are taxed at a Lower Rate
By David Block, William McBride
A joint hearing held by the Senate Finance Committee and the House Ways and Means Committee on June 28 will discuss capital gains taxation in the context of broader tax reform. A number of proposed changes have been highlighted; The Bowles-Simpson proposal recommends taxing capital gains and dividends at the same rate as labor income, while many congressional Democrats recommend raising the rate, citing concerns about both revenue and inequality. Any proposal focusing on raising the rate will likely fail to raise the predicted revenue, as demonstrated by both economic history and the high burden already placed on American corporations.
The justification for a lower tax rate on capital gains relative to ordinary income is threefold: it is not indexed for inflation, it is a double tax, and it encourages present consumption over future consumption.
First, the tax is not adjusted for inflation, so any appreciation of assets is taxed at the nominal instead of the real value. This means investors must pay tax not only on the real return but also on the inflation created by the Federal Reserve.
Second, the capital gains tax is merely part of a long line of federal taxation of the same dollar of income. Wages are first taxed by payroll and personal income taxes, then again by the corporate income tax if one chooses to invest in corporate equities, and then again when those investments pay off in the form of dividends and capital gains. This puts corporations at a disadvantage relative to pass through business entities, whose owners pay personal income tax on distributed profits, instead of taxes on corporate income, capital gains, and dividends. One way corporations mitigate this excessive taxation is through debt rather than equity financing, since interest is deductible. This creates perverse incentives to over leverage, contributing to the boom and bust cycle.
Finally, a capital gains tax, like nearly all of the federal tax code, is a tax on future consumption. Future personal consumption, in the form of savings, is taxed, while present consumption is not. By favoring present over future consumption, savings are discouraged, which decreases future available capital and lowers long term growth.
Not only has a low capital gains tax rate worked to encourage savings and increase economic growth, a low capital gains rate has historically raised more in tax revenue. At a 2010 talk at the Cato Institute Dr. Daniel J. Mitchell and Dr. Richard W. Rahn argued that the government has actually raised more revenue with a lower long term capital gains tax rate than a higher rate. For example, in 2007 the IRS raised $122 billion with a 15% tax rate as opposed to $7.8 billion in 1977 ($26.7 billion in 2007 dollars) with a 40% tax rate. In fact, when President Bush signed into law a cut in the top rate from 20% to 15%, revenue increased from $51.3 billion in 2003 to $137.1 billion in 2007 (although it fell significantly after the 2008 financial crisis, understandably).
Attempting to use the tax code to address income inequality will likely disappoint those who seek to attack the lower tax rate on high net worth individuals caused by a lower capital gains and dividends rate. Inequalities caused by globalization and differing education levels will not be remedied by destroying future investment; to the contrary those most likely to be hurt the most by lower economic growth are those with lower incomes.
The intensification of international competition for lower corporate tax rates has been highly publicized, but international capital gains taxation has been largely ignored. Capital gains taxation adds another layer of taxation onto American businesses, making them less competitive. How does the U.S. stacks up in terms of the total taxation of corporate investment. The U.S. capital gains rate (federal plus state) is above the OECD average. Thirteen countries in the OECD have no capital gains tax. The U.S. integrated capital gains tax rate (corporate rate plus capital gains) is the 4th highest in the OECD. This burden will rise to the highest in the OECD starting January 1 if the Bush tax cuts are allowed to expire and the Obamacare investment surtax of 3.8% goes into effect.
The combination of history, international competition, and the destructive nature of the capital gains tax suggests any attempts to raise revenue by raising rates are doomed to failure. The focus on June 28th should not be on raising the capital gains rate, but should instead be focused on how to keep the rate low. History shows that this is the most effective way to both raise revenue and promote economic growth.
Low Capital Gains Taxes May Not Help the Economy
By Brendan Greeley
For a certain kind of person (the kind, say, who invests often and well), capital gains hold a special place in their hearts, not to mention their wallets. So imagine their reaction when, just before leaving Washington to go campaigning, the Senate Finance and House Ways and Means Committees held a joint hearing on what they called the “treatment” of capital gains. That’s political speak for “taxation.” And it offers the strongest sign yet that the individual rate on long-term capital gains, which has been at 15 percent since 2003, may be up for negotiation in budget discussions after the election.
Since 1950 capital gains have generally been taxed at a lower rate than income, to spur investment. The rate under President George W. Bush went from 20 percent to 15—the lowest ever—and was billed as a way to stimulate the economy. (If nothing’s done by Jan. 1 to change tax and budget provisions already passed by Congress, the rate will snap back to 20 percent, a scenario both parties hope to avoid.) Mitt Romney wants to ditch capital gains tax altogether for people earning less than $250,000. President Barack Obama, in his Affordable Care Act, increased the rate by 3.8 percent for high earners beginning in 2013, and has proposed the so-called Buffett Rule, which would among other things end an accounting interpretation that allows private equity and hedge fund managers (and Romney) to save money by paying tax on their earnings at the capital gains rate. Neither candidate, though, contests the Bush administration’s basic logic: that a lower capital gains rate encourages investment, which creates jobs and helps the economy grow.
That doesn’t mean they’re right. Leonard Burman, who teaches economics at Syracuse University’s Maxwell School, presented a graph at the joint hearing that plotted capital gains tax rates against economic growth from 1950 to 2011. He found no statistically significant correlation between the two. This was true even if Burman built in lag times of five years. After several economists took him up on an offer to share his data, none came back having discovered a historical relationship between the rates and growth over those six decades. “I certainly did throw the gauntlet down for the true believers,” says Burman. “If they found the relationship, they’re saving it for a special time.”
More proof that the rationale behind the Bush tax cut doesn’t hold up comes from the Congressional Research Service, a nonpartisan group run by the Library of Congress. In mid-September CRS released a paper that analyzed economic growth and changes to the top marginal tax rates, both for personal income and capital gains, from 1945-2010. “The reduction in the top tax rates appears to be uncorrelated with saving, investment and productivity growth,” it concludes. “The top tax rates appear to have little or no relation to the size of the pie.”
It hasn’t always been a foregone political conclusion that the capital gains rate should be lower than that for income. The 1986 tax reform ushered in by President Ronald Reagan pegged capital gains at the same rate as the highest personal income bracket, which was reduced from 50 to 28 percent. David Brockway, who served as the chief of staff of Congress’s Joint Committee on Taxation during the negotiations for the overhaul, says that wasn’t an ideological decision. Rather, it had been decided that the reform would be revenue-neutral, and bumping up the capital gains rate seemed an easy way to raise money. In 2010 the bipartisan Simpson-Bowles commission also proposed making the rates identical. This suggests that, in a closed negotiation, higher taxes on gains may not be a deal-breaker.
Brockway, who now works as a tax lawyer in Washington, still agrees with that approach. He explains that any difference between the rates will always drive people to come up with creative ways to hide income as an investment. “Allegedly, a mouse can fit through a crack in the wall a quarter-inch wide,” he says, “and if you leave a sixteenth of an inch, you get cockroaches.”