Capital Gains Tax - The Obama Effect

We talked about Obama's tax cuts in an earlier post. Today we are going to discuss Obama's plan to increase the capital gains tax. This is a tax charged on capital gains or profits from stocks, bonds, precious metals, and property.¹ So, who wins with an increased capital gains tax? Does the government win with increased tax revenues? We know for sure the politician wins if he gets elected for promising to "stick it to the rich," but what about the American people? Let's explore the effects of an increased capital gains tax.

Charles Gibson from ABC recently interviewed Obama and asked a question about the economic effects of a capital gains tax. Obama could not hide his ignorance on the subject, but that isn't important to him as Thomas Sowell states:

What effect a higher capital gains tax rate will have on the economy today and on people's pensions in later years is a question that is not even on Senator Obama's radar screen.²

Why would Charles Gibson ask such a question? Because history shows that government often takes in higher revenues from a lower capital gains tax.

Raising the capital gains tax reduces the formation of capital equipment. Why is that bad? Capital equipment allows workers to be more productive which gives them the ability to earn higher wages. Therefore, capital gains taxes contribute to stunted wage growth for skilled American workers.

Roughly 95 percent of the growth in wages over the past 40 years is explained by the capital-to-labor ratio.³

Also, lower tax rates on capital gains increases the volume of capital gains realizations. This is what causes an increase in tax revenues. The increase in revenues can be explained by the "lock-in" effect, which causes people to hold on to their investments to avoid paying a rate perceived to be too high. While the tax revenue increase is significantly higher right after the cuts are imposed, there is a normalizing of the gains over time. The drop in gains over time has been the strongest argument of critics, but does not provide sufficient evidence to discard the policy. It certainly provides no evidence to increase the tax. The critics don't take into account other unseen benefits of lowering the rate either.

Another negative scenario is that inflation and phantom gains can have an adverse affect on capital gains. The U.S. has had inflation every year since 1940, except 1949.⁴ With inflation the value of capital rises in dollar terms even if the real value remains constant. This can cause someone to be taxed for a gain they never really had even with the lower long-term tax rate. The higher the capital gains tax and the lower the real return, the more likely this situation is to occur.

In 2004, the capital gains tax generated $56 billion, about three percent of federal revenues.³ That accounts for very little of overall federal tax revenues. Therefore, higher, static, or even lower capital gains taxes has little effect on the total tax revenue collected regardless of the direction it travels.

Finally, the capital gains tax dampens risk incentive by reducing the rate of return for risk takers.³ Reduced rates of return mean that people will undertake less risk. If entrepreneurs take less risk, economic growth will decline. That hurts the rich, middle class, and poor alike.

"The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital . . . the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy."
-John F. Kennedy

Sources:
1. Capital Gains Tax. Wikipedia.
2. The Gailbraith Effect? Human Events. Thomas Sowell. August 12, 2008.
3. Tax Cut Beneficiaries. Walter Williams. January 11, 2006.
4. Capital Gains Taxes. The Library of Economics and Liberty. Joseph J. Cordes.

Hurricane Ike: Gas Shortages

Josh Mathes over at Capitalism's Truths made a great point about political pressure regarding price gouging during the recent hurricane. Gas stations were pressured to hold gas prices steady despite increasing demand, so naturally a lot of them ran out of gas.

Had they been able to raise prices accordingly, shortages would have been reduced and only the people that really needed gas would have bought it. Instead, everyone with the notion to fill up their half-full gas tanks just to be "safe" did so. A good portion of economics is the study of how society distributes scarce resources.

Capitalism is the most efficient system of rationing limited resources. It rations to those that receive the greatest benefit from the resources through supply and demand. Thomas Sowell expressed the concept well with:

While economists are talking supply and demand, politicians are talking compassion, "change" and being on the side of the angels-- and against drilling for our own oil.¹

Source:
1. Thomas Sowell, Too "Complex"?, May 13, 2008.

Obama's Economic Plan: Tax Cut or Income Redistribution?

After listening to speeches from both presidential candidates about their economic policies, one has to wonder what are the main differences between them. This is the first of many posts I will be doing differentiating the economic positions of these two candidates. In this post, I am going to break down one part of Senator Obama's Ecomonic Plan.

Obama has given many speeches recently focusing on the economy. In these speeches, he said that he will give a tax cut to 95% of American families. In fact, there is a partisan website dedicated to this tax cut that supposedly calculates how much you will get back. Of course, they don't tell you how they do the calculating, just that the data comes from the Tax Policy Center. Ironically, the Tax Policy Center states

"TPC estimates the Obama plan would cut taxes by $2.9 trillion from 2009-2018. McCain would reduce taxes by nearly $4.2 trillion."

I'm sure many of you saw the recent Bill O'Reilly interview with Senator Obama where he again states this as part of his economic policy. Bill O'Reilly, however, calls out the Senator on this issue and calls it what it really is. O'Reilly states

"...you're taking the wealthy in America and the big earners, OK, you're taking money away from them and you're giving it to people who don't [have money]. That's called income redistribution. It's a socialist tenant."

The two key phrases in the quote are income redistribution and socialist tenant. Obama wants to take money from the top 5%, who already carry the majority of the tax burden and give it to the bottom 95% regardless of if they pay taxes or not. That means someone who pays absolutely nothing in taxes, under Obama's plan, would get a check from the government. I don't know about you but that sounds like income redistribution and socialism to me.

While income redistribution and socialism are misguided ideals to me, it is the way he promotes them that's the most troubling. He is using class warfare to get across this message to the American people. Look at this Obama quote taken from an Investor's Business Daily article

"The rich in America have little to complain about. The distribution of wealth is skewed, and levels of inequality are now higher than at any time since the Gilded Age."

The article goes on to state that the division between the classes is always in flux. While right now you might be in the middle class, there's a good chance you will move up either through some personal effort or by riding an expanding economy. I have attached a chart¹ from this article that shows how economic growth can propel you from one income quintile to another. This begs the question: is there really any difference between the classes since they're always in flux?

What about people like you and me? People who work hard everyday and pay their taxes accordingly. We're going to get a tax cut right? Well, not exactly. What Obama proposes is less of a tax cut and more of a tax credit. Listen to what Charles Krauthammer said on Special Report with Brit Hume

"Now, if you aren't paying taxes because your bracket is low, you are getting a check. If you are, the check is in the form of a credit, and it reduces your income tax. Normally if you say "I'm cutting taxes," it is a cut in rates. This is not a cut in rates. This is a check. In other words, it is what we called earlier in the year a "stimulus package," and that is spending. It is not a tax cut. It's a clever way for a Democrat to increase spending that is essentially a handout and call it a tax cut."

One word in this quote leaps off the page and that's "handout". Basically, Obama wants to give all the people who don't pay taxes a handout while calling it a tax cut. This just goes to illustrate that you must always read the fine print when it comes to any candidate's economic policies. Just because something sounds good in a sound bite doesn't mean it's good for the country.

Source:
1. Obamanomics Flunks The Test. Investors Business Daily. August 1, 2008.

How Oil Prices are Determined

I have friends who talk about gas prices as if oil and gas companies participate in price fixing to set the price as they wish. This is a false concept. History and economics tell us a different story.

Who are the stakeholders in this equation of oil prices? Producers, traders, and consumers all play a key role in determining the price of oil and gas.

Oil producers like Exxon Mobil, Chevron, and governments of other countries control the supply of oil based on economics. When oil prices go up, producers seek out more oil to bring to the market. When oil prices go down, producers slow down production. This is driven by a profit motive known as the law of supply.

Commodity traders help determine oil prices by bidding on oil futures contracts. They make their bids based on factors such as current supply in terms of output, oil reserves, and demand for oil.

Consumers determine price by providing demand for the product. As the price increases the demand falls and as the price decreases the demand increases. This is normally shown through what is known as a demand curve. During the rise to $4.00/gallon gasoline, many factors contributed to the rapid price increases. One factor was China importing extra oil products for the Olympics causing an artificial rise in demand. After the Olympics, China's government realized they had extra reserves and decided to cease importing oil until more of the reserves are depleted. You may have noticed how the price of gas dropped around $.50 per gallon in some places after the Olympics. The market is normalizing and prices should continue to drop barring any unforeseen crisis.

When someone starts to complain about oil prices, remember the stakeholders and forget the "evil oil company" propaganda.

What Does the Freddie Mac/Fannie Mae Bailout Mean to Taxpayers?

I'm sure that most of you have heard about the massive government bailout of the financial institutions of Freddie Mac and Fannie Mae. Both of these mortgage lenders have somewhat of an identity crisis. Are they part of the private or public sector? The answer is both. As Neil Cavuto points out in a transcript from his show "You're a private entity, so you can make money. Or you're a public entity, so you can't fail. Turns out you can't make money. And you can very much fail."

So how is it going to effect you, the taxpayer? Well, Neil states that the bailout is going to cost the government more than $400 billion. This adds even more debt to the huge national deficit number they are always talking about (which stands around $10 trillion as of now). Neil goes on to say that the tax cuts that both presidential candidates are promising are basically dead. While I don't know about the validity of that statement, I do know that I don't like paying someone else's mortgage note.

I don't know for sure, but after hearing this I think that government bailouts might be a bad idea. At least one presidential candidate is looking to change this practice. Of course, it's also good to know that Chuck Norris agrees with me.

Capitalism,Taxes and Redistribution of Wealth

Taxes have a huge effect on the economy and are often the subject of heated debates. Very few can agree on who should take on the tax burden.

Often, our tax system quickly becomes a redistribution of wealth (AKA taking from those that earned it and giving to those that didn't) instead of a means to finance needed government activities like national defense. The respected economist, Walter Williams, pointed out what taxing the wealthy is really like in this statement:

"Why is it that Michael Jordan earns $33 million a year and I don't even earn one-half of one percent of that? I can play basketball, but my problem is with my fellow man, who'd plunk down $200 to see Jordan play and wouldn't pay a dollar to see me play. I'm also willing to sell my name as endorsements for sneakers and sport clothing, but no one has approached me. The bottom line explanation of Michael Jordan's income relative to mine lies in his capacity to please his fellow man. The person who takes exception to Jordan's salary or sees him, as my letter-writer does, as making "little contribution to society" is really disagreeing with decisions made by millions upon millions of independent decision-makers who decided to fork over their money to see Jordan play. The suggestion that Congress ought to take part of Jordan's earnings and give it to someone else is the same as arrogantly saying, "I know better who ought to receive those dollars."

Jordan deserves every bit of the wealth he accumulated because of the excellence he created through hard work and practice. Fans and consumers rewarded him for it. That is capitalism at its best.

I would like to make another point that is rarely made about taxing the wealthy or the middle class for that matter. The government robs them of the opportunity to choose of their own free will to give to those in need. Politicians take away that wonderful feeling of giving and helping others in need to turn around and take the credit for themselves. Not every wealthy person gives back of course, but most realize that giving value to others was the key to the door to success and wealth.

Governor Palin and Tax Cuts

Governor Palin made a pretty incredible speech on Wednesday night at the Republican Convention. She proved to be quite a powerhouse and an understandable source of fear for the Democratic ticket. One of the big issues for this election is the economy. Palin and the Republicans have indicated that they are for tax cuts, but how does that really affect the economy?

Let's talk specifically about raising taxes for the wealthy, a concept that the Left so often promotes.

The argument is that tax cuts only help the wealthy. If this means that the wealthy are benefited proportionately to the amount they pay in comparison to other taxpayers, this is right. It makes sense that if you have a tax cut, taxpayers pay less. The more taxes you pay, the more money you save from tax cuts. But as you should know, the wealthy still pay nearly all taxes. In fact, since the Bush tax cuts, the wealthy actually pay a higher percentage of all federal income taxes than before. In 2000, the top 25% of income earners paid 84% of all federal income taxes. That number was 86% in 2005 according to IRS data. If the argument that tax cuts only help the wealthy, this percentage should have decreased.

Another argument is that cutting taxes reduces federal income for needed government activities. While this is certainly the case as you approach 0% taxes, it is untrue in general. The truth is that optimal tax revenues are generated by a median and generally acceptable tax rate. Therefore, if taxes are too high (which they usually are), reducing the rate will lead to increased revenues.

This leads to another common argument that if tax cuts raise revenues, why don't we just make the rate 0% and have unlimited tax revenue. Professor Laffer made this concept understandable. If tax rates are 0%, obviously revenue is also 0%. If taxes are 100%, revenues are still 0%, because no one is going to work if the government confiscates all earnings.

I heard someone say, "You have to be kidding that I will work less if the government taxes me 2% more." This statement is probably true for that person and most, but as all economists know, there is a curve. Some people would actually work less. The greater the tax burden, the more it affects the incentive to work.

I look at the current tax system as a big bully trying to steal your lunch money. If you give up 2% more, what is to stop him from taking a little more and a little more? You have to stand up to bullies and say, "Enough is enough."

The First Rule of Economics

There is no free lunch. You've heard all the terms like free health care, free benefits, and free education. At first glance, they appear to cost nothing, but it is the unseen that bears the cost.

French economist Frederic Bastiat's (1801-1850) pamphlet pointed this out in "What is Seen and What is Not Seen", where he says, "There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen."¹

I always laugh when I hear people talking about the "free" benefits they get with their job. They think of them as a perk to the job, but really they are just a trade off between their wage. Their employer only has a certain amount to pay each worker before that business is no longer profitable. If the employer spends more of this money on their benefits, the employer must spend less on their wages.

The seen is always evident, but the unseen is where the key to the economic equation lies.

The trite expression "There is no free lunch" has become trite precisely because it has turned out to be true for so long and in so many different contexts.
-Thomas Sowell

Source:
1. There is No Free Lunch. Walter E. Williams. September 24, 2001.

The Constitution and Economic Freedom

I created this blog to discuss things that I believe passionately about and to provide information on the principles of economics. I hope to do this based on demonstrable or tested truths rather than rhetorical opinions. Everyone has some beliefs based in their surroundings and experiences. You could say that I was always a conservative, but I did not really become a conservative until I studied economics in college. I quickly wondered how anyone that studied and understood economic principles could ever desire things like increasing taxes and raising the minimum wage. My economics professor once said, "a free market system isn't perfect, but it's the best system we know about."

There are two things that I firmly believe in when it comes to politics and government: The Constitution and economic freedom, two things that make America a great country. The problem is that these two pillars in the creation of the United States of America are under attack. There are groups attacking from many angles trying to build a different America: “The world as it is” and “The world as it should be..."

We can only fight this stigma, this flawed ideology, by educating ourselves. I think my economics professor understood this and did his best to educate his students on economic principles proven over and over throughout history. I hope to do the same.

"Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence."
-John Adams