Sunday, September 21, 2008

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

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.

1 comment:

Stan said...


You've obviously put a lot of work into your blog. I especially appreciate your decision to cite your sources. Good work.

- Stan (