Reasons to keep capital gains taxes low

| December 29 2012
Christopher Cook

Demonizing the rich is in vogue right now. Obama and the Democrats do it regularly, and polls show that more Americans are on their side. This is more likely to happen in tough economic times, and make no mistake—these are tough economic times. Still, while that is a reason, it is not an excuse. Rich people are humans every bit as poor and middle income people. They aren’t more or less greedy, more or less bad. You find all kinds in every income cohort.

The one thing you find in greater measure among rich people, however, is job creators. If the poor and the middle classes demonize the rich, that is a hop skip and a jump from raising taxes on the rich. And the biggest consequence of that is that it makes it less likely that that the poor and the middle classes will have jobs. Talk about shooting yourself in the foot.

The foregoing provides more information on why raising capital gains rates is a bad idea.

From the Cato Institute’s Advantages of Low Capital Gains Tax Rates (pdf):

“Bunching” and “Lock-In” Effects

Taxing of capital gains upon realization creates numerous problems. One problem is “bunching,” which means that realizations often come in a transitory spike, such as the one-time sale of a family business. The spike may push a taxpayer into a higher tax bracket than usual, which is unfair because the gain may represent years of modest accrued gains. This is one reason that some countries use a low, single rate to tax gains, rather than the normal graduated tax rate structure.

Another problem is “lock-in,” which occurs when taxpayers delay selling investments that have large unrealized gains in order to avoid the immediate tax hit. Lock-in induces people to hold assets longer than optimal, and they may forgo diversification opportunities because they are stuck in current investments.

Capital gains lock-in reduces market efficiency. It interferes with the crucial economic activity of people shifting their funds from lower- to higher-yielding investments. Economic growth is synonymous with economic change, and thus growth is dependent on capital being moved from older to newer uses. Capital gains taxes create a barrier to that beneficial movement.

In a study of capital gains tax policy, the OECD found that ameliorating lock-in was a main concern of tax policy officials in its member countries.8 Most countries have responded to the lock-in problem by implementing a reduced effective tax rate on individual capital gains.

Inflation

If an individual buys a stock at $10 and sells it years later for $12, much of the $2 in capital gain may represent inflation, not a real return. In an economy with inflation, capital gains taxes can substantially reduce returns, and even turn them negative. And uncertainty about future inflation makes returns from capital gains more risky. Thus, inflation and capital gains taxes together suppress investment, particularly in growth companies.

This problem is widely appreciated, and one solution is to index capital gains for inflation. For investments in corporate equities, indexing would be a straightforward process of adjusting a stock’s purchase price by a measure such as the consumer price index, which was the approach used by Australia between 1985 and 1999.

However, most countries do not index capital gains, but instead roughly compensate for inflation by reducing the statutory rate on gains or providing an exclusion. In 1999, for example, Australia abandoned inflation indexing in favor of a 50 percent exclusion for gains.

Double Taxation of Corporate Equity

A key reason for reducing tax rates on both capital gains and dividends is that the underlying income is already taxed at the corporate level. Corporate profits in the United States bear a heavy burden from an average federal-state tax rate of 40 percent. When individuals receive corporate profits in the form of dividends and capital gains, the income is taxed again. By contrast, wage and interest income are only taxed at the individual level because they are deductible to corporations.

With respect to capital gains, note that corporate share values generally equal the present value of expected future earnings. If the value of expected earnings rises, shares will increase in value, which creates a capital gain to the individual. But those future earnings will be taxed at the corporate level when they occur. Thus hitting taxpayers now with a capital gains tax is double taxation.

Double taxation of capital gains and dividends disadvantages corporate equity compared to debt. The result is that firms tend to overleverage, which makes them more unstable and vulnerable during downturns. One way to fix the problem is to reduce individual taxes on corporate equity, which was the goal of the 2003 reforms that cut dividend and capital gains tax rates to 15 percent.

Even with federal capital gains and dividend tax rates at 15 percent, the U.S. tax system is biased against corporate equity. Ernst & Young calculated combined corporate and individual tax rates on capital gains for the OECD countries.9 The U.S. rate of 50.8 percent is much higher than the OECD average of 42.0 percent. The U.S. disadvantage will get worse in 2013 when scheduled tax increases push up the combined tax rate to 56.7 percent.

Globalization and Competitiveness

One reason to cut capital gains taxes is more practical than theoretical—international tax competition. If a government today tried to tax high earners on their capital income at the same high rates as their wage income, the tax base would shrink dramatically and little revenue would be raised. A general rule for efficient taxation is for governments to tread lightly on mobile tax bases, and capital gains are one of the most mobile.

The inverse relationship between tax rates and tax bases has been strengthened by globalization. Capital is highly mobile across borders, which has prompted nearly every country in recent decades to cut tax rates on corporations, wealth, estates, dividends, capital gains, and withholding taxes on cross-border investment flows.10Many countries acknowledge that competition is a key reason to cut tax rates on capital. The parliamentary report supporting Canada’s tax cuts in 2000 proposed that “international competitiveness be the criterion guiding the choice of a capital gains tax regime.”

From Six Reasons To Keep Capital Gains Tax Rates Low:

1. Inflation. If an individual buys a stock for $10 and sells it years later for $12, much of the $2 in capital gain may be inflation, not a real return. Inflation — and expected inflation — reduce real returns and increase uncertainty, which suppresses investment, particularly in growth companies.

One solution is to index capital gains for inflation, but most countries instead roughly compensate for inflation by reducing the statutory rate on gains or providing an exclusion to reduce the effective rate.

2. “Lock-In.” Capital gains are taxed on a realization basis, which creates lock-in. Taxpayers delay selling investments that have large unrealized gains to avoid the tax hit. As a result, people hold assets too long and forgo beneficial diversification opportunities.

For the overall economy, lock-in reduces growth because it blocks the beneficial shifting of resources from lower- to higher-valued uses.

3. Double Taxation. Corporate share values generally equal the present value of expected future earnings. If expected earnings rise, shares will increase in value, creating a capital gain to the individual. But those future earnings will be taxed at the corporate level when they occur; thus hitting individuals now with a capital gains tax is double taxation.

Dividends are also double-taxed, with the result that the U.S. tax system is biased against corporate equity and in favor of debt. This destabilizes companies and the overall economy.

Ernst & Young calculates the current U.S. combined corporate and individual tax rate on capital gains at 50.8% — compared to an OECD average of 42.0%.

Our tax burden on dividends is equally out of line. The U.S. disadvantage will get much worse next year with the scheduled tax hikes on capital gains and dividends.

4. Competitiveness. Capital has become highly mobile across borders, prompting nearly every country in recent decades to cut tax rates on corporations, wealth, estates, dividends and capital gains. U.S. politicians get on a high horse and denounce individuals and firms that shift investments abroad, but the mobility of capital is a permanent reality.

The higher the tax rates on capital, the more job-creating investments are scared away. When Canada cut its federal capital gains tax rate to 14.5%, a parliamentary report proposed that “international competitiveness be the criterion guiding the choice of a capital gains tax regime.”

keep reading

14 comments
John Bunzl
John Bunzl

This appears to be an excessively one-sided view. The argument that taxing the rich only hurts the poor is the age-old fallacy that only serves to keep the rich rich and the poor poor. The only argument that really cuts any ice is the need to maintain competitiveness. But even this is short-sighted in the sense that lowering taxes to keep capital and investment in the U.S. only lasts until other nations retaliate by lowering THEIR tax rates. This creates a race-to-the-bottom between nations and explains why corporation tax levels around the world have continually reduced, so forcing governments to increase taxes on individuals. This, ultimately, is in no one's interests.

WesternFreePress
WesternFreePress moderator

 @John Bunzl We're not making the argument that taxing the rich ONLY hurts the poor. Different taxes cause differing degrees of harm to the rich, to the poor, and to the economy. They hurt the rich to varying degree, but they never help the poor. Heavily progressive taxes can, for example, reduce income inequality, but they always do so by lowering the wealth of the rich rather than by lifting the wealth of the poor.

John Bunzl
John Bunzl

 @WesternFreePress

 You are misreading me. What I meant was that the essence of your (in my view, false) argument is this: that it is not in the interests of the poor for the rich to be taxed because, according to you, that ends up hurting the poor, But that argument is plainly incorrect.

If the rich are taxed and that revenue is redistributed to the poorest, as it is in most civilised Western countries, obviously the wealth of those poorest increases. Income inequality is also reduced.

In most countries these obvious facts are taken for granted and have resulted in some of the most progressive and prosperous societies, such is in Scandinavia. In those places, the rich understand and accept that it's in their interests to pay relatively high taxes, not only to permit wealth redistribution to the poor, but also to pay for decent public services, like health care, education, etc. These are services which the rich, too, benefit from after all. So let's hope the rich elsewhere start to widen their horizons by seeing that paying proper taxes is, ultimately, in their interests too. Moreover, in the case of the USA, the whole nation might avoid a 'fiscal cliff'.

WesternFreePress
WesternFreePress moderator

 @John Bunzl Re; the IHDI, can you tell me which nations (other than Singapore and Hong Kong) are the most free-market?

 

I agree that "'too big to fail' dilemmas, rampant corporate abuses, and the need to be bailed out by the government (i.e. by the taxpayer)" are bad. Very bad. Government should not bail out private businesses. Government should not create an environment in which certain actors or cohorts are able to benefit at the expense of others. (You may not agree, but for a clearer explanation of what I mean, please see this on Public Choice: http://www.westernfreepress.com/2012/05/24/schools-of-thought-in-classical-liberalism-part-3-public-choice/. The Chicago School sees some potential exceptions, and that may indeed be reasonable: http://www.westernfreepress.com/2012/05/23/classical-liberalism-part-2-milton-friedman-and-the-chicago-school/)

 

The problem between us now is that you see government as a solution to market failures, whereas I see government solutions as often being worse than the problem. There is a role for government in providing security, justice, infrastructure, and in helping to mitigate externalities and third-party effects. But when government steps too far outside of that role, it can often make things worse. Yes, there are market cycles and market failures, but government's attempts to smooth those over can produce worse failures.

 

Check this out, specifically the excerpt from Thomas Sowell. (http://www.westernfreepress.com/2011/12/15/the-new-deal-was-a-failure-hoover-and-fdr-prolonged-the-great-depression-with-big-government/) The market crash in '29 was bad, but things were resolving themselves in fairly short order. Then the government stepped in and made things really bad. Similarly, monetary policy was arguably too tight, which made things worse. Again, that was a government failure, not a market failure. Moreover, the 1920s boom was, to some degree, fueled by easy money and loose credit, which is also the result of government policy.

 

Just as the 19th century was, largely, the century of classical liberalism (libertarianism), the 20th century was the century of belief in statist ideals and solutions. It has long been in vogue to blame the 1930s on capitalism and market failures, and to cast the government as saving us from that. Unfortunately, that viewpoint is bolstered more by a now-ingrained belief in statism than in actual economic facts.

John Bunzl
John Bunzl

 @WesternFreePress

 I have no doubt you hold your view sincerely and believe a more free-market approach will produce better results in both human AND straight enconomic terms. My point was that the evidence of the IHDI, for example, seems to suggest that only the economic objectives will be achieved by a more free-market approach. Meanwhile, other broader human aims will be made worse.

 

Personally, I agree that markets should be used in preference to governments PROVIDED, as I said, the long-term result is genuinely better, and is not punctuated by a periodic collapses, 'too big to fail' dilemmas, rampant corporate abuses, and the need to be bailed out by the government (i.e. by the taxpayer). But the trouble is that, sadly, experience and the evidence show that, unfortunately, freer markets seem incapable, generally, of doing that. So I am no fan of government, per se, I only recognise the limiitations of markets and therefore believe that making them even freer, and lowering taxes for the rich still-fiurther, etc are not going to produce a better outcome in terms of an index such as the IHDI; i.e. in broader human - rather than merely economic - terms.

 

My point all along has been, then, that while we both seem to agree on the wider point of a mixed market approach, in terms of the "degree of tilt" towards the free-market (rather than to government), going further in favour of the free-market is likely to produce worse results in terms of a broader measure such as the IHDI.

WesternFreePress
WesternFreePress moderator

 @John Bunzl Just for clarity: I am utterly opposed to anyone going hat in hand to the government: corporations, unions, farmers, etc. A level playing field with simple rules, coupled with a government that doesn't do much other than provide broadly accepted public goods, is the only way to prevent cronyism, corporatism, and other public choice theory types of dysfunction.

 

Second, and more important, I get the impression that you may be falling into the predictable pattern of accusing someone (me), however tacitly and carefully, of lacking compassion simply for holding free-market, limited government views. ("If, on the other hand, you define "the good" more narrowly and take no regard of . . .") This is pretty boilerplate statism: to believe that the state is better at producing good results and to imply that notions to the contrary are indicative of a lack of desire for good results, lack of human compassion, etc.

 

I would not do you the disservice of imputing to you a lack of compassion, and if that is what you are doing here, please consider a different approach. I believe it is the case that human beings operating freely will, in the end, produce results that are far more compassionate and effective at alleviating want than the state can. In fact, I think that state solutions are, on the whole, a disaster for most people. But I am not going to convert that belief into an imputation that you, as a supporter of greater use of such solutions, lack compassion or a desire to see good results achieved.

John Bunzl
John Bunzl

 @WesternFreePress

 You say "I don't believe that a move in a freer direction would produce worse results, I believe it would produce better results. We simply appear to differ in that regard".

 

That's right. Our differences, it seems to me, stem from differing perceptions of what we each see as "the good". I have no objection whatever to free-market solutions IF they can achieve a better result than public solutions AND if they can do so reliably without needing to run cap-in-hand to the government when things go wrong (viz. the sub-prime crisis).

 

Regarding what we each see as "the good", if we define that as the overall well-being of a national society, the IHDI (Inequality Adjusted Human Development Index) http://en.wikipedia.org/wiki/Human_Development_Index , for example, suggests that "highly developed" countries that tend to follow the mixed-market approach generally seem to do better than those that follow a more free-market approach.

 

If, on the other hand, you define "the good" more narrowly and take no regard of inequality, lack of publicly-funded health care, etc, countries following a more free-market approach may do better. But as I said, it depends on your aim; on how you define "the good".

WesternFreePress
WesternFreePress moderator

 @John Bunzl Actually, I recognize that you are an advocate of mixed-market approaches (as opposed to some crazed Marxist, or whatever), and I apologize if I am giving you an impression to the contrary. My quibble is with your assertion is that it appears to assume, a priori, that the solutions you advocate are, in fact superior.

 

What is "appropriate regulation"? Regulation is a preemptive solution to mitigate externalities and third-party effects (such as pollution). But is that the only way, or are some of the solutions posited by libertarians (using property rights, for example) a potential alternative? (For example, instead of using quotas on North Atlantic cod, they have tried giving each fishing vessel quasi-property rights over a section of ocean; the fisherman, instead of continuing their old ways, which result in "the tragedy of the commons" immediately began taking much better care of their section, resulting in a rebound of cod stocks.)

 

What is appropriate taxation? There is plenty of evidence that progressive income taxation kills economic growth but does not produce greater revenue (whether the top marginal tax rate is 91% or 35%, the revenue as a percent of GDP is within a narrow 7 to 9% range. Why not try flat taxation, for example, or taxation on consumption instead?

 

There is a role for government to provide some public goods (especially the nonexcludable, nonrivalrous kind), and to mitigate certain externalities. But there is also much that can be done by private entities, by the civil society, by market forces, and by millions of human beings cooperating and interacting voluntarily.

 

I don't think you're some raging marxist or socialist or some such. But I do believe that you are assuming that the state MUST play a role in certain things, and do so in certain ways, in order to produce certain desirable social outcomes. I believe that there are other ways. I don't believe that a move in a freer direction would produce worse results, I believe it would produce better results. We simply appear to differ in that regard, unless I am misunderstanding.

John Bunzl
John Bunzl

 @WesternFreePress

 Again you misrepresent me. Free markets, enterprise and industrialization were wonderful drivers of the modern age, and we've all benefited greatly - no doubt about that. But the other half of that story - the part you seem to want to ignore - is that we learned over time that free markets need to be complemented by appropriate regulation and taxation, to deter pollution, avoid exploitation, help the poorest and to fund public services. Because that, on the whole, was what was seen to be in everyone's best interests as a whole. Even the rich, over time, generally acknowledged that to be in their wider interests too - which is why it happened. So the desire to go back to just the free markets part of that equation, as you seem to be advocating, while jettisoning the regulation/taxation part, would seem to be a retro-grade step.

WesternFreePress
WesternFreePress moderator

 @John Bunzl Re: The 19th century, I encourage those who share your core assertion (namely that the 19th century was some sort of example from which to run screaming) to read the first few chapters of Milton's Friedman's "Free to Choose."

 

http://books.google.com/books?id=F5z1B5SwGUEC&pg=PT157&lpg=PT157&dq=%22from+waterloo+to+the+first+world+war%22+friedman&source=bl&ots=SKaRDtrnhO&sig=q2dl5I_rrRz4z-zbnY-zjnbm_gM&hl=en&sa=X&ei=_pjhUMWwNIf-0gHrsIGoDA&ved=0CEsQ6AEwBA

John Bunzl
John Bunzl

 @WesternFreePress

 Yes, it is hard to compare. The reason, probably, is that most people instinctively realise that complete economic freedom, a rolling back of regulation, and people being treated strictly equally would pretty much mean going back to the Industrial Revolution; that is, to the dawn of the modern era when free markets were first emerging and there were no significant regulations on business or on capital owners. As most national societies today seem to intuit (including, generally, the rich), going back to such an un-regulated position would only be to invite unfettered pollution and human exploitation on an unheard of scale. So, to my mind at least, thank heavens we're short of comparisons!

 

Yes, economically freer nations generally do better in terms of growth and GDP - that's true. But in a world where capital moves freely across national borders, much of that gain or benefit is likely to have arisen because of differences between nations that make one nation more attractive to global markets than another, rather than because of what any particular nation does in isolation. In fact, because we live in a global economy in which capital moves freely, looking at individual nations and trying to determine what works and what doesn't is becoming a bit futile. So interconnected are our national economies these days that it's even harder to make sensible comparisons.

WesternFreePress
WesternFreePress moderator

 @John Bunzl One of Sweden's advantages is heavier taxation of consumption instead of corporate or income taxes. According to an OECD study from a few years ago, that is the best way to go, growth-wise.

 

Also, we have to understand our terms. "Poor" means different things depending on the person with whom we are speaking. Today's bottom quintile has a higher standard of living than the middle quintile did in the 1950s. If you make over 35K, you are in the top 1% worldwide. There will be, in every population, some people who cannot work, who are truly in need of our help. But today's welfare-state mixed-market quasi-capitalist nations of the West have defined things a good deal more broadly than that.

 

One of the difficulties here is that we have nothing to compare to. In the modern, information-age era in which we live, we pretty much only have welfare-state mixed-market quasi-capitalist nations to look at. If we had a free, representative, modern Western nation that was trying our some more libertarian solutions (flat taxation, a focus on civil rather than state solutions for social questions, etc.), we could compare and see what works better. There are a few budding examples here and there (Chile's privatized retirement system is working well; Poland and Estonia seem to be benefiting from a more free market approach), but we don't have a massive record to look at. Most nations in the West are wedded to heavily progressive taxation and all the other statist assumptions that came into vogue beginning with Bismark's Prussia and have remained so ever since.

 

We do, however, have plenty of data that at least compares existing nations vis-a-vis freedom and success. The more economically free nations do better (more prosperity, personal freedom, life expectancy, etc.) than the less economically free ones. But even the most economically free ones aren't nearly as free as they could be. You assume that the poor benefit from wealth transfers from the rich, but in the absence of having a large example of a modern economy in which people are treated more equally and where even greater economic freedom was allowed to work its magic, it's hard to compare.

John Bunzl
John Bunzl

 @WesternFreePress

 Well, as the article you just linked to says, "In many ways, it [Sweden] is a large-government capitalist welfare state. It's what the commentators in the video below refer to as a mixed economy. But it is not an example of the success of socialism."

 

But I never suggested Scandinavian countries were examples of "the success of socialism"! I only suggested they were good examples of how sensible taxation, including relatively high taxes on the rich combined with appropriate re-distribution to the poor, not only benefit the poor, but the rich too.

 

One can argue, of course, about the DEGREE of taxation, etc, but in Europe this arrangement, whether in Scandinavia or elsewhere in Europe, is regarded as pretty normal and uncontentious. But in the US, for some reason, this is labelled with the smear-word "socialism", a term designed to smack of communism, (presumably so as to scare the poor so as to keep the rich as rich as possible).

 

Appropriate taxation of the rich to help the poor and to fund decent public services is in everyone's interests. It just depends how widely you define what is in your best interests. In Europe, generally, the rich seem to define what is in their interests more broadly than the rich do in the US. In Europe they generally regard free markets balanced with appropriate taxation and re-distribution, not as 'socialism', but as nothing more than appropriately balancing competitive markets with co-operative goverance.