Reasons to keep capital gains taxes low
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.
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.”
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.”