A Capital Gains Primer

Published in Wall Street Journal

On Thursday the House Ways and Means and Senate Finance committees held a rare joint hearing on taxing capital gains in the context of tax reform. The timing couldn’t be better because President Obama recently restated his support for lifting the top capital gains tax rate next year on those with earnings above $250,000 to 23.8%, or almost 60% above today’s 15% rate. If Mr. Obama’s Buffett Rule is also adopted, the rate would rise to 30% for those earning $1 million—the highest rate since the late 1970s.

The question is to what purpose? This won’t raise much if any revenue for the government (see “Obama’s Revenue Soup,” April 9, 2012). But it will impose a big cost on the economy. Amid sluggish growth that has prompted the Federal Reserve into unlimited monetary easing, it is hard to imagine a worse time to raise the tax on capital investment. None other than Lord Keynes wrote that “the weakness of the inducement to invest has been at all times the key to the economic problem.”

The current Democratic obsession with raising the capital gains tax comes from a mistaken belief that the preferential rate applied to the sale of a family business, farm or financial asset is a “loophole” that mainly benefits the rich.

But that ignores the vital link between tax rates and capital investment. The lower the tax, the greater the incentive to take risks. And though Warren Buffett may not believe that tax rates matter, studies by economists such as James Poterba of MIT have documented the “significant influence” of capital gains taxes on the “demand for venture funds.”

Thanks to rate reductions in 1978, 1981, 1997 and 2003 (see chart), the statutory capital gains tax has fallen to 15% from about 40%. These rate cuts unleashed historic levels of venture-capital funding for business start-ups. The funds helped launch America’s entrepreneurial and high-tech revolution over the last 30 years exemplified by iconic American firms from Wal-Mart to Microsoft, Home Depot and Google that employ hundreds of thousands of Americans.

Far from being a loophole, the low tax rate applied to capital gains is beneficial and fair for several reasons. First, under current tax rules, all gains from investments are fully taxed, but all losses are not fully deductible. This asymmetry is a disincentive to take risks. A lower tax rate helps to compensate for not being able to write-off capital losses.

Second, capital gains aren’t adjusted for inflation, so the gains from a dollar invested in an enterprise over a long period of time are partly real and partly inflationary. It’s therefore possible for investors to pay a tax on “gains” that are illusory, which is another reason for the lower tax rate.

Third, since the U.S. also taxes businesses on profits when they are earned, the tax on the sale of a stock or a business is a double tax on the income of that business. When you buy a stock, its valuation is the discounted present value of the earnings.

The main reason to tax capital investment at low rates is to encourage saving and investment. If someone buys a car or a yacht or a vacation, they don’t pay extra federal income tax. But if they save those dollars and invest them in the family business or in stock, wham, they are smacked with another round of tax.

Many economists believe that the economically optimal tax on capital gains is zero. Mr. Obama’s first chief economic adviser, Larry Summers, wrote in the American Economic Review in 1981 that the elimination of capital income taxation “would have very substantial economic effects” and “might raise steady-state output by as much as 18 percent, and consumption by 16 percent.”

Almost all economists agree—or at least used to agree—that keeping taxes low on investment is critical to economic growth, rising wages and job creation. A study by Nobel laureate Robert Lucas estimates that if the U.S. eliminated its capital gains and dividend taxes (which Mr. Obama also wants to increase), the capital stock of American plant and equipment would be twice as large. Over time this would grow the economy by trillions of dollars.

Moving rates higher has damaging effects. Economist Allen Sinai estimates in a report for the American Council for Capital Formation that raising the capital gains rate to between 20% and 28% would reduce U.S. employment by between 231,000 and 602,000 jobs a year, and that with slower growth and a weaker stock market “the federal budget deficit actually ends up larger.”

Even on class-warfare grounds, it is counterproductive to raise taxes on capital. Most of the returns on investment in a business benefit workers (not shareholders), because they become more productive with more modern factories, computers and equipment made possible with investment capital.

Isn’t that precisely what we want in America today? As consumers and the government inevitably reduce their debt loads, the economy needs a higher level of capital investment to spur business creation and a spirited bidding up of stagnant wages. Democrats who argue for higher taxes on capital are advocating less investment and dooming workers to fewer jobs at lower wages.

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