Capital Gains Taxes and the Economy

Executive Summary

In 2011, capital gains tax rates for taxpayers in the top four income brackets are set to move higher.  At yearend, the current 15% tax rate on capital gains for assets held one-year-or-more will rise to 20% for individuals earning approximately $34,000-or-more and married couples earning $68,000 or higher.

This paper assesses the macroeconomic effects of changes in capital gains tax rates for individuals, with estimates from simulations with the Sinai-Boston (SB) large-scale macroeconometric model of the U.S. economy.  The Model is used in simulating reductions, and increases, in capital gains taxation starting in 2011 and extending to 2016, relative to the current 15% rate paid by many taxpayers.  The capital gains tax rates considered ranged from 0% to 50% with gradations at 5%, 10%, 20% and 28%.

Several conclusions are suggested by the results:

  • Very high, or very low, individual capital gains tax rates relative to the current level can do significant damage, or provide significant help, to the economy.
  • Raising the capital gains tax rate from 15% to 20%, 28% or 50%, reduces growth in real GDP, lowers employment and productivity and, ex-post, or after feedback, negatively affects the federal budget deficit. For example, at a 20% capital gains rate compared with the current 15%, real economic growth falls by an average of 0.05 percentage points per annum and jobs decline by an average of 231,000 a year.  At a 28% rate, economic growth declines by 0.10 percentage points and the economy loses an average of 602,000 jobs yearly.  When the capital gains tax rate is increased to 50%, real GDP growth declines by an average of 0.3 percentage points per year and there are an average 1,628,000 fewer jobs per annum.
  • Despite an “ex-ante” or “static” increase in tax revenues from a rise in the capital gains tax—after the negative effects on the economy and feedback effects on tax receipts from a worsened economy and a weaker stock market, the federal budget deficit actually ends up larger, by over $1 billion per year with a 20% capital gains rate and almost $10 billion per year if the tax rate is 28%.  And, at 50%, despite the ex-ante, or planned, increase in tax revenues, $191.5 billion per annum, the actual, or ex-post, federal budget deficit actually ends up lower, by $67 billion per year.
  • Reducing the capital gains tax rate to 0% increases growth in real GDP by a little over 0.23 percentage points per year. Jobs increase by an average of 1,322,000 per annum. The unemployment rate drops 0.7 percent at its lowest point.  And, productivity growth improves 0.5 percentage points a year.
  • The net impact on the federal budget of a reduction to 0% is a decline in tax receipts of $23 billion per year, ex-post, far less than the ex-ante revenue loss of the tax change.  This tax cut produces new jobs at a cost of only $18,000 per worker.
  • When the capital gains tax rate is decreased to 5% from the current 15%, growth in real GDP rises an average of 0.2 percentage points per annum, the unemployment rate falls an average of 0.2% per year, and nonfarm payroll jobs increases an average of 711,000 a year. At this capital gains rate, productivity growth improves an average 0.3 percentage points per year.
  • Lower and higher capital gains tax rates also affect the financial positions of households and corporations. When capital gains taxes are reduced, the aftertax return on equity rises, stock prices increase, household wealth is higher, some capital gains are realized, consumption increases, output and production rise, capital spending increases, household financial assets tend to rise, liabilities decline, debt service burdens are reduced, and household financial conditions improve. These financial effects from the lower capital gains taxes are supportive to additional spending out of disposable income and tend to sustain and raise and for a longer time the multiplier effects from the reduction in the capital gains tax.

Corporations benefit as equity prices rise and profits improve from the better economy. This provides additional cash flow that can reduce growth in borrowing or add to financial assets, improving measures of financial well-being for the nonfinancial corporate sector. Higher capital gains taxes would have opposite effects.

Enhanced financial positions for households and businesses provide resiliency to the economy in the face of negative shocks reduce the cost of financing and financial risks taken by those who provide funds for new businesses, entrepreneurship, and innovation.

While a small increase in capital gains taxes does not have a large negative impact on the economy, much higher capital gains taxes are very punitive.

For example, a 20% capital gains tax rate is not much higher than the current 15%. But, any capital gains tax hike is counterproductive because it brings weaker real economic growth, reduces consumption and real consumption per capita, causes losses in jobs, a higher unemployment rate, less productivity growth, and lower potential output. There is little “bang-for-a-buck” for the economy per dollar of tax revenue on any capital gains tax hike; indeed, the revenues gained ex-post are hardly worth the loss in economic growth, in jobs, in productivity and potential output.

Similarly, or conversely, significant reductions in the capital gains tax rate, e.g., to 5% or even 0%, bring strong gains in real economic growth, in new jobs, and likely will increase entrepreneurship and new businesses, increase capital formation, raise productivity growth, bring higher potential output, and greater efficiency.

The challenge for macroeconomic policymaking and Washington will be how to devise macroeconomic policies that can increase real economic growth and jobs with minimal increases in the federal budget deficit; or, if possible, reductions. Capital gains tax reduction scores well on these grounds. Capital gains tax reductions, not increases, on what activities, and on whom, perhaps in the context of full tax reform and whether to tax consumption, income, or capital, are more general issues to be considered.

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