Time to Repave the Tax Road

Tax rates on capital gains are in the line of fire once again, mostly due to a popular New York Times op-ed written by wealthy investor Warren Buffett, who bemoaned that he paid a lower tax rate than his secretary. Buffett further argued that rates on capital gains have no bearing in “scaring off” investment. However, legislation introduced by Representative Peter Roskam (R-IL) that permanently caps the individual capital gains and dividend tax rates at 15% reflects recent economic research showing the benefits of permanent, low tax rates on income from investment.

One of the main sources of uncertainty that has characterized the U.S. tax code during the last decade is “Sunsets.” Sunsets are temporary provisions in the tax code that are set to expire at a given point in time. Capital gains and dividend tax rates have been handled with sunset provisions since 2003. Given the weak U.S. economic recovery, despite considerable fiscal stimulus and monetary easing, policymakers should question the effectiveness of “temporary solutions” on economic and job growth. Nobel Laureate Milton Friedman’s permanent income theory states that a (or “the”)household consumption choice is not determined solely by current income but also on expectations of future earnings. In other words, temporary changes in household income will not have a significant impact on current consumption spending. This logic can also be applied to the impact of tax policy changes. In fact, a 2010 National Bureau of Economic Research paper written by Francois Gourio and Jianjun Miao (http://www.nber.org/papers/w16157) shows that permanent reductions in capital gains tax rates from 20% to 15% increase both investment and the capital stock by 3.2%, consumption by 0.2%, output by 0.4% and employment by 0.1% in the long run.  They state that, “This result reflects the fact that the capital gains tax cuts reduce the user cost of capital and hence benefit the economy in the long run.” In contrast, when capital gains tax cuts are temporary, there is no long-run impact on investment, employment and other key economic indicators.

Capital gains taxation is inherently inefficient (double taxation) and biased against risk taking (only a portion of capital losses are permitted to be deducted while the entire gain is taxed). In recent years, “sunsets” have led to increased uncertainty surrounding taxation of capital gains. The investment decision depends on expected future outcomes.  As such, uncertainty over the capital gains tax rate has a negative impact on the investments that drive our economic growth.

Capital gains taxation also creates a lock-in effect for entrepreneurs by creating an incentive to hold onto assets with gains, rather than optimally rebalancing their portfolio. Active business assets, the types of business assets that are likely to be associated with capital gains for entrepreneurs, make up a large portion of the aggregate portfolio of household assets according to a 2010 paper by Williams College professor William M. Gentry (http://www.accf.org/media/dynamic/4/media_497.pdf).  Using the 2007 Survey of Consumer Finance, Gentry shows that 11.1 %of households hold these types of assets and that these assets account for 19% of household portfolios compared to the 11.7% portfolio share of stocks held outside of retirement accounts. In addition, the data reveals that unrealized gains associated with active business assets are almost 6 times larger than unrealized gains on corporate stock. According to Gentry, “The magnitude of unrealized capital gains on active business assets suggests that capital gains tax rate could play an important role in whether and when these assets are sold.”  Through this lock-in effect, capital gains taxes put another shackle on the decision making process of entrepreneurs.

The current economic environment is plagued with uncertainty. Tax policy should not impose additional burdens to the process. Instead, the U.S. tax system should be redesigned in a manner that encourages the entrepreneurial spirit that led to U.S. economic dominance and increases the competitiveness of our businesses in the global marketplace. Filling tax “potholes” does not seem to work anymore. It is time to repave the road and make permanent the current 15% individual capital gains tax rate.