Capital Gains and the Economy

Tax revenue is a vital part of the United States government. The income generated from taxes allows the government to finance public works programs, build infrastructure and maintain a military. When the government needs to raise more revenue it generally raises the tax rate to create more income. The idea of raising taxes to raise revenue generally works; however, history has show that more revenue is not gained from the capital gains tax. When the capital gains tax rate rises there is less revenue generated, investment capital decreases, and the economy slows.

The capital gains tax is a tax charged to the profit realized from the sale of an asset that was purchased at a lower price. Capital gains are commonly realized from the sale of stocks, bonds and property. A capital gain is treated as an income and like any income, it is taxed. Under current United States tax code there are two different types of capital gains, short term and long-term gains. A short-term gain is considered to be the purchase and sale of an asset for a gain in less than one year. Long-term capital gain requires a year or more between the purchase of an asset and the sale of the asset for a gain. Short-term capital gains are taxed at the ordinary income tax level of the investor, however; long-term capital gains are taxed differently. Currently investors in the 10% to 15% income tax range pay no long term-capital gains tax and everyone else pays a 15% tax on capital gains. (Beach, Hederman & Guinevera, 2008)

Economic growth in America is important and relies on the input of two factors: input of capital and labor, and the productivity of the inputs. For the economy to grow capital and labor in the market must increase or a more efficient way to produce products is found, or both situations occur. The need to invest in capital is directly related to the growth of the economy by increasing the amount of capital available in the economy and by enhancing labor productivity.  Labor productivity can be directly complemented capital in the economy for investment in more productive operations. (The Economic Effects of Capital Gains Taxation, 1997)

When capital gain tax rates raise the return on an investment is lowered and the cost to acquire capital increases.  When the return on investment is lower there is less investment and the amount of available capital in the economy decreases. The inverse to an increase in the capital gains tax would be a decrease to the capital gains tax. A decrease in the capital gains tax rate is believed to stimulate investing and the amount of capital in the economy by producing more profitable and successful businesses, because they are able to acquire the funds required to under go new potential income projects.  The trickledown effect would produce higher wages, raising the standard of living and create jobs. (Throning, 1995)

A recent study was conducted by DRI/McGraw-Hill it was estimated that the reducing individuals long-term capital gains taxes by 50% and corporations capital gains tax by 25% the level of business spending would have been $18 billion dollars higher than it was in 2007 creating the GDP of America to be roughly 0.4 percent higher. The conclusion of the study notes “the evidence suggests to almost all economists that a capital gains cut is good for the economy and roughly neutral for tax collections.”(Jorgenson, Dale, Yun & Kun-Young) The lower tax rate would only have positive effects on the economy such as higher standards of living, increased productivity and increased investment. A lower capital gains tax would increase individual wealth that could be re-invested or contributed to a personal savings account.

Over one hundred million Americans own stock, the majority of Americans that hold stock hold them in mutual funds. (Chait, 2008)  In 2007 mutual fund holders paid over $16 billion dollars in long-term capital gains taxes.  Congressman Jim Saxton, the ranking member of the Joint Economic Committee states: “…Under current law, if shareholders do nothing more than buy and hold mutual fund shares, they will be hit with taxes on long-term capital gains realized by the fund, even if they are immediately reinvested in the fund.”(Mutual Fund Shareholders Slammed Again by Higher Taxes, 2008) As stated that is capital transferred directly to the federal government rather than directly re-invested in the economy.  One recent study by the National Bureau of Economic Research stated that the each dollar in federal tax increase has led to an additional $1.07 in federal spending. (Tax Increase Would Damage Economic Outlook, 2008) 

The federal government requires large amounts of funds to continue operation and generally overspends, the current solution it to raise taxes to help pay for large expenses. Despite normal intuition a decrease in the capital gains tax rate has yielded higher tax revenues. Using historical evidence as proof that a lower capital gains tax increases revenue, in 1978 when the capital gains tax was lowered, tax revenue began to increase. When the tax was reduced again in 1981 tax revenue increased again drastically until 1987 when the capital gains tax increased and revenue began to decline. In 1986 the tax revenue generated from the capital gains tax at the lowest point it has been in fifty years, was over three times of that in 1977. The lower tax rate and higher tax revenue suggests that more investors are placing capital gaining on capital investments. With larger amounts of capital investments businesses are able to easily acquire working capital and continue operations. As stated earlier, more capital invested in the economy will increase the stand of living, increase income and lower unemployment. (The Economic Effects of Capital Gains Taxation, 1997)

An increase in the standard of living will allow households to purchase more good and good of higher quality. A higher standard of living allow for more money to be spent and an even larger inflow of capital into the economy. An increase in household income will allow for a larger household savings and investing rate. If households invested the extra income, there would be a snowball effect of new capital pumped into the economy. The circuitous effect of increasing capital into the economy would also result in a decrease in unemployment. Historically when unemployment is low, interest rates are higher, allowing for an increase in investor capital gains and one more stream for more capital gains tax revenue. 

A reduction in the capital gains tax could counter the lock-in effect, which occurs when capital assets are not sold because the gains on capital are taxed at a high rate. When investors lock-in the tax base for the capital gains tax is lowered. Unlocking assets allows holders capital to sell holdings and achieve desired returns.  It is estimated that there are billions of dollars of equity that are currently locked into assets.  (The Economic Effects of Capital Gains Taxation, 1997)

When a decrease in the capital gains tax yields higher tax revenue it is time to examine the position of the tax rate on the Laffer curve. It is reasonable to assume that when the tax is high it falls on the downward side of the curve. When the tax rate falls on downward side of the Laffer curve the government is limiting the revenue it can receive.  Investors are motivated to find ways to avoid paying the tax. To avoid paying capital gains tax investors could not enter into activities what will produce gains on capital such as stock ownership thus limiting the amount of capital in the economy available for companies to acquire. (Thorning, 1995)

With a very tenuous relationship between revenue from the capital gains tax rate and the level of investment based on the level of the capital gains tax rate and the effect on the entire economy it is important to look towards the future. With current capital gains tax law set to expire and rise by 2011 and a presidential election just around the corner, it is critical to know each candidates position on capital gains tax. What each candidate plans to do with the capital gains tax could have a critical effect on the economy.

On December 31, 2010, the tax rates on capital gains and dividends enacted in 2003 is set to expire. The current long-term capital gains tax rate of 15% will increase to 25%. With the tax higher a lock-in effect could occur where capital is not sold after January of 2011. Prior to the tax rate increase many investors will liquidate assets early to avoid paying the higher taxes.  Senator Barack Obama said that he would not renew the current capital gains tax rate and allow the tax to increase.  (Satow, 2008)  Senator John McCain has stated he want to keep capital gains taxes at current rats. With the current credit crunch and many businesses unable to rise capital from banks they must turn to investors. If investors are motivated not to invest capital back into the economy because of higher taxes, many businesses will fail. 

In all sectors of the economy there is a need for capital funding. Many businesses require funds to continue operation that are in turn repaid to the investor along with an incentive for taking the risk of lending money. When the capital gains tax rates are raised the incentive for taking the risk of investing is diminished.  When there is a lack of investors the ability to raise capital for industries becomes limited and very expensive so new projects are not taken further limiting the amount of capital in the economy.  When the taxes of investing are reduced it has been proven that there is more money into the economy and the government receives more from tax revenue.

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