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Capital Gains: A Three Part Series

Posted by Andrew Quinlan on May 4, 2010

Over the next several days we will be highlighting a series of papers by Stephen J. Entin of the Institute for Research on the Economics of Taxation (IRET). These papers examine the looming possibility of an increase in the capital gains tax rate and make a strong case for reducing the rate.

The first paper, entitled The Effect Of The Capital Gains Tax Rate On Economic Activity And Total Tax Revenue, begins as follows:

The President and the Congress are hoping to raise substantial revenues to pay for social spending programs, including health care. They are relying in part on scheduled increases in tax ratesin 2011, when the Bush tax cuts expire. They would extend the tax cuts for people in the bottom four tax brackets (roughly, for couples with $250,000 or less in adjusted gross income), but would let the tax rates rise in the top two tax brackets on income, capital gains, and dividends.

However, taxpayers react to higher tax rates by earning and reporting less income. Higher taxes on capital retard capital formation and reduce wages across the board. The particular tax increases that the Congress and the Administration are most likely to adopt would damage the economy and reduce the tax base. In fact, they are likely to result in lower federal revenues, and larger budget deficits.

Under current law, most of the tax reductions in the 2001 tax act (the Economic Growth and Tax Relief Reconciliation Act of 2001) and the 2003 tax act (the Jobs and Growth Tax Relief Reconciliation Act of 2003) will expire at the end of 2010. The maximum tax rates on capital gains and dividends were lowered to 15% by the 2003 tax act. In 2011, the capital gains rate will revert to 20%. In 2011, the tax rates on dividends will revert to ordinary income tax rates, with a top rate of 39.6%. (The 2001/2003 acts cut individual marginal tax rates on ordinary income. These cuts will also expire. The top tax rate will rise from 35% to 39.6%, and will apply to dividends.)

President Obama has suggested at various times accepting the scheduled increase in the capital gains tax rate to 20%, or raising it further to as much as 28% or to some rate in between. He has been vague on what would happen to dividends. Some action by Congress on these tax rates is expected before 2011. One likely option is to allow some increase in both rates, while maintaining equal treatment for dividends and capital gains, rather than letting the rates diverge again. This paper examines the economic and revenue consequences of letting tax rates on dividends and capital gains increase in the top two tax brackets to 20%, 24%, or 28%. The analysis finds that higher tax rates on capital income would discourage investment and result in a smaller capital stock than would exist if the rate remained at 15%. At the three higher tax rates, the private business sector capital stock would be 3.8%, 6.8%, and 9.5% lower, respectively. As a result, productivity, wages, and hours worked would be lower than otherwise. Incomes before- and after-tax would be less than otherwise across the board. Pre-tax business sector labor compensation and capital income would be 1.4%, 2.5%, and 3.5% lower, respectively.

The biggest percentage declines in after-tax incomes would be in the top income classes, where the capital gains and dividend tax rates were raised (in the top AGI class, about 2.9%, 5.1%, and 7.1% in the three cases). The next greatest percentage losses would be in the lowest income classes (about 1.3%, 2.4%, and 3.3%). Middle income classes would be partially protected by declines in income taxes as their incomes fell, and would have the smallest drop in after-tax income (about 1.1%, 2.1%, and 3.0%). Allowing for these income changes, everyone would bear some of the actual economic burden of the tax increases, not just people with incomes above $250,000. The tax rate increases would not raise the anticipated revenues. About 91% to 95% of the revenue gains expected from the imposition of the 20%, 24%, and 28% rates would be lost due to lower incomes. Instead of raising income tax revenue by $30.7 billion, $54.7 billion, or $77.5 billion, respectively, the net income tax increases would be only $2.5 billion, $2.9 billion, and $4.0 billion in the three cases. Lower levels of output, payroll, and consumption would reduce payroll taxes, corporate income taxes, excise taxes, and tariff revenue, resulting in net revenue losses. There would be further revenue reductions due to the decline in the capital stock, which would decrease the amount of capital gains available to be realized. The combined revenue effect would be losses of $24.9 billion, $46.2 billion, and $64.8 billion in the three cases. Lower wage rates would reduce federal budget outlays, but the combined effect would be a significant increases in federal budget deficits (by $17.4 billion, $32.8 billion, and $46.0 billion, respectively). State and local government budgets would be similarly hurt.


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