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Capital Gains: Part Three

Posted by Andrew Quinlan on May 11, 2010

The final paper in Stephen J. Entin of IRET’s three part series about the capital gains tax rate is entited, Revenue Estimation Of Capital Gains Needs Improvement, and as the title promises it explores the inacurate revenue estimates applied to potential changes in the capital gains tax rate:

Two recent studies in IRET’s Capital Gains Tax Series have examined the taxation of capital gains from two different perspectives. The first study is “The Effect of the Capital Gains Tax Rate on Economic Activity and Total Tax Revenue” by IRET President Stephen J. Entin.1 The Entin paper looks at how changes in the tax rate on capital gains and dividends (currently 15% for both) affect the economy. In particular, it examines the effects on the amount of capital investment, productivity, wages, and GDP. These are the macroeconomic effects of the tax. They influence the size of the capital stock and the amount of economic output and income (GDP). These changes in turn affect the amount of taxable income and government tax revenue. The effects are large, important, and should be considered when making decisions about what to tax and what the tax rate should be. They are sufficient to offset between 92% and 95% of the expected increase in income tax revenue from an increase in the capital gains tax rate to 20% or 28%. Factoring in the losses of other tax revenue due to the lower levels of wages and GDP, total revenues would fall, not rise. All told, the revenue loss from the economic damage would offset more than 180% of the expected revenue gains from raising the rate from 15% to 20%, 24%, or 28%.

The second study, “The Relationship Between Realized Capital Gains and Their Marginal Rateof Taxation, 1976-2004,” is by Professor Paul D. Evans of Ohio State University.2 The Evans paper focuses on one aspect of taxpayer behavior: how a tax rate change would affect the quantity of existing capital gains that taxpayers choose to realize on a permanent basis, beyond temporary timing effects. This realization effect is a microeconomic change in taxpayer behavior that does not affect the size of the capital stock or the amount of economic output and income. The Evans paper predicts a moderately large ongoing taxpayer realizations response at current tax rates, which would offset about 106% of the increased income tax revenue that would be calculated to occur from a one percentage point hike in the capital gains tax assuming the amount of gains did not change. The permanent realizations response to a tax rate change depends in part on how high the rate was to begin with. Various other studies of this type, studying different years and using a variety of methods, have come up with answers that range from quite large (resulting in revenue losses if the rate were to be raised, and net gains if it were to be reduced) to fairly small (offsetting about a sixth of the “no reaction” revenue change) at various initial levels of the tax rate. These offsets would be due only to the change in the quantity of gains taken, not to any economic changes resulting from the change in the tax on capital. In this paper, we look at the findings of earlier studies on the realizations and timing effects of tax rate changes on capital gains. The purpose is to gain a better understanding of what the revenue estimators do, what they tell the Congress, and how they influence policy decisions. The goal is to explore how seriously the Congress should take these projections, and to suggest that the Congress ought to take additional factors into consideration in deciding what to do with the tax. This focus on the revenue consequences for the federal Treasury is not to be taken as an assertion that federal revenues are the most important aspect of the imposition of the tax. In the case of capital gains taxes, and other taxes that have large economic impacts, the effect of the tax on the income and employment of the population deserves more attention than the narrowly-estimated revenue effect on the federal budget.


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