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The Contributions of Eduardo Morgan Jr.

Posted by Andrew Quinlan on August 12, 2010

The fight for financial freedom and limited government is global. The Center for Freedom and Prosperity recognizes Eduardo Morgan Jr., an individual whose work for his native Panama echoes much of our own efforts to defend fiscal sovereignty from the onslaught of anti-growth taxation and regulation.

As Panama’s Ambassador to Washington from 1996 to 1998, Eduardo Morgan Jr. saw his country attacked by US political and economic leaders. Ever since, he has dedicated himself to exposing the hypocrisy of the OECD and its members for attacking other countries that want to compete for investment and capital.

Since the beginning of the year, Eduardo has also contributed factual analysis to the online discussion with his blog, which I highly recommend to our readers. His work on behalf of Panama should serve as an inspiration to all individuals and nations that seek freedom and prosperity.

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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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Capital Gains: Part Two

Posted by Andrew Quinlan on May 6, 2010

As previously noted, IRET has published a series of three excellent papers on the case for lowering the capital gains tax rate. The second paper is introduced by Stephen J. Entit and written by Paul Evans. Entitled, The Relationship Between Realized Capital Gains And Their Marginal Rate Of Taxation, 1976-2004, it begins as follows:

The tax rates on long-term capital gains (gains on assets held at least one year) are scheduled to rise in 2011. The current top statutory rate of 15% would rise to 20%. President Obama has suggested at various times raising the top rate further, to as much as 28%. How much additional revenue, if any, should the government expect to get from such increases in the tax rate on capital gains? Previous research has indicated that cutting the tax rate to roughly current levels may actually have raised revenue for the Treasury. If so, hiking the rates could reduce revenue, in addition to hurting growth and job creation.

IRET asked Professor Paul D. Evans of Ohio State University to take a fresh look at how taxpayers might respond to an increase in the capital gains rate, using taxpayer data from the most recent available years. His study, The Relationship Between Realized Capital Gains and Their Marginal Rate of Taxation, 1976-2004, is presented below. Evans finds that taxpayers are still sensitive to the tax rate on capital gains, and would report fewer gains if the rate were raised. Based on 2004 data, the revenue maximizing tax rate may be just under 10%. Raising the capital gains tax rate from the current 15% to 20% or more would reduce federal capital gains tax revenue. Additional revenue would be lost from other parts of the income tax and from other federal taxes due to reduced investment, employment, and income. The optimal capital gains tax rate to maximize public welfare, and to help the federal budget, is surely closer to if not zero.

The tax rates on long-term capital gains (gains on assets held at least one year) are scheduled to rise in 2011. They were reduced in the Jobs and Growth Tax Relief Reconciliation Act of 2003, with the cuts effective through 2008. The reductions were extended through 2010 in the Tax Increase Prevention and Reconciliation Act of 2005. (The top tax rate on dividends was also cut to 15% to match the top rate on capital gains. It too will increase in 2011, reverting to ordinary income tax rates.) Before the 2003 reduction, the top tax rate on long term capital gains was 20% for taxpayers in the top four tax brackets and 10% for taxpayers in the 10% and 15% ordinary income brackets. (However, for gains on assets held five years or more, the top rate was only 18% in the top four brackets and 8% in the 10% and 15% brackets.) In 2003, the top rate of 20% (or 18%) was cut to 15% for taxpayers in the top four tax brackets. The capital gains rate for taxpayers in the 10% and 15% brackets was reduced from 10% (or 8%) to 5% through 2007, then to zero for 2008-2010. Under current law, in 2011, the 15% tax rate on long term gains will revert to 20% (or 18% for 5-year holdings) for the top four brackets. The zero rate will revert to 10% (or 8% for gains held 5 years or more) in 2011. The 10% (or 8%) rate will apply to taxpayers in the 15% ordinary income tax bracket. (The 10% tax bracket, which was carved out of the 15% bracket by the Economic Growth and Tax Relief Reconciliation Act of 2001, will expire and be reincorporated in the 15% bracket in 2011). (Note: these rates exclude the effects of the Alternative Minimum Tax. For taxpayers in the phase-out range of the AMT exemption, an additional dollar of capital gains reduces their AMT exemption by $0.25, and subjects that additional amount of wages, salaries, and interest income to additional AMT. The combined effective marginal tax rate due to the additional capital gains is then 21.5% or 22% in the 26% and 28% AMT rate brackets (15% plus a quarter of 26% or 28%). If the capital gains rate were to rise, the new AMT-impacted rates would be 6.5% or 7% above whatever the new rate is set at.)

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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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