Fiscal Cliff: Capital Gains and Dividend Tax Increases Pose Greatest Threat to Economy

December 05, 2012


The debate over the fiscal cliff will continue for the near future, but much of the debate is focused on the short-term effect of “going off the cliff.” It is true that the immediate impact of the fiscal cliff deserves attention, but the potential long-term damage to the economy may be even more damaging.  

A Tax Foundation Special Report shows that if congress and the White House fail to get a deal done, the effects of the fiscal cliff would lower projected GDP by 9.61 percent over ten years. That would be a loss of $1.5 trillion to an already struggling economy.

The different tax increases in the fiscal cliff have their own share in the $1.5 trillion in damage, with the impact of the investment tax increases outweighing the others many times over. The tax increase on capital gains and dividends would account for $960.4 billion of the $1.5 trillion lost economic activity. The reason for the impact is simple: when you tax more of something, you get less of it.

The tax increase on capital would ripple across the economy and badly lower future output and cut wages. Capital fuels an economy. The equation is simple: a high amount of capital leads to greater investment; investments in technology, and research and development, lead to greater productivity; in turn, this productivity leads to higher wages. A higher tax on capital hurts this process and depresses wages.

This table shows how each tax change impacts on the economy ranked in order of damage and in the terms of GDP and wages.

Changes in:
GDP ($ in billions)
Wage Rate
Total Fiscal Cliff -9.61% -1,515.90 -7.35%
Capital gains & dividend increase -6.09% -960.4 -5.27%
Estate Tax Increase -1.19% -187.6 -1.04%
Rise in marginal tax rates -1.16% -182.3 -0.39%
Savings & income HI surtax -0.54% -85 -0.44%
Restore Marriage Penaty -0.49% -78 -0.15%
Restore PEP & Pease -0.14% -22.7 -0.05%

In an economy struggling to get back on the right track, tax policy that further endangers the economy does not help. But with a deficit north of $1 trillion, the budget needs a combination of spending cuts and revenue increases to close the gap.

As the simulation shows, not all revenue raisers are created equal. In some cases, not all necessarily damage the economy. In fact, some of them help the economy: the best revenue raiser is economic growth.

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