How People Respond to Investment Taxes and What This Means for Economic Growth

March 24, 2014

Capital gains realizations and dividend payouts increased significantly between 2011 and 2012, ahead of a tax increase in 2013.

According to the IRS, capital gains realizations increased 60.4 percent, increasing from $310.9 billion in 2011 to 498.7 billion in 2012. Qualified dividends saw a similar increase, up 50.9 percent after increasing from $125.2 billion in 2011 to $188.9 billion in 2012.

This increase corresponded with an increase in both the capital gains and dividends tax rates. On January 1, 2013, the capital gains and dividends tax rate rose from 15 percent to 23.8 percent (which includes the 3.8 percent surcharge from the Affordable Care Act).

This result – large timing changes corresponding with investment tax changes – isn’t unusual with capital gains because taxpayers are able to choose when they sell their stocks and collect their gains. The data shows this to be true.

Th chart below compares the capital gains tax rate and federal revenue. Before the capital gains rate went up in 1986, we see a similar case to 2012, as people sold their stocks ahead of the tax increase. Likewise, when the rates are cut, you can see the revenues spike as well.

This helps illustrate an important point: capital is highly responsive to taxes. This is important because investment is crucial to growing the economy.

Unfortunately, current U.S. tax policy creates heavy biases against saving and investment through double, triple, and even quadruple taxation. We have the highest corporate rate in the OECD and have high taxes on dividends, capital gains, and business investment. And currently, the United States ranks second to last in investment as a percentage of GDP among developed countries and has been on the decline.

This is bad for everyone.

In the long-run, lower investment means a smaller capital stock. This means that workers will have fewer factories and machines and less equipment to work with. This means fewer computers, backhoes, front loaders, lawn mowers, pumpjacks, office buildings, etc. When workers don’t have tools to work with, they become less productive; wages drop, economic growth slows, and lower living standards.

On the other hand, if we remove biases against saving and investment, we would see the opposite. Productivity and wages would increase, the economy would growth, and living standards would increase.

For more on the effect of taxes on investment and what tax changes can improve the economy, see here and here.

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