As President Obama prepares to roll out another taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. increase proposal targeting capital gains and dividends, it’s instructive to look at what happened the last time he did that. Fortunately, the IRS just released preliminary data on tax year 2013, the year the top tax rate on capital gains and dividends went from 15 percent to 23.8 percent. The fiscal cliff deal raised the top rate to 20 percent and the Obamacare investment surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. added 3.8 percentage points.
From the IRS data, we can see that investors didn’t just sit there and pay the higher tax rate. Qualified dividend income dropped 25 percent, from $189 billion in 2012 to $141 billion in 2013. Capital gains dropped 12 percent, from $475 billion to $416 billion. Recall this was in the midst of a historic stock market boom.
Because the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. collapsed, tax revenue also fell. We estimate that tax revenue from dividends decreased 11 percent, from $21 billion in 2012 to $19 billion in 2013, and tax revenue from capital gains decreased 7 percent, from $63 billion to $58 billion. This is based on our estimate of average tax rates (effective), since the IRS does not provide these numbers. We estimate the average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. (effective) on dividends increased from about 11 percent in 2012 to 13 percent in 2013, and for capital gains it increased from about 13 percent to 14 percent.
A longer view of history indicates that investors pushed a lot of dividends and capital gains into 2012, the final year of the low tax rates. However, history also indicates that this is not merely a one-year shifting effect. When the top capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. rate was raised in 1986, capital gains realizations remained depressed for 10 years until the tax rate was lowered in 1997. It shows that investors have many options to avoid high tax rates, including reducing their investment, which is of course the worst outcome for the economy.
It also shows the need for dynamic scoringDynamic scoring estimates the effect of tax changes on key economic factors, such as jobs, wages, investment, federal revenue, and GDP. It is a tool policymakers can use to differentiate between tax changes that look similar using conventional scoring but have vastly different effects on economic growth. , which would account for these economic effects at the time legislative proposals are being considered. Our dynamic analysis indicates the President’s tax hikes would lose money, i.e. shrink the economy, the tax base and tax revenue.
The bottom line is that we are likely on the wrong side of the Laffer curve when it comes to taxing capital gains and dividends, or any other capital income. That means raising taxes from here would be counterproductive, not only in terms of the economic damage but also in terms of paying off the national debt.
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