Federal Government Lost Money from 2013 Tax Increases on Investors

As President Obama prepares to roll out another tax 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 surtax 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 base 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 rate (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 tax 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 scoring, 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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