President Obama’s Capital Gains Tax Proposals: Bad for the Economy and the Budget

President Obama is proposing tax increases on the capital income of upper income taxpayers and higher taxes on heirs to fund 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. reductions for middle income families and college students. The biggest tax increase on the list involves a higher top tax rate for capital gains and dividends. The Treasury estimates that the entire package of tax increases will raise $320 billion over ten years. The revenue will be used in part to pay for some $200 billion in middle income tax breaks.

According to the Tax Foundation’s Taxes and Growth (TAG) model, these expected revenues will not materialize because the tax hikes will depress the rate of growth in the economy. The proposed tax increase on capital gains and dividends would depress capital formation, lower wages, and reduce job creation. The net effect will be a loss of revenue.

By contrast, our model shows that the proposed tax credits are not the sort that would raise GDP or employment by any significant amount. The Treasury’s revenue estimates, based on a static economic outlook, miss these effects.

Proposals of this nature would benefit greatly from a thorough dynamic economic analysis of their effects on taxpayer behavior and the consequences for the economy. We have been routinely preparing such analyses and are in the process of examining the president’s recommendations. Our preliminary results suggest that they would not achieve the president’s objective of improving incomes in the middle-class.

Increase in Taxes on Capital Gains and Dividends to 28 Percent

The President has proposed an increase the top tax rate on capital gains and qualified dividends to 28 percent for jointly filing couples with $500,000 or more in income. (We assume that the threshold for single filers would be $444,444, the same relative ratio to joint filers as for the start of the current 20 percent top capital gains tax rate.)

Raising the tax rate on capital gains and qualified dividends differential would raise the cost of creating and using capital assets, reduce productivity, and reduce jobs and wages. It would gradually reduce GDP and labor income compared to current law. Long term, the reduced GDP and personal incomes due to the tax increase would result in lower total federal tax receipts. In addition, the rate hike would slow the pace at which people trade assets and realize capital gains, at least for several years, which would actually reduce revenue in the short term as well. Thus, the proposal would lose revenue in the short run and the long run. None of the expected revenue from the tax hike would materialize.

We first model the economic effects of the tax, and then discuss the realizations effect in the following section.

Economic Effects of the Capital Gains and Dividend Tax Rate Increase

Currently, the top capital gains and dividend rate is 20 percent for taxpayers with income above $450,000 for joint filers and $400,000 for single filers. It was raised from 15 percent in the 2012 budget deal (effective in 2013). However, under the Affordable Care Act, the investment income is newly subject to the Medicare Hospital Insurance Tax at a rate of 3.8 percent, producing a combined rate of 23.8 percent.

We believe the President’s proposed 28 percent rate is a combination of an increase in the ordinary top capital gains and dividend tax rate from 20 percent to 24.2 percent, with the 3.8 percent surtax lifting the total to 28 percent. We have used our TAG model to estimate the economic and revenue effects that increase.

A combined top tax rate of 28 percent on capital gains and qualifying dividends for couples with income over $500,000 would:

• Reduce GDP by 0.8 percent.
• Lower the stock of business capital assets by 2.29 percent.
• Reduce wage rates by 0.69 percent and private sector hours worked by 0.14 percent, about equivalent to a loss of 134,600 full time jobs. This could cost a family earning $50,000 about $345 in income.
• Estimated by conventional method, appear to raise about $19.9 billion a year in 2015 dollars if no change in realized gains and dividends were triggered, and ignoring economic effects.
• Estimated on a dynamic basis, reduce revenue by about $11.8 billion a year after the slower growth due to the tax reduces GDP, jobs, and wages.

The Economic Effect of a Capital Gains and Dividend Tax Rate Increase to 28 percent
(24.2 percent on Capital Gains and Dividends plus 3.8 Investment Income Surtax)
ECONOMIC AND BUDGET CHANGES VERSUS CURRENT LAW
(billions of 2015 dollars except as noted)
Gross Domestic Product	-0.80%
Capital Stock (Plant, Equipment, Buildings, etc.)	-2.29%
Wage Rate	-0.69%
Private Sector Hours Worked	-0.14%
Full-time Jobs Equivalent	-134,579
Dynamic Revenue	-$11.8
Static Revenue	$19.9
GDP Change in Dollars (Lost Income)	-$141.8

Taxes on capital gains and dividends are part of the cost of creating and using capital (what economists call the service price of capital). When the tax and the service price go up, the amount of plant, equipment, and buildings in the economy goes down. With less capital to work with, labor is less productive, and wage and employment are depressed. This is the source of the long run revenue loss under the proposal. More important than the lost revenue to the Treasury is the lost earnings of people at all income levels.

Realization Effects of a Higher Tax Rate on Capital Gains and Dividends

People can delay the payment of capital gains taxes by holding onto assets instead of selling them. This is called the “lock-in effect.” If the tax rate is reduced, some of the locked in gains may be realized. Realizations may rise by enough to boost revenues to a level higher than before the tax rate reduction, at least for a while. When an increase in the 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. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. rate is announced in advance, people rush to realize gains ahead of the tax increase. After the increase, they take fewer gains. The opposite behavior is observed if a rate reduction is anticipated. Gains are deferred until the rate cut goes into effect; then a rise in realizations is seen. (Similarly, companies are likely to increase dividend payouts after a dividend tax cut became effective, and to slow the growth of dividends if the tax rate is raised.)

This timing behavior regarding the realization of capital gains is one of the “micro-economic” behaviors that Treasury, the Joint Committee on Taxation (JCT), and the Congressional Budget Office (CBO) are supposed to consider in estimating the revenue effect of tax rate changes (even under the usual “macro-economic” static revenue estimation convention that assumes that the GDP and employment are not affected).

The lock-in effect has been studied extensively, and rate changes in the past have given ample evidence that the effect is large and lingering. The evidence is very strong that raising the rate from 15 percent to 20 percent, to 23.8 percent, and to 28 percent, results in lower revenues to the Treasury for at least several years.

The Steiger Amendment of 1978 lowered the top capital gains tax rate to 28 percent from 40 percent (or just under 50 percent for taxpayers subject to a 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. ). The Economic Recovery Tax Act of 1981 further reduced the top rate on gains to 20 percent. The Senate Finance Committee asked the Treasury to study the effect of the rate reductions on realizations and revenues. The Treasury published several studies of the lock-in effect on realizations in the mid- to late-1980s, four studies by the Office of Tax Analysis and one study by the Office of Economic Policy. The possible additional gains in revenue from an improved economy were not considered by these reports.[1]

The Treasury studies found that the government collected more capital gains tax revenue at a 28 percent rate than at a 40 or 50 percent rate, and collected more revenue at a 20 percent tax rate than at a 28 percent tax rate. They did not investigate whether the revenue maximizing rate was between the two rates, or less than 20 percent. The Office of Tax Analysis was of the opinion that the timing effect of the rate reductions might be temporary, and that realizations would return to normal after a very few years. Thus, the revenue gains might be only short term, and the rate reduction would reduce revenues eventually. The Office of Economic Policy was of the opinion that the realizations change and revenue gains might be considerably longer.

In a 1978 paper, Martin Feldstein and colleagues found that a capital gain tax rate change produces a permanent effect of significant size. They concluded that reducing the capital gains tax rate from its 1973 top rate in excess of 40 percent to 25 percent would increase realizations by enough to raise revenue.[2] Lawrence Lindsey in 1988 concluded “that capital gains tax revenues are maximized at [a] 20 percent rate or lower, with a central estimate of 16 percent. Some of any gain in revenue may be temporary, but … even in the long run about 5.4 percent more capital gains will be realized for every one percentage point reduction in the capital gains tax rate.”[3] A 2009 study by Professor Paul Evans of the Ohio State University found the revenue maximizing rate to be just under 10 percent.

The top tax rate on capital gains was raised back up to 28 percent in the Tax Reform Act of 1986, effective in 1987. This was as close to a controlled experiment as one is ever likely to see in economic policy. As should be expected, realizations soared in 1986 to beat the rate hike. In 1987 and the following years, realizations plunged in real dollars and as a share of GDP. However, the realizations did not rebound soon thereafter. They remained depressed for a decade until the top tax rate on gains was again reduced to 20 percent by the Taxpayer Relief Act of 1997, after which realizations rose to pre-1986 levels.

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