What Dynamic Analysis Tells Us About the President’s Tax Hike on Capital Gains and Dividends

The centerpiece of President Obama’s plan to increase taxes on the wealthy to fund tax credits for the middle-class is increasing the top tax rate on capital gains and dividends for high-income taxpayers.

Currently, the top capital gains and dividend tax rate for couples earning over $450,000 and singles with incomes above $400,000 is 20 percent. In addition, the Affordable Care Act subjects this investment income to an additional 3.8 percent Medicare Hospital Insurance Tax. This brings the combined capital gains and dividend tax rate for high-income taxpayers to 23.8 percent.

The President is proposing to increase the combined rate on capital gain and dividends to 28 percent. This means an ordinary rate of 24.2 percent on capital gains and dividends plus the 3.8 percent HI tax.

Tax Foundation economists used our Taxes and Growth (TAG) dynamic tax model to estimate the macroeconomic effects of the combined rate of 28 percent. While the stated intent of the proposal is to target only high-income families, a dynamic analysis indicates that the effect on the economy would not be costless, nor would the impact be solely felt by wealthy taxpayers—all other income groups would see lower after-tax incomes. Moreover, the plan would actually lose tax revenues, not gain them.

Table 1 below summarizes the annual economic effects of the proposal at the end of the adjustment period (roughly 5 to 10 years). The level of the overall economy (GDP) would be .80 percent lower than would otherwise be the case. This translates into roughly $142 billion less GDP per year. Also, the nation’s capital stock would fall by 2.29 percent and the wage rate would shrink by 0.69 percent. The later may sound insignificant, but as Table 2 shows, it would mean $461 less income for a family earning between $50,000 and $75,000.

A smaller economy means less revenues for the federal Treasury. According to conventional (or “static”) scoring, the plan should bring in roughly $20 billion per year in new revenues, a dynamic analysis—which accounts for the effects of the smaller economy—indicates that the plan would actually lose nearly $12 billion in federal revenues.

Table 2 illustrates the distributional effects of the President’s capital gains tax plan under both static scoring and dynamic scoring. The static scoring clearly shows that the incidence of the tax falls largely on taxpayers earning over $500,000 per year. However, once all of the macroeconomic effects of the policy are estimated by the dynamic model, we can see that after-tax incomes fall for families up and down the income scale because of the policy’s effects in reducing GDP, investment, wages, and hours worked.

Taken together, these results suggest that while targeted to the wealthy, raising the combined top capital gains tax rate to 28 percent would negatively impact the economy, jobs, family incomes, and federal revenues.