Why Capital Gains are taxed at a Lower Rate

A joint hearing held by the Senate Finance Committee and the House Ways and Means Committee on June 28 will discuss capital gains taxation in the context of broader tax reform. A number of proposed changes have been highlighted; The Bowles-Simpson proposal recommends taxing capital gains and dividends at the same rate as labor income, while many congressional Democrats recommend raising the rate, citing concerns about both revenue and inequality. Any proposal focusing on raising the rate will likely fail to raise the predicted revenue, as demonstrated by both economic history and the high burden already placed on American corporations.

The justification for a lower tax rate on capital gains relative to ordinary income is threefold: it is not indexed for inflation, it is a double tax, and it encourages present consumption over future consumption.

First, the tax is not adjusted for inflation, so any appreciation of assets is taxed at the nominal instead of the real value. This means investors must pay tax not only on the real return but also on the inflation created by the Federal Reserve.

Second, the capital gains tax is merely part of a long line of federal taxation of the same dollar of income. Wages are first taxed by payroll and personal income taxes, then again by the corporate income tax if one chooses to invest in corporate equities, and then again when those investments pay off in the form of dividends and capital gains. This puts corporations at a disadvantage relative to pass through business entities, whose owners pay personal income tax on distributed profits, instead of taxes on corporate income, capital gains, and dividends. One way corporations mitigate this excessive taxation is through debt rather than equity financing, since interest is deductible. This creates perverse incentives to over leverage, contributing to the boom and bust cycle.

Finally, a capital gains tax, like nearly all of the federal tax code, is a tax on future consumption. Future personal consumption, in the form of savings, is taxed, while present consumption is not. By favoring present over future consumption, savings are discouraged, which decreases future available capital and lowers long term growth.

Not only has a low capital gains tax rate worked to encourage savings and increase economic growth, a low capital gains rate has historically raised more in tax revenue. At a 2010 talk at the Cato Institute Dr. Daniel J. Mitchell and Dr. Richard W. Rahn argued that the government has actually raised more revenue with a lower long term capital gains tax rate than a higher rate. For example, in 2007 the IRS raised $122 billion with a 15% tax rate as opposed to $7.8 billion in 1977 ($26.7 billion in 2007 dollars) with a 40% tax rate. In fact, when President Bush signed into law a cut in the top rate from 20% to 15%, revenue increased from $51.3 billion in 2003 to $137.1 billion in 2007 (although it fell significantly after the 2008 financial crisis, understandably).

Attempting to use the tax code to address income inequality will likely disappoint those who seek to attack the lower tax rate on high net worth individuals caused by a lower capital gains and dividends rate. Inequalities caused by globalization and differing education levels will not be remedied by destroying future investment; to the contrary those most likely to be hurt the most by lower economic growth are those with lower incomes.

The intensification of international competition for lower corporate tax rates has been highly publicized, but international capital gains taxation has been largely ignored. Capital gains taxation adds another layer of taxation onto American businesses, making them less competitive. The table below shows how the U.S. stacks up in terms of the total taxation of corporate investment. The first column shows the U.S. capital gains rate (federal plus state) is above the OECD average. Thirteen countries in the OECD have no capital gains tax. The second column shows that the U.S. integrated capital gains tax rate (corporate rate plus capital gains) is the 4th highest in the OECD. This burden will rise to the highest in the OECD starting January 1 if the Bush tax cuts are allowed to expire and the Obamacare investment surtax of 3.8% goes into effect.

The combination of history, international competition, and the destructive nature of the capital gains tax suggests any attempts to raise revenue by raising rates are doomed to failure. The focus on June 28th should not be on raising the capital gains rate, but should instead be focused on how to keep the rate low. History shows that this is the most effective way to both raise revenue and promote economic growth.

Follow William McBride on Twitter @EconoWill