The top federal tax rate on capital gains is set to increase from 15% to 23.8% in January. The expiration of the Bush tax cuts will push up the rate by 5 points, and the new ObamaCare investment tax will add an additional 3.8 points.
Some policymakers view low capital gains taxes as an unfair loophole. But capital gains are unique, and low rates on gains boost entrepreneurship, investment and growth.
The average tax rate on capital gains among the 34 nations of the Organization for Economic Cooperation and Development is just 16.4%, By contrast, the U.S. rate including both federal and state taxes will jump to 27.9% next year.
U.S. policymakers need a refresher on why capital gains tax rates should be kept low.
1. Inflation. If an individual buys a stock for $10 and sells it years later for $12, much of the $2 in capital gain may be inflation, not a real return. Inflation — and expected inflation — reduce real returns and increase uncertainty, which suppresses investment, particularly in growth companies.
One solution is to index capital gains for inflation, but most countries instead roughly compensate for inflation by reducing the statutory rate on gains or providing an exclusion to reduce the effective rate.
2. “Lock-In.” Capital gains are taxed on a realization basis, which creates lock-in. Taxpayers delay selling investments that have large unrealized gains to avoid the tax hit. As a result, people hold assets too long and forgo beneficial diversification opportunities.
For the overall economy, lock-in reduces growth because it blocks the beneficial shifting of resources from lower- to higher-valued uses.
3. Double Taxation. Corporate share values generally equal the present value of expected future earnings. If expected earnings rise, shares will increase in value, creating a capital gain to the individual. But those future earnings will be taxed at the corporate level when they occur; thus hitting individuals now with a capital gains tax is double taxation.
Dividends are also double-taxed, with the result that the U.S. tax system is biased against corporate equity and in favor of debt. This destabilizes companies and the overall economy.
Ernst & Young calculates the current U.S. combined corporate and individual tax rate on capital gains at 50.8% — compared to an OECD average of 42.0%.
Our tax burden on dividends is equally out of line. The U.S. disadvantage will get much worse next year with the scheduled tax hikes on capital gains and dividends.
4. Competitiveness. Capital has become highly mobile across borders, prompting nearly every country in recent decades to cut tax rates on corporations, wealth, estates, dividends and capital gains. U.S. politicians get on a high horse and denounce individuals and firms that shift investments abroad, but the mobility of capital is a permanent reality.
The higher the tax rates on capital, the more job-creating investments are scared away. When Canada cut its federal capital gains tax rate to 14.5%, a parliamentary report proposed that “international competitiveness be the criterion guiding the choice of a capital gains tax regime.”
5. Growth Companies. Reduced capital gains taxes encourage entrepreneurship because the capital-gain payoff from a successful start-up is improved relative to a wage job. Low taxes also boost outside investment from angels and venture capitalists because their reward for taking risks on unproven young companies is a possible gain years down the road. The higher the tax rate on gains, the fewer potential projects will get the green light.
Angel investors are usually high-earners who could alternatively invest in safer assets, such as in tax-free municipal bonds. The capital gains tax rate directly affects their willingness to fund start-ups and growth companies.
Furthermore, when angels exit their investments, they often use their after-tax returns to fund more young companies in an ongoing virtuous cycle. Higher capital gains taxes would drain cash out of that reinvestment cycle, which has been at the core of Silicon Valley’s success since capital gains taxes were slashed in the late 1970s.
6. Government Revenue. A recent Congressional Budget Office study found that the longer-term responsiveness of capital gains realizations to the tax rate is quite large. It found a persistent elasticity of -0.79, which means that a 10% cut in the tax rate would increase ongoing realizations by 7.9%.
This indicates that the government’s revenue loss from a capital gains tax cut would be a fraction of what a static score would show, and its gain from a tax hike would also be very small.
Aside from increasing realizations, capital gains tax cuts would boost share prices, increase investment in growth companies and spur greater entrepreneurship. The economy would enjoy more innovation and higher productivity, which would translate into higher incomes for all workers over time. As the economy expanded, the government would also win as tax revenues from all sources increased.
These advantages of low capital gains taxes have led many economists over the decades — from Irving Fisher to Alan Greenspan — to call for ending these taxes altogether. Eleven OECD countries today don’t tax long-term capital gains.
So rather than hiking capital gains taxes, U.S. policymakers should be helping to revive investment and growth by moving toward a zero-tax regime for capital gains.