Capital Gain Taxes & Investment: Risk and Return
In the latest praise of the 2003 tax cuts emanating from the National Review, David Gitlitz makes two assertions. One is the old Post Hoc Ergo Propter Hoc rag that simply because real GDP growth has been strong since the passage of the 2003 tax cut, the cause of this growth must have been the tax cut. Mixed within this nonsense comes his second argument:
For the past couple of years it’s been a rough ride for the economic pessimists and their handmaidens in the media, people who have utterly failed to comprehend the fundamental shift in the economic landscape set off by George W. Bush’s slashing of the tax burden on capital formation. In the nine quarters since Bush enacted the cuts in capital gains and dividend taxes in mid-2003, which with the stroke of a pen boosted the after-tax returns on risk-taking, real quarterly economic growth has averaged 3.7 percent.
In case you missed it, his second argument is that lower tax rates on capital gains raises the after-tax return on investment, which he dubs risk-taking. Of course, the usual argument goes something like this – lower tax rates on capital gains increasing after-tax returns and thereby encourages more investment by inducing households to hold more stocks and fewer bonds. This claim is quite old and rather incomplete. Lower tax rates do tend to increase the ex post after-tax return. But the issue should be framed in terms of the impact on expected returns versus risk.
Let’s note a couple of papers that discuss the risk increasing aspects of a reduction in the capital gains tax rate. William Niskanen is arguing here (as he has argued before) that having a lower tax rate on capital gains than on dividends encourage excessive risk-taking:
The primary policy problem is that the current U.S. tax code increases the conditions that lead to corporate bankruptcy.The corporate earnings subject to tax, for example, exclude interest payments but not dividends; this leads corporations to use more debt finance than would be the case if the tax treatment of interest and dividends were the same … The simplest direct way to reduce these tax-related problems is to allow corporations to deduct one-half of their dividend payments from the earnings subject to the corporate income tax. This would make the combined corporate and personal tax rate on capital gains and dividends about the same for most investors without changing any other feature of the corporate or personal income tax code, roughly eliminating those adverse conditions attributable to the current difference in these rates.
Niskanen’s solution is to reduce the tax rate on dividends rather than increase the tax rate on capital gains (the latter going against the holy grail for the tax cut jihadists). But also consider from Economic Letters (1992) the paper Does reducing the capital gains tax rate raise or lower investment?:
The effect of taxation of capital gains on the decision to purchase a risky asset is explored within a theoretical framework similar to that of the capital asset pricing model. Tax rate reductions have two offsetting effects. One is to raise the after-tax expected return while the other is to increase the amount of risk borne by private agents. Conditions for determining which effect dominates are derived.
Besides utilizing the Capital Asset Pricing Model (CAPM) to address which effect dominates, this 1992 paper points to a 1944 paper by Evsy Domar & Richard Musgrave in the Quarterly Journal of Economics that made the same essential point – governments share in risk-taking through taxation. While Domar & Musgrave made their argument a generation before CAPM was an essential part of financial economics, right-wingers who argue that lower capital gains tax rates increase the return to risk-taking have not figured out what CAPM says some two generations later.