The Effect of Capital Gains Tax on Investment
Matt Yglesias, servitor to our corporate overlords, suggests that the reduced capital gains tax rate paid by rentiers like Willard Romney is really a very, very good thing. To wit:
The main reason Romney’s effective rate is so low is that the American tax code contains a lot of preferences for investment income over labor income.
. . .
But this is definitely an issue where the conservative position is in line with what most experts think is the right course, and Democrats are outside the mainstream.
. . .
That’s the theory, at any rate. It’s a pretty solid theory, it’s in most of the textbooks I’ve seen, and it shapes public policy in basically every country I’m familiar with. Even researchers like Thomas Piketty and Emmanuel Saez (see “A Theory of Optimal Capital Taxation”) who dissent from the standard no taxation of investment income position think capital income should be taxed more lightly than labor income. Empirically, it’s a bit difficult to verify that variations in capital gains tax rates and the like really are making a material difference to investment levels. But then again the data is noisy.
Scott Lemieux at LGM demurs.
Sure, if you 1)accept the premise that reducing or eliminating capital gains taxes will result in productive infrastructure investments rather than worthless accounting tricks, 2)ignore the economic benefits created by consumption, 3)assume that significant numbers of people will forgo money for doing nothing just because the profits will be taxed , and 4)ignore the fact that in most jurisdictions consumption is also “double taxed,” then reducing capital gains taxes looks good. But since all of these assumptions are (to put it mildly) highly contestable, it’s just question-begging.
My response to Matt is that in my jaundiced opinion, you might as well consult The Necronomicon of Abdul Alhazred as an economics textbook for an issue like this; and that in a world that has on the one hand Krugman, Thoma and Delong, and on the other Fama, Cochran and Cowan, a consensus among experts is about as likely as lions lying down with lambs for some purpose other than a quick snack.
To Scott I say, why assume or ignore anything when that oh-so-noisy data is readily available?
Graph 1 shows the capital gains tax rate and year-over-year growth in gross domestic private investment (GPDI,) each presented as a percent. If Matt and what he calls “the mainstream” are right, then there should be a negative correlation between the tax rate and investment growth, since higher taxes would be a disincentive to investment.
Instead, what we find is that over time, as the capital gains top rate has gone down, so has GPDI. This is indicated by the downward slope of the best fit straight lines through each data set. The best fit lines are based on the data through 2008, so the huge 2009 negative in GPDI is not represented.
One way to handle noisy data is to superimpose a moving average. The dark heavy line that snakes up to a top in 1978 is an 8-Yr moving average. This top corresponds exactly with the last year of the 40% Cap Gains Tax rate. The purple horizontal line is the period average of GPDI YoY growth from 1954 through 2011. Note that until 1986, the 8 Yr line is mostly above the long average line, and since 1986 it is mostly below.
This is not because the bottoms in the GPDI data set are lower since 1986. A quick look shows that, except for the 2009 plunge, they are not. It is because the peaks are lower. The table gives a count of extreme data points for GPDI growth, before and after 1982, the year the Cap Gains rate was reduced to 20%.
Even at a detail level, it appears that a higher tax rate corresponds with a higher rate of investment growth, as both curves peak in 1978.
Graph 2 provides a close-up view of 1985 through 2005.
When the Cap Gains tax rate was increased from 20 to 28% in 1987, the rate of investment growth increased from 1.4 to 5.2%, and stayed at about that level until it was derailed by the 1990-91 recession. Then from 1992 through 2000, 8 of 9 years had GPDI growth above the long average (purple line,) an unprecedented occurrence. Granted, the last three of these years were at the lower C G Tax rate of 21.19%, instituted in 1998. But also note that this decrease did absolutely nothing to spur increased investment.
Cutting across the data in a different way, Graph 3 presents a scatter plot of the C G Tax Rate and YoY GPDI growth, each presented as an 8 Yr average.
Even with smoothing, there’s a lot of scatter. No surprise, since many other factors can affect investment: business cycle, commodity price shocks, wars, etc. I’m tempted to say the obvious relationship is that a higher C G Tax rate leads to higher investment, but I don’t want to get into a correlation-is-not-causation brouhaha. So I’ll simply say that the idea that lowering C G taxes leads to increased investment – and therefore increased economic growth – is not only unsupported by the data, it is refuted by the data, and therefore contrary to fact.
So, once again, we find a mainstream economic idea that is only valid in some imagined alternate reality.
Capital Gains Rate data can be found here (Returns With Positive Net Capital Gains Table, 1954-2008) and here. There are a few slight discrepancies between these sources, mostly in transition years. I have used the maximum tax rate, column farthest to the right in either table.
Gross Domestic Private Investment is FRED series GPDI.
Cross posted at Retirement Blues
This bullshit about low cap gains being essential for capital formation is nonsense.
There’s plenty of money sloshing around the globe; if there was a good investment in the US that money would find its way here.
There are plenty of Asians looking for safety and stability in their investments and jackasses like Romney and Adelson aren’t our only sources of capital.
Domestic oil companies aren’t our only source of oil and right wing prima donnas don’t control the global capital markets even though they like to pretend otherwise.
Yglesias has a point. The received wisdom for some time has been that taxing capital reduces growth and hurts efficiency by distorting capital markets.
But that’s where he should have stopped. Assuming that Yglesias reads the competition, he must be aware of the CRS study, must have seen Megan’s efforts to bate Mike, must know the gist of Jazzbumpa’s chart, must know the “yeah, but Clinton” response to claims about the wonders of tax cuts.
Yep, the data are widely known and Yglesias almost certainly isn’t so ill-informed as to be unaware of it. So why would he write as if he were not aware? This is the sort of thing Brooks would do. It’s the sort of thing Rush would do, if his audience didn’t grow restless so easily. Oh, maybe that’s WHY Yglesias is ignoring the data…
By way, the “Romney’s effective tax rate is low because of the law” thing is true, in the same way lots of pundit claims are true – in a way that distracts as much as it enlightens. Romney made a career of gaming the system, and did it well. His tax rate is low because when you game the tax system to make your money, your money ends up generating income that isn’t heavily taxed.
The received wisdom for some time has been that taxing capital reduces growth and hurts efficiency by distorting capital markets.
But that’s where he should have stopped.
If he had stopped there, he’d still be a tool. The received wisdom is demonstrably wrong, and with very little effort. I gathered the data and made the first graph in less than 20 minutes.
Having been involved in hundreds of cap gains transactions (mostly as an adviser) and have done many of the follow up tax returns, it seems that any lower tax rate on cap gains should be tied to a truly long-term cap gain, > 5 years preferably.
Or, index cap gains with a > 3 year holding period for inflation.
Cap gains are not the magic elixir for everything, but neither are cap gains non-consequential.
Isn’t this the same “debate” that Steve Roth just posted about? Yglesias must not be reading the same economics research papers that Roth and Jared Bernstein seem to be familiar with. So much for consensus of opinions in the “science” of econommics.
Roth’s opening lines:
“Jared Bernstein tells us yet again what the data has been telling us forever (my bold):”
“I agree with Chye-Ching Huang, who agrees with the Congressional Research Service, Len Burman, and me: over the long, historical record of special tax treatment for investment incomes and tax cuts to the top marginal tax rates, one simply doesn’t find significant correlations with greater investment, savings, productivity, or income growth.”
There is too much money in ‘investments’ and not enough in the real people real transaction economy. As proof I offer trillions ‘invested’ at zero percent or below.
What to the wealthy has been a virtuous circle of lower cap gains taxes engendering more schemes and mechanisms to direct money into financial assets and so inflating them and so producing more cap gains and so on has hollowed out, to use a common phrase, the economy. The virtuous circle of the top is our vicious circle.
Now rounding back to the investments at zero return and I would add money printing meant to boost financial asset prices, we are near the end game.
Yglesias may dream of working for Pete Peterson someday but is timing is off. He has bought into the Technocratic dream as Harvard grads are wont to do.
Why was the received wisdom thrown into the garbage can in 1986, temporarily? Why isn’t it applied to all types of income from savings? Why should we provide incentives to obtain income from investments (including inherited wealth), when at the same time we do not provide incentives to invest income?
I’m not offering rhetorical questions. I’m suggesting that the received wisdom, in addition to lacking empirical support, is more political wisdom than theoretical or logical economic wisdom. Sort of like somebody saying tax cuts on job creators will grow the economy–uh, no, economic growth has not been the motive for those tax cuts since 1980.
you don’t believe in the free market?
you don’t think that if people had to pay “full” taxes on capital gains, the interest rates would reflect that?
see, all Republicans believe in the pfree market, except when they see a way to game the tax code.
what they want for free is the benefits of living in a country where other people pay the taxes.
the only reason I have any money after 4years of obumer ,low cap gains!
On the data come on give us the very scattered raw scatter without smoothing. We can handle it.
On Lemieux I think the key argument is the first. The lower capital gains rate is the main source of legal tax avoidance. This is costly not just because of lower government revenue but also because real decisions are made in order to disguise income as capital gains. Real decisions which would not make economic sense otherwise. Not to mention the huge cost of the lawyers and accountants and such.
The standard economic theory case for a 0 tax on capital income and capital gains is really that as t goes to infinity the optimal rate goes to zero. This tells us nothing about t = 2012 AD. It is also true that the optimal tax on capital income goes to zero as inequality goes to zero. the argument that taxes on capital income are good as capital income goes mainly to the rich is dodged by assuming that in the long run we are all equal (really this is how the models work — I have done the math http://rjwaldmann.blogspot.it/2008/06/optimal-capital-income-taxation-it-is.html
I just required some information and was searching on Google for it. I visited each page that came on first page and didn’t got any relevant result then I thought to check out the second one and got your blog. This is what I wanted!
I do believe in free markets, but I also understand economics is mixed with finance and psychology and the net present value of money.
“All Republicans” do not believe in anything, there are plenty of diverse opinions and cheap insults do not add to the discussion.
As a long-time tax lawyer in New York, I can vouch for that fact that, when planning for individuals, there are two main goals: convert ordinary income into capital gains, and defer income as long into the future as possible.
The whole concept of taxing long term capital gains at a different rate than ordinary income is probably the single most important factor in the complexity of the tax law. Dozens of provisions in the Internal Revenue Code are dedicated to foiling attempts to convert ordinary income into capital gains. It is one of the most pernicious features of our tax law.
I have long been convinced that the idea that lower capital gains taxes have beneficial effects on the economy is hogwash, pushed by the rich elite as a rationale for having them taxed at lower rates than everyone else. It should be no wonder that the first time this concept was introduced in the tax law our Secretary of Treasury was Andrew Mellon….
The real,question here is, What is the purpose of a lower capital,gains tax?
If it is to allow the recipient of the gain to keep more of it, then the lower tax accomplishes that.
If it is to spur investment, then a lower tax fails.
I do not believe in free markets. Who was it who not long ago pointed out that “the market” is a concept only tenuously related to real world economies? I can’t come up with a link. I think the gist is economies are rule based, not market based.
The “free market” is an even higher level abstraction. Aint never been one, no time, no where.
My idea of a free market is that nobody should be able to cheat me out of my money. Their idea of a free market is that they should be able to cheat me out of my money with no consequences. That’s not a free market, that’s theft. “Regulating markets” means “preventing theft” – it makes people more free, not less….
i am inclined to agree with you. I was speaking of free markets as a concept. i spell it pfree markets when i wish to refer to the religious concept.
those insults were not cheap.
i do think the idea of taxing all income at the same rate and letting the relatively free market sort out the adjustments to pay and prices that would restore economic “justice” is an experiment worth making. Frankly I am very very tired of all the
reasons why “i should be taxed less than the other guy.”
as for the “net present value of money,” that is another concept misunderstood and abused by people who should know better.
at the risk of being tedious
the original point i was trying to make was that the people who call for lower capital gains taxes are also the people who claim they are for “free markets”
that free market should, in principle, adjust itself to whatever taxes are imposed, as long as they are predictable and fall reasonably according to ability to pay in the first instance.
what that last means is that a confiscatory tax on someone with no resources to pass the costs through to customers would probably be damaging, but, for example, if “all taxes” were a flat tax on gross income, or value added, (some will need to correct me about the technical difficulties here), the corps would “merely” pass the cost of taxes on to their customers just like the cost of any other expense. the people would pay a little more for the product instead of paying their taxes directly to the irs.
i shouldn’t push this because it’s too radical a concept. but the idea that the market would adjust (interest rates) if capital gains were taxed the same as other income does not seem so impossible that it isn’t worth trying… in spite of the howls about how unfair it is.
Frankly, I would be willing to adopt a radical proposal for eliminating the double tax on corporate profits – say, by allowing corporations to deduct dividends the same way they do interest – in exchange for equalizing tax rates on labor and capital income. Of course, along with that should come a radical reduction in the number of activities that we currently exempt from tax altogether. There is no logical reason, economic or otherwise, for a think tank to be tax exempt for example.
A question: How does the capital gains tax compare with income tax rates throughout this time period?