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The Effect of Capital Gains Tax on Investment – Appendix

In comments to my previous post, Robert requested the unsmoothed data from Graph 3.  Here it is.   GPDI is plotted against the Capital Gains Tax Rate.

Since the Capital Gains Tax Rate (X-axis) is quantized, the result is columns of data.  Compared to the smoothed version, there is little change in either the slope or intercept of the best fit straight line.  R^2 is, of course, much lower.

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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.

Graph 1  C G Tax Rate and GPDI, 1954 – 2011

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.

Graph 2  C G Tax Rate and GPDI, 1985 – 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.

Graph 3 Scatter Plot of GPDI Growth vs C G Tax Rate, Smoothed

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

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Guest post: Greg Mankiw doesn’t understand competitio​n for investment

by Kenneth Thomas of Middle Class Political Economy

Greg Mankiw doesn’t understand competitio​n for investment

Greg Mankiw’s column in Sunday’s New York Times makes the case that competition between governments is a good thing, that it makes them more efficient in the same way that competition among firms does. He paints it as also being about choosing re-distributionist policies or not, with Brad DeLong and Harold Pollack both ably making the case that of course governments should engage in redistribution.

As author of Competing for Capital, however, I am more interested in the question of whether government competition for investment leads to more efficient outcomes. The answer, in short, is that it does not. Indeed, competition for investment leads to economic inefficiency, heightened income inequality, and rent-seeking behavior by firms (a further cause ofinefficiency).

Mankiw claims:

…competition among governments leads to better governance. In choosing where to live, people can compare public services and taxes. They are attracted to towns that use tax dollars wisely….The argument applies not only to people but also to capital. Because capital is more mobile than labor, competition among governments significantly constrains how capital is taxed. Corporations benefit from various government services, including infrastructure, the protection of property rights and the enforcement of contracts. But if taxes vastly exceed these benefits, businesses can – and often – move to places offering a better mix of tax and services.

Mankiw doesn’t stop to think about what this competition looks like in the real world. To attract mobile capital, immobile governments offer a dizzying array of fiscal, financial, and regulatory incentives to companies in sums that have been growing over time for U.S. state and local governments, as I document in Competing for Capital and Investment Incentives and the Global Competition for Capital. His discussion centers on the reduction of corporate income tax rates, which is surely a part of the competition, but which is no longer an issue when an individual firm is negotiating with an individual government.


At that level, the issues then become more concrete: Can we keep our employees’ state withholding tax? Can we get out of paying taxes every other company has to pay? Will you give us a cash grant? The list goes on and on. As governments make varying concessions on these issues, you then begin to see the consequences: discrimination among firms (especially to the detriment of small business); overuse and mis-location of capital as subsidies distort investment decisions; a more unequal post-tax, post-subsidy distribution of income than would have existed in the absence of incentive use (a corollary of the fact noted by Mankiw that “capital is more mobile than labor”); and at times the subsidization of environmentally harmful projects. Moreover, many location incentives are actually relocation incentives, paying companies at times over $100 million to move across a state line while staying in the same metropolitan area, with no economic benefit for the region or the country as a whole (Cerner-OnGoal, now in Kansas rather than Kansas City, is a good case in point).

Once upon a time, about 50 years ago in this country, companies made their investment decisions based on their best estimate of the economic case for various locations without requesting subsidies. On the rare occasion when a company did ask for government support, it was at levels that would appear quaint today. For example, when Chrysler built its Belvidere, Illinois, assembly plant in the early 1960s, it asked for the city to run a sewer line out to the facility–and it even lent the city the money to do it.

Today, companies have learned that the site location decision is a great opportunity to extract rents from immobile governments, and invest considerable resources into doing just that. An entire industry has sprung up to take advantage of businesses’ informational advantages over governments–and, indeed, intensify that asymmetry–to make rent extraction as effective (not “efficient”!) as possible.

Finally, let’s reflect on the force that makes this process happen, capital mobility. The fact that capital has far greater ability to move geographically than labor does, and that governments of course are geographically bound to one place, is a source of power for owners of capital. Modern economists, especially conservatives and libertarians, often have great difficulty acknowledging the role of power in market transactions, though their ostensible hero, Adam Smith, did not. To treat this power as a natural phenomenon rather than a social one, as Mankiw does, is dangerously close to saying that might makes right. But that’s not the way things are supposed to work in a democratic society, or a moral one.

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