Getting Geeky: Raising Capital Gains Taxes

One of President Obama’s proposals in his 2015 State of the Union speech was that Congress raise the capital gains tax to increase revenue, decrease income inequality and make the richest 0.1% pay a fairer portion of their income to taxes.

After the speech, Republicans and Fox News flew into the expected paroxysm of rage and fury. While it was difficult to discern what the “Loyal” Opposition was so unhappy about – other than that the ideas had come from President Obama, of course – one of the frothing points seemed to be the idea that raising the capital gains tax would discourage investment and hurt the economy.

It’s been a while since we’ve gotten down and rolled in geeky economics goodness here at Wickersham’s Conscience, so let’s examine that thesis: that raising the capital gains tax will hurt investment.

Refresher course: The capital gains tax is the tax imposed on income – the technical term is “gain” – derived from the sale of stuff you’ve owned for one year or more. The maximum rate of long-term capital gains is 20%, as opposed to the 39.6% of ordinary income. Sell something in six months and make money on it, you pay taxes at 39.6%; own something a year and sell it for a profit, and you only pay taxes at 20%. There are dozens – hundreds – of complications, exceptions and qualifications, but that’s the heart of it.

Think about it for a moment. For any wage slave like WC or his readers this tax break is out of reach. Who can afford to tie up enough money to matter for an entire year? Even if you aren’t completely hand to mouth, even if you have a little put by, it’s not likely to be enough to make the tax break work for you. On the other hand, someone who can afford to tie up $1 million or so at a 10% annual return gets $100,000, and the tax bite is only $20,000. If you make $100,000 by your labor, you’ll pay almost $40,000 in taxes. It’s obviously, patently inequitable.

There’s have to be a pretty huge reason to justify such disparate treatment. The Republicans will tell you its all about raising capital for growth. It’s about venture capital: greater risk requires greater reward. They claim low capital gains tax rates are crucially important for spurring entrepreneurship, investment, and growth.

UC Berkeley economist Danny Yagan tested that hypothesis. In a recent paper, “Capital Tax Reform and the Real Economy: The Effects of the 2003 Dividend Tax Cut” (pdf, slides), Dr. Yagan looked at former President Bush’s tax cut on corporate dividends, which had the same avowed purpose of encouraging investment. He compared the recent performance of C corporations, which pay taxes on their distributions to their owners, and the performance of S Corporations, which don’t.

Source: UC Berkeley Economist Danny Yagan, “Capital Tax Reform and the Real Economy: The Effects of the 2003 Dividend Tax Cut”

Source: UC Berkeley Economist Danny Yagan, “Capital Tax Reform and the Real Economy: The Effects of the 2003 Dividend Tax Cut”

The blue line is C corporations; the red line is S corporations. the black vertical line is President Bush’s dramatic reduction in the tax rate on C corporation dividends. And you can see that except for total payouts to shareholders, there’s no real change. And payouts to shareholders, of course, are corporations paying dividends, not investing in money.

Which leads to two conclusions:

1. Change in tax policy favoring corporations don’t change investment or net investment, or compensation to employees.

2. Instead, it just means more money is passed along to shareholders.

If you’re still following along, you’ve realized that’s exactly the opposite result of what the Republicans are claiming.

Some have suggested that ordinary taxpayers actually do benefit from the capital gains tax, because they have significant sums tucked into retirement plans. First, most Americans don’t have signficiant retirement savings. A U.S. News & Report study found:

The survey of over 1,000 adults living across the U.S. also found that 69 percent of 18-to-29-year-olds and a third of 30-to-49 year-olds have yet start putting something away for their later years.

The Bankrate findings jibe with other research that illustrate the dearth of retirement savings. The median retirement account balance for all working-age households in the U.S. is $3,000, and $12,000 for near-retirement households, according to the National Institute on Retirement Security.

And for those that do, the overwhelming majority of retirement plans are deferred income plans; that is, they pay no taxes on investments until they actually draw the retirement fund down, paying 39.6% tax on the funds as they do. Sure, when you are retired you may fall into a lower bracket. But avoiding taxes by being old and poor isn’t exactly an ideal plan, either.

So what do you call a tax break that only benefits the very wealthy, doesn’t accomplish what it claims to be for and at a policy level is indefensible?

You call it Republican, of course.