Taxing Capital Income Increases Revenue, Reduces Inequality

In September, President Obama released a deficit reduction package for consideration by the congressional Super Committee that included a new tax reform recommendation regarding millionaires. Dubbed the "Buffett Rule," the proposal states, “No household making over $1 million annually should pay a smaller share of its income in taxes than middle-class families pay,” and it would address a long-standing disparity between the taxation of labor income and investment income. Indeed, going beyond the Buffett Rule and taxing capital income on par with labor income would not only bring in much needed revenue, it would help to reduce income inequality, a source of economic inefficiency.

Capital gains are the increase in the value of capital assets, which most generally include real estate, stocks, and bonds. When the capital gains tax was established by Congress in 1913, the capital gains tax rate was equal to the income tax rate, but in 1922, Congress lowered the capital gains tax rate, and – except for a few brief periods since – it has continued to enjoy preferential treatment. Today, capital gains benefit from the lowest tax rate in modern history at 15 percent, down from 20 percent during the Clinton administration.

Most of the benefits of this preferential tax treatment accrue to the wealthiest Americans. A recent Congressional Research Service (CRS) report on the economic effects of capital gains taxation found that wealthier households “are substantially more likely to own assets that can generate taxable gains than lower income households.” Indeed, “Well over half of the assets that can generate taxable capital gains are owned by the richest 5 [percent] of households,” with the richest 20 percent owning 83 percent of all stocks and mutual funds, 93 percent of bonds, and 79 percent of farm and business real estate. Home ownership, which is more spread out through the income spectrum, accounts for the vast majority of the lower 80 percent of households’ relationship with capital gains.

For several decades, Republicans have advocated for further reductions in the capital gains tax. Supporters argue that lower capital gains taxes increase tax revenues because they release investors to sell stocks and bonds they held onto longer than they otherwise would have because of the “prohibitive” tax on their return. Known as the “lock-in” effect, the capital gains tax is said to discourage “capital gains realizations” and persuade investors “to hold on to appreciated assets they would otherwise sell.”

Some economists have argued that the capital gains tax slows economic growth because investors may be discouraged from taking advantage of investment opportunities that would result in higher tax bills. Former Federal Reserve Chair Alan Greenspan gave voice to this theory during the 1990s when he notably told Congress that the “major impact” of the capital gains tax, “as best I can judge, is to impede entrepreneurial activity and capital formulation.” He added that the appropriate capital gains tax rate was zero.

Yet, according to CRS, reductions in the capital gains tax rate are not likely to negatively impact saving, as an increased return on investment due to a lower tax rate actually encourages households to save less in order to maintain their target wealth level. Thus, the report concludes, capital gains taxes do not significantly impede entrepreneurial activity or capital formulation and rate reductions are unlikely to affect economic growth over the long term. Moreover, “the bulk of the evidence” surveyed by CRS “suggests that reducing the capital gains tax rate reduces tax revenues” overall, especially in the long run.

Capital gains tax cut supporters also argue that such a cut would be an effective economic stimulus measure. CRS observes, however, that government spending would be a more effective economic boost. Because the wealthiest households hold the vast majority of capital gains assets, neither a temporary or permanent reduction of the capital gains tax rate would provide much economic stimulus, as these households are more likely to save additional income, rather than putting it back into the economy through purchasing goods and services.

Further reductions of the capital gains tax rate may even be harmful to economic growth. A new study by economists at the International Monetary Fund (IMF) found that increases in income inequality could hurt a nation’s potential for growth. The study turns conventional economic wisdom on its head by questioning the choice between efficiency and equality, concluding instead that “improving equality may also improve efficiency, understood as more sustainable long-run growth.” In fact, “equality appears to be an important ingredient in promoting and sustaining growth.”

The wealthiest households have always realized the most income from capital gains, but over the past 25 years, the benefits from capital gains have become even more concentrated, contributing to the overall concentration of wealth within the top tier of the income distribution. Both the reductions in the capital gains tax rate and the reduction in income tax rates for the very wealthy have fueled the redistribution of wealth upward.

Economists at the IMF found that inequality mattered more to whether a country continued to enjoy economic growth relative to other factors, such as the openness of political institutions, trade openness, exchange rate competitiveness, and even external debt. Inequality was correlated with slower growth over the past 25 years.

The authors of the IMF report note that "better-targeted subsidies, better access to education for the poor that improves equality of economic opportunity, and active labor market measures that promote employment" could promote more equality and more growth. Cuts in the capital gains tax rate are unlikely to spur growth through private investments, but increases in the rate could provide public revenue for the social investments needed to spur growth – and more equitable growth at that.

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