Regular readers (all four of us) will recall an earlier post where I mentioned that labor supply is unresponsive to tax rates. This is to say, the whole “if the government taxes me more than X%, then I just won’t bother going to work!” hypothesis is not supported by empirical evidence. The other part of the tax-rates-and-economic-growth equation is saving and investment. Many argue that low rates of tax on capital income in particular (you know, the kind only rich people have to any significant degree) help encourage saving, investment, and therefore higher economic growth. This argument is particularly important to refute because under current law, capital gains are taxed at a special, favorable rate of 15% (compared to a top marginal rate of 35% for “ordinary income”), and many major Republican figures advocate the total elimination of any tax on capital gains at all. Since the argument is demonstrably false, this “capital gains preference” is nothing more that a massive handout (to the tune of ~$92 billion in 2006) to the rich.
The first part of the pro-preference argument is that it encourages saving. By increasing the after-tax reward for deferring current consumption and investing in a capital asset (e.g., corporate stock, a partnership interest, a house, etc.), so the argument goes, the preference provides an incentive for people to save more, making more resources available for investment (we’ll ignore the fact that many forms of saving, such as 401(k) plans, IRA’s, and interest on bonds or saving accounts do not enjoy special capital gains treatment, which seems totally arbitrary). This sounds theoretically plausible. But it overlooks two important wrinkles. For one thing, it ignores the fact that individuals face two countervailing incentives when the rate of return on saving is increased. First, as the preference proponents point out, they have an incentive to save more and consume less, since the relative return of saving has increased (the “substitution effect”). Second, however, they face an incentive to save less because they can get the same level of future consumption for a lower cost in terms of deferred present consumption. As a result, a higher return on saving could theoretically increase or decrease saving, depending on which effect is larger. The question is therefore an empirical one, and the answer cannot be blithely assumed. As it happens, the responsiveness of private saving rates to an increase in the rate of return may be “small or even negative.” (p. 57, “The Labyrinth of Capital Gains Tax Policy,” by Leonard Burman).
(Note: the same competing forces apply to the question of tax rates and labor supply as well. Increasing taxes on work creates a substitution effect that discourages work but an income effect that encourages work, because more work will be necessary to earn the same level of after-tax income. This may be why tax rates have no significant net effect on labor supply.)
Second, this whole analysis recognizes only private saving and ignores the effect of a capital gains tax preference on public saving. The capital gains preference decreases government revenue (p. 2-3). If the resulting increase in the federal deficit (or decrease of the surplus) is greater than the increase in private saving, then the preference will cause a net decrease in total national saving. If it causes a net decrease in national saving, then interest rates will rise (because a larger amount of government debt will drive up the cost of borrowing) and the cost of capital for private business will increase. If the capital gains preference ends up increasing the cost of capital for private business, then it would defeat its whole stated purpose – i.e., to stimulate investment and therefore economic growth. It will not surprise you to learn that under any reasonable set of assumptions, a capital gains tax cut would in fact decrease public saving by more than it would increase private saving. (Id., p. 66)
There is another big reason why we should not be surprised that a capital gains preference would not increase investment: most capital gains are never taxed at all anyway. (Id., p. 51). This is because half of all individual capital assets held by individuals are either held until death or donated to charity. And on top of that, all capital gains attributable to foreign investors, tax exempt institutional investors like endowments and charitable trusts, and corporations, (which between them almost certainly amount to the greater part of U.S. investment) are not subject to the individual capital gains tax.
Since the preference most likely suppresses investment, it makes sense that capital gains tax rates do not have any empirically observable effect on economic growth rates. (Id., Figure 5-1, p. 82). And if this is the case, there is surely no sensible rationale for continuing the preferential treatment of capital gains. After all, any policy that ends up taxing the gains on assets that are so incredibly concentrated (the top 1% own ~40% of all financial assets) is repugnant from a distributive justice standpoint.
Bear in mind, part of the Box-Norquist-Sir Loin agenda is to totally eliminate the taxation of capital income altogether. So this battle is very current and highly significant for anyone who cares about our increasing economic inequality and our decreasing tax progressivity.
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Hello! I just went to the Wikipedia entry on capital gains tax (http://en.wikipedia.org/wiki/Capital_Gains_Tax) and noticed the wide range of tax policies among different countries. Some countries don't tax at all, others at differing rates... but everyone, even the Europeans, seem to treat this particular type of income differently. Does everyone use the same set of arguments, that its important for promoting saving and investment? And what's going on with our enlightened Eurocrats?
ReplyDeleteActually, reviewing the article again, there appears to be one country that treats capital gains like regular income for tax purposes, Estonia. But they also have a flat tax.
ReplyDeleteApparantly Estonia was serious about getting rid of, and getting far from, communism.
ReplyDeleteCarlos, you're absolutely right. If anything, the U.S. probably has a relatively small preference for capital gains compare to Europe, where many countries don't tax capital gains at all (sorry Chris - you guys actually suck worse on this one). I am not familiar with their policy debates. But I cannot imagine, with my brain's mind, what possible justification there could be for a preference or an exclusion besides a tax subsidy to stimulate economic growth.
ReplyDeleteAll I know is: I use a bank, I get burned on capital gains tax.
ReplyDeleteOh, and I learned something from The Federalist (who's clearly and economic and American history genius) while I was searching Sir Google's Web to get that Aqua Teen quote correct.
ReplyDeleteI think about that quote every time I think about capital gains. And that's a lot.
ReplyDelete"You should consider a Broth IRA."
Hi all,
ReplyDeleteThanks, Ryan, for the post. I also do not buy into the national savings rationale for the preferential CG rates. However, doesn't the preferential rate do more than alter the choice between savings and consumption? What if the economic choice for the taxpayer were not between savings and consumption, but rather between two different forms of capital investment. To the extent the transaction would not receive some special non-recognition treatment, doesn't the preferential rate ease the burden on savers when their first investment choice may begin looking worse than other choices? In that case they would have to liquidate (theoretically a taxable event) and then reinvest the proceeds.
So, even if the taxpayer had a stationary level of savings in mind (i.e., a level unaffected by the preferential CG rate), offering the preferential rate may at least be defended on the grounds that it is good policy to incent long-term savings and loosen (while not totally undoing) the lock-in effects of a capital investment.
--Wade
Hey Wade. A few responses to your points. First, you are right that the capital gains preference provides a tax subsidy for some kinds of capital investment, but not others. I discuss the economics of savings (generally) vs. consumption because that is usually the form the pro-preference argument takes.
ReplyDeleteBut in one sense, this point does not cut in favor of the capital gains preference, at least as it exists now. If the policy rationale is to increase investment, why not extend it also to interest income from bonds and savings accounts? Surely that money ends up being recycled into investment as well. The current preference gives a totally economically arbitrary advantage to certain forms of capital investment over others.
But your main point seems to concern the so-called "lock-in" effect of the capital gains tax. In other words, so the argument goes, the imposition of a tax burden upon realization gives investors a disincentive to cash out of a current investment in order to reinvest in a higher return investment where the tax burden is greater than the difference in expected return between the two investments.
Sure, this is true. But for one thing, it probably doesn't matter much in terms of aggregate capital formation because most investment capital is supplied by entities not subject to the capital gains tax. And a lot of short term trading is simply "noise," and therefore investors' perceptions that one investment may have a slightly higher rate of return than another are often wrong. More fundamentally, however, the policy goal of reducing lock-in is directly contradicted by the holding period rules. If the idea is to make it easier to cash out of an investment in favor of a higher return investment, why on earth would you force the investor to hold onto the first investment for a year before giving them the benefit of the lower rates? The law is a garbled mess even if we evaluate it by reference to the policy goal it is purported to advance.
Finally, I think we should bear in mind the big picture. This policy benefit (i.e., reducing "lock-in") is microscopic compared to the potential for the preference to suppress investment, distort the form investments take, and (most importantly to me) provide an unjust tax subsidy to the rich. Moreover, if lock-in were truly a major economic problem, and if reducing or eliminating capital gains taxes were able to solve that problem, then you would expect lower rates of tax on capital gains to be correlated with economic growth rates. And, as I mention in the main post, they are not.
It's entirely evident that whoever composed this article, despite their faux intellectual affectation, has absolutely no clue of how economics works in the real world nor any sense of history (and yes, people actually do work less when you tax more. Ronald Reagan, for one, declined movie roles because the taxes were confiscatory and, if Reagan isn't quite your cup of tea, take a look at the dearth of productivity in socialist nations. What, pray tell, is your explanation for why the best and brightest of France are going to London for career opportunities? Do you really think it's the weather or the fish and chips?). What, again, is your explanation for how Ireland, the former "sick man of Europe" went from economic basket case to being known as the "Emerald Tiger?" Do you think it was by raising taxes and increasing regulation? Also, as for capital gains cuts leading to higher interest rates, that is patently wrong. Increased investment leads to productivity gains which are, themselves, inimical to inflation and low inflation means low interest rates. If your concern truly is deficit spending then a) how can you advocate more socialist programs which, by definition, mean more government spending, and b) explain the fact that the U.S. has achieved more wealth and economic development than any other country in the world when it's run deficits for all but about 50 years of its existence?
ReplyDeleteAdditionally, how can you earnestly decry tax cuts that benefit the wealthy when only the wealthy pay taxes in this country? How can you cut the taxes of those who don't pay any taxes to begin with. Come on now, it's not complicated math were talking about here.
As for socialism, do you really think the former Soviet Union, North Korea, and Communist China had better standards of living than those in the west? If so, why have Russia and China begun the conversion to capitalism (not to mention the whole of central and eastern Europe)? Do you think these people are eager to return to socialism? There's a reason socialism is typically imposed at the end of a gun and that reason is because it doesn't make any logical sense at all. It's like you're trying to argue that the Earth is flat when that argument was firmly defeated and shown conclusively to be false centuries ago.
Look, socialism doesn't work. Never has, never will. As the old saying goes, the definition of insanity is doing the same thing over and over and expecting different results. By this measure I believe we can conclusively declare socialists and their adherents to be insane.
Wow that's some pretty strong stuff. Allow me to retort.
ReplyDelete1. My “faux intellectual affectation” comes from merely restating points made by the authors I have read to the best of my ability. If it sounds “faux intellectual,” take it up with the professional economists I cite. Anyway, I have cited serious scholarly books that rely on serious scholarly studies to support the propositions that savings and labor supply are not very responsive to tax rates. You have merely cited “how economics works” and Ronald Reagan’s personal finance decisions. The authors of the books I cite (Slemrod/Bajika and Burman) are distinguished Economics Ph.D.'s and noted experts on tax policy. They understand economics better than any of us, and certainly better than Reagan (which of course isn’t saying much, though I hear he was a good actor). By all means, take a look at the articles and see if you can find errors in their methodology. But you can't just dismiss their findings by invoking "how economics works." And I’m sorry but anecdotes about what Reagan may have or may not have done are irrelevant. It's the data that matters, not self-interested little fables.
2. This is whole “everyone is ditching France to go to the UK” thing is nonsense. France, total train wreck that it is, has a higher HDI (a simple formula based on GDP/capita, educational attainment, and life expectancy) (http://en.wikipedia.org/wiki/List_of_countries_by_Human_Development_Index) rating than the UK and a very similar GDP/capita. Also note that the U.S. is behind Iceland, Norway, Australia, Canada, Ireland, Sweden, Switzerland, Japan, The Netherlands, France, and Finland – all more social-democratic countries by this measure. Seriously, any clown journalist from a right-wing rag can find a few rich French dudes working in London who are into finance and hate taxes to bitch and moan about the taxes in France and turn it into an article about how the French elite are leaving in droves. Once again, look at the big picture. France offers the better standard of living than the UK by a common and uncontroversial metric. Not to mention, the fact that high earners may leave a high tax country to go to a low tax country says absolutely nothing about whether high taxes would in fact be destructive in the absence of jurisdictional competition. In other words, if everyone in the world had to have the same tax rate, is it clear that the best rate would be a low one? I’m sure you think so, but the authors I have cited have shown otherwise.
3. Soviet-style Communism does not work. The authors of this blog reject Soviet Communism and seek a liberal, democratic form of socialism. Therefore, the closest example is not North Korea, but Sweden, the Netherlands, France, Norway, Denmark, and Finland. Each of these countries is among the wealthiest in the world, enjoys comparable wealth to the U.S. and has a higher HDI than we do (except for Denmark, which is 2 spots behind us). And incidentally, now capitalism is imposed at the point of a gun in China and Russia. Neither country has become any more democratic since their conversion to capitalism.
4. You missed the point of the capital gains tax analysis. The point is that the preference actually doesn’t increase investment. Your counterargument just assumed that it did, likely on the strength of a few too many Wall Street Journal editorials. The empirical evidence (which, again I cite and you are welcome to look up and take issue with) contradicts this. So the rest of the good things you mention that flow from increased investment are irrelevant to the policy question.
5. My concern is not “truly deficit spending.” It is distributive justice and economic equality. That’s my main problem with the capital gains preference – it favors the very wealthy. I’m fine with deficits if the money is spent broadly improving the standard of living, reducing economic inequality, and increasing social mobility. But the people who support the capital gains preference make the argument that the preference increases economic growth. As the studies I cite authoritatively demonstrate, this argument is flatly wrong because the decrease in public saving is greater that the increase in private saving (which is relatively very small). Again, read the books and tell me what’s wrong with them.
6. Deficits need not totally negate economic growth, but they do suppress it by increasing interest rates. This “how economics works.” It may be worth it to do this in some cases (see above), but not when the whole point of the policy (i.e., the capital gains preference) is to increase economic growth.
7. The U.S. has not accumulated more wealth than any other country in the world. By nominal GDP/capita (http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28nominal%29_per_capita), we rank 11th (behind such socialist all-stars as Norway, Iceland, Denmark, Sweden, Finland and the Netherlands) and by PPP GDP/capita (http://en.wikipedia.org/wiki/List_of_countries_by_GDP_%28PPP%29_per_capita), we rank 8th (still well behind Norway). Of course the U.S. is still quite wealthy, but that wealth is largely enjoyed by a relatively small group of people (http://en.wikipedia.org/wiki/List_of_countries_by_income_equality). Our wealth is great, but it is far from unrivaled, and it is so highly concentrated that it fails to benefit the vast majority of Americans.
8. Do see this (http://workingsocialism.blogspot.com/2008/03/more-stats.html) for a “faux intellectual” (albeit correct) comparison of productivity in the U.S. with productivity in more left-leaning Europe.
9. See this post (http://workingsocialism.blogspot.com/2008/06/two-deceptive-arguments.html) to read my rebuttal to the “only the rich pay taxes” bit. If you don’t think the tax system in this example unfairly benefits the rich, then that’s your prerogative. But I believe in progressive taxation, the idea of a “social contract,” that we have obligations beyond ourselves, and that the rich have ipso facto benefited the most from the opportunities our society offers; therefore I think the rich have a moral (and, ideally, a legal) obligation to contribute significantly more to the public coffers. I guess this is just a philosophical difference we’re going to have to accept.
10. I am not entirely sure why economic growth took off the way it did in Ireland. I know a big part of it was the well educated, English speaking, and relatively inexpensive (at the time, anyway) work force. The currency credibility given by the Euro, favorable ECB monetary policy, and the truly enormous amounts of EU infrastructure development funding were all crucial too. It also helped that they had never truly “industrialized” so they passed entirely over the throes of first world deindustrialization. Honestly, I should read about it more. But the table I cite in Slemrod and Bajika shows that there is a slight positive correlation between tax burden as a percentage of income and GDP/capita. Country specific cases are interesting, but they are often far more complicated than brief Wall Street Journal editorials make them appear, they usually are far more attributable to non-tax factors that tax rates, and they are never a satisfactory substitute for broader data. The table I cite offers the broad data set necessary to reject your general argument.
11. Actually, you should work on your economic history. The New Deal era (’45-’68), which was characterized by very high marginal tax rates, high rates of unionization, and stringent government regulation, was the greatest era of sustained economic growth and social mobility in this country’s history. Read up on it. It makes the feeble and inegalitarian Reagan recovery look like a joke.
James T., who's kidding who here? The brightest of France ARE moving to London for the fish and chips. Haven't you ever been to Masters Super Fish? That mustard battered cod will shoot you up the lift and out the Tube. However, it can safely be said that France's best and brightest aren't flocking to London for Yo! Sushi. That place is a cute novelty at best.
ReplyDeleteJames T:
ReplyDeleteI hesitate to pile-on with the others against you, because in order to keep things interesting on the blog, we need all the participation from shockingly mistaken people we can get.
But instead of refuting any of the points you make (Ryan already handled that), allow me to suggest you simply take a trip to Scandinavia, the Netherlands, France, or Germany.
Bring a bit of general information on taxation and spending in those countries for light reading, and do take the time to ask as many people as you can about their quality of life, and where they got the money for their kids education, healthcare, and what they would do if suddenly they found out they'd been fired. Most will be happy to discuss with you over a beer, so long as you learn a few basic expressions to get the ball rolling.
If you're still not convinced that it's a bit more nuanced than "Capitalism=freedom, socialism=oppression", take a few more weeks off work to watch people getting the crap kicked out of them for demonstrating in China, critical journalists getting shot in elevators by the Russian secret service, or the woman and children enslaved in factories around the world in order to ensure consumer choice at Best Buy and GAP.
You will most certainly come away from a great vacation saying "I must be insane, this socialism stuff can work," and what's more, you'll have much better anecdotes to bring to the table than tales of what the Kipper used to do back in Hollywood when he wasn't picking bugs out of some monkey's backhair.