Monday, July 14, 2008

Capital Gains -- Where's the Investment Gain?

The capital gains tax rate is currently at a level lower than at any time since the beginning of the New Deal. Advocates of cutting capital gains tax rates argue that low capital gains tax rates stimulate investment. Are low capital gains tax rates stimulating investment?

A July 1oth story from by Robert Cohen for Newhouse News Service quotes Lee Burman, a senior fellow at the Urban Institute arguing that

the argument that low capital gains rates are important to investment and entrepreneurs is "overstated" He said that the lower rates tend to "fuel all sorts of tax-shelter activity, much of it unproductive, and benefit the wealthy.

Low capital gains tax rates are a good idea... except for the problems this creates. One of the reasons that tax revenue from capital gains taxes tends to go up when the taxes are cut is that this gives investors incentive to transform everything taxable into a capital gain. For instance corporations have been buying back their stock at an unsustainable pace in recent years, probably in part to create capital gains for their investors.

A partial solution to this problem is the one we propose in Trading Away Our Future. Tax any capital gain that is consumed at regular income rates. This would dramatically reduce the incentive for tax shifting. Any capital gain that is reinvested in a productive income-producing investment would not be taxed.

There would still be some incentive for tax shifting, but only with savings. And encouraging savings is not a bad idea for the U.S. economy at this time.

If policymakers would rather not reduce capital gains taxes in any form, an increase could also be structured along the lines we discuss, with consumed capital taxed at higher regular income rates, but reinvested capital gains taxed at lower contemporary capital gains rates. This would not reduce the incentive to invest or take risks to produce income in the future at all. It would reduce the incentive to produce (and then consume) capital gains.

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