Posted by: bmeverett | October 5, 2011

Capital Gains and Losses


During his campaign in 2008, President Obama spoke often about raising the capital gains tax for high income earners from the current 15% to 20% and possibly as high as 28%. During a debate between Senator Obama and Hillary Clinton on April 16 of that year, moderator Charlie Gibson noted that government tax receipts from the capital gains tax went down when the rate was raised and up when the rate was lowered. Obama replied that he supported an increase in capital gains taxes on grounds of “fairness.” This exchange was troubling for two reasons. The first is that Obama seemed unaware of the history of capital gains taxes and their impacts. He took a strong position on a key issue without having done his homework. Second, he argues that tax policy should be based on a subjective concept of “fairness” rather than more rigorous principles of good public policy. Fairness can easily be a trap if you follow policies that make everyone equally poor.

We start with the premise that many people, including most wealthy people, earn much of their income from investments and that those earnings ought to be taxed. Tax policy, however, should not interfere with capital flows, which are the life-blood of the economy. Taxes on investment income must be structured with particular care, since distorting capital markets leads to reduced economic growth with dire consequences for everyone, especially the poor.

Let’s look at different ways of taxing investment income. First, we can tax earnings at the corporate level in the year in which they occur. Second, we can tax dividends paid to shareholders, and, third, we can tax the appreciation on share prices (“capital gain”). The first two are pretty straightforward, but capital gains are a bit more complex. Most economists argue that share prices reflect the net present value of the company’s expected future earnings. For example, if a company earns $10 per share every year and investors expect these earnings to continue at that level indefinitely, the value of a share at a 12% discount rate would be about $83. In theory, the share price will not appreciate unless the company’s expected earnings increase (or the expected value of alternative investments decreases, but we’ll ignore that issue for now). Capital gains taxes are, like dividend taxes, a way of taxing the earnings of the company.

Now let’s consider a few scenarios. In our current tax structure, a marginal corporate tax rate of 35% is applied to a company’s annual earnings. If the company retains those earnings for future investment and shareholders hang onto their stock, the government collects no additional taxes on these earnings in that year. If the company distributes some or all of its earnings as dividends, however, shareholders must pay a 15% tax on those dividends on their personal tax forms. In addition, shareholders must pay a 15% capital gains tax on any share appreciation if they sell the stock.

Overall, this system imposes a steep marginal tax rate of almost 45% (35% plus 15% of (1-35%)), but it also creates some powerful distortions. Companies have a strong incentive to retain earnings and thus avoid saddling their shareholders with additional tax. That’s fine if the company has a list of quality investment opportunities, but shareholders might prefer to invest their share of earnings elsewhere. Inevitably, some capital is diverted from higher quality opportunities to lower quality ones when earnings are retained. The current system also creates a strong incentive for shareholders to hold onto their stock, even if they believe they have better investment opportunities elsewhere. We thus have a tax structure that not only imposes high tax rates on investment earnings (see my last post on The Buffett Rule) but also impedes the free flow of capital.

I should note here that complex tax laws generate creative thinking. Many companies, including the large oil companies, distribute money to their shareholders through stock buy-backs. Reducing the number of outstanding shares increases the price per share. This process essentially turns current corporate earnings into capital gains for shareholders. Taxes on these gains can be deferred until the stock is sold. Many politicians hate this process because it circumvents their ability to get their hands on these funds.

Now let’s consider President Obama’s proposals. He wants to increase the tax rates on dividends and capital gains to “at least” 20% for individuals earning more than $200,000 a year. Such a move would increase the overall marginal tax rate on investment earnings to 48% (35% plus 20% of (1-35%)) not only extracting a greater share of investment capital for the government, but also reinforcing the incentives for companies to retain earnings and for shareholders to hold onto their stock. As Charlie Gibson astutely pointed out, the result is likely to be less revenue for the government through tax derral, but also greater distortion of capital markets.

Another theoretical possibility would be for the government to deem corporate earnings to have been distributed to shareholders whether dividends have been paid or not. This approach would eliminate perverse incentives to retain earnings, but would also be hopelessly complicated and would require shareholders to pay cash taxes on money they have not yet received. Definitely a step in the wrong direction.

The simplest solution would be to tax investment earnings only at the corporate level and eliminate all taxes on dividends and capital gains. Setting a steep marginal corporate tax rate of 40% would be better than the current system, giving companies complete flexibility on retaining or distributing earnings and giving shareholders flexibility to sell or hold their stock. Even better would be a lower corporate tax rate of 20% to encourage investment, but that rate would provoke cries of unfairness and make the Buffett Rule actually come true. Even though there is a good theoretical argument for reducing taxes on investment and increasing taxes on consumption, this approach is simply politically impossible.

Once again, simplification is the key. Taxing investment income at an appropriate rate at a single point is the economic answer, but not a good political answer. The Democratic Party is still committed to extracting as much money from the economy as it can. Crying “unfair” has been their strongest weapon for over a hundred years. That’s what happens when your only analytical tool is the Focus Group. We deserve better.

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