Capital Gains Tax: Myth and Facts

By Aiya Anvarova

The idea that the lower capital gains tax rates are a good thing for the economy that spur investment, lead to job creation, encourage people to sell assets without fear of tax consequences and actually raise total tax revenue has rooted so deeply in the minds of Americans, both Republicans and Democrats, that the Congress hardly has ever questioned the validity of this theory. However, recent dismal economic slump has led many people to doubt some of the principles of the American economy, including the premise that the lower capital gains tax promotes economy. Despite the fact that it has become a common belief that the low capital gains tax rates encourage active investment and economic growth, there is no sound historic evidence to support this assumption.   

Since 1950 capital gains have generally been taxed at a lower rate than income, to spur investment. The rate under President George W. Bush went from 20 percent to 15—the lowest ever—and was presented as a measure to stimulate the economy. However, this approach didn’t bring any significant improvements in the state of economy. In fact, the years following the 2003 tax cut were part of the most dismal economic condition since the Great Depression. All the economic indicators such as output growth, job creation, poverty reduction and investment were all below average, if not all-time lows.

One of the arguments in favor of the lower capital gain tax is that if capital gains taxes are high, asset owners may be reluctant to sell their assets and trigger the tax. Therefore, they hold onto the investment, resulting in an inefficient allocation of capital that reduces growth. They will be willing to spend the capital on consumption rather than invest it, again reducing economic efficiency. In other words, if the capital gains taxs are high the capital owners will be unwilling to invest their assets that will lead the economy into stagnation.  

However, these arguments popularized by the Republicans don’t seem to be supported by the history and the facts. There’s no real evidence that a low capital gains tax rate boosts the stock market, investment, or the economy in the long run, rather it will have some temporary effect. “I have worked with investors for 60 years,” said Warren Buffet, “and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”

In fact, it hasn’t always been a foregone political conclusion that the capital gains rate should be lower than that for income. The 1986 tax reform enacted by President Ronald Reagan set capital gains at the same rate as the highest personal income bracket, which was reduced from 50 to 28 percent. The reason why Reagan’s administration decided to increase the capital gain tax was not an ideological decision but rather an attempt to raise the money for the government and this strategy worked. The low tax rates on capital gains are also an important part of many individual income tax shelters, which employ sophisticated financial techniques to convert ordinary income to capital gains. The strategy of equalizing tax rates on capital gains and ordinary income may help solve the problem of the enormous tax avoidance spawned by the low capital gains tax as it will discourage capital owners from hiding their income as an investment.   

Based on the historic evidences, including the effects of the 2003 unprecedented capital gains tax cut, the low capital gains taxes don’t have direct long-term positive impact on the savings, investment and economy, in general. Various independent studies showed that there was no statistically significant correlation between the capital gains tax and economic growth from 1950 to 2011. In fact, the reduction in capital gains tax was often followed by the economic slump and rising unemployment. Thus, the argument for lower capital gains rates rests more on faith than science.

List of References

Mufson S., and Yang J. L. (2011. Sept. 11). Capital gains tax rates benefiting wealthy feed growing gap between rich and poor. The Washington Post. Retrieved from http://www.washingtonpost.com/

Stewart, J. B. (2011, August 19).  Questioning the dogma of tax rates. New York Times. Retrieved from http://www.nytimes.com/