Taxing Capital Gains at Ordinary Rates: Evidence Says Do It…So Does Buffet

August 20th, 2011 at 3:12 pm

Why not tax capital gains as ordinary income?

That’s an old chestnut among those of us who believe that the differential between tax rates on different types of income causes more harm than good.

James Stewart has a great piece in today’s NYT asking this question.  The usual objection to increasing the rate on capital gains—that’s the money you get when you sell an asset for more than you paid for it—is that it will discourage investment.

And once again, we have a great quote from Warren Buffett:

“I have worked with investors for 60 years 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.”

[Side note: I’m serious about this: Warren Buffett should be the next Treasury Secretary.  No rush re Tim, but when he steps down, I have a feeling Buffett would be a great Treas Sec’y.  He’s knows business and markets, he’s affable and could presumably work well with folks on all sides.  And he’s got great progressive instincts on taxes and fiscal sanity.  Sure, the ruling classes would oppose him based on his recent calls to “stop coddling the rich” but that’s a fight I’d very much welcome.]

What about evidence?  Plotting the top cap gains rate against real business investment doesn’t show much (see first figure—biz investment is in natural logs to show proportional growth over this long time series).  Cap gains bounces around based more on politics than policy, while investment pretty much grows with the cycle.  Hard to see anything in the picture supporting the view that either the level or changes in cap gains taxes play a determinant role in investment decisions, just like Warren said.

Sources: Citizens for Tax Justice and BEA

There’s been considerable academic work on this question, but tax expert Len Burman, quoted in the NYT piece, called the academic evidence “murky, at best.”  A few correlations support this view.

The table shows correlations between (the log change in) real private investment and both levels (KGAINS) and changes (DKG) in capital gains tax rates, from 1929-2010.  The correlations have the “wrong” sign and are statistically significant, meaning increases in the level or positive changes in the capital gains tax rate are associated with an increase in the growth rate of real private investment.

Source: Same as prior figure

That probably just reflects the fact that both real investment and tax changes can be cyclical, so I did a second correlation exercise that controls for the cycle (I ran a VAR with 2 lags on cap gains, the log change in real business investment, and unemployment rates).  The graph shows the impact on real private investment growth over a number of years if you raise the capital gains rate.  The result is…nothing.  The investment line barely budges and is statistically insignificant.

Sources: CTJ, BEA, BLS

These are quick correlations—not causal models.  But they are consistent with both the literature and the insights of practitioners like Buffet.

There are a few economic principles that we consistently get wrong in ways that do lasting damage to our economy and diminish our future.  At the top of this list are arguments about large behavioral responses to changes in tax rates.  I don’t think it’s zero, but I’ve simply never seen compelling evidence that tax increases significantly hurt growth, labor supply, jobs, wages, or that rate decreases provide much of a boost the other way.  And when you factor in the benefits of the investment and services government provides—something the literature tends to ignore—the hyper-responsiveness arguments are even less compelling.

(That reminds me—the one place Stewart slips up in the piece is buying into the argument that if you raise the cap gains rate, you should be open to arguments to return some of the revenue you gain back to taxpayers in the form of lower rates—“Much of the [revenue] windfall from higher capital gains rates could be offset by cutting the rate on ordinary income.”  That doesn’t make sense—if you don’t believe that taxing cap gains as ordinary income is a problem in terms of investment and growth, then why tweak other rates?)

So, in the interest of better, simple tax policy that diminishes a distortion in the system while raising some much needed revenue, we should seriously consider taxing capital gains as normal income.  I know—not exactly consistent with our current politics, but perhaps Sec’y Buffet can take a run at this someday.

 

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41 comments in reply to "Taxing Capital Gains at Ordinary Rates: Evidence Says Do It…So Does Buffet"

  1. koreyel says:

    Jared,

    You are doing stellar work here on explaining basic economic principles and ideas. Along that high ridge line: I’d like to see you tackle the idea behind using the natural log on the y-axis.

    Yeah you touched on it with the comment of proportional growth and time series. But since these log axes are used so often I think it really wants a good bit more simplifying. For example, “proportional growth” as distinguished from what other sort of growth?


    • Jared Bernstein says:

      Good question. The idea is that when you’re looking at a very long time series like this where the values cover a huge range–they start small and get large–you want to differentiate between say a 50 unit change at the beginning of the series and a 50 unit change at the end. If the base is 100 at the beginning and 10,000 at the end, that a 50% change at the beginning and a 0.5% change at the end. Under a regular scale, 50 units are treated the same at the beginning and end of the series. Using a log scale adjusts for the growth in the base such that the 50 unit change over a 10,000 base will appear as a much smaller increase in the series.


      • D. C. Sessions says:

        More than that, a log scale (doesn’t really matter what base log) turns exponential functions like compound growth into straight lines. This makes it very easy to compare two exponential trends such as GDP growth and debt growth by just comparing the slopes.


        • David A. Spitzley says:

          Coming to this thread very, very late, there’s also the fact that due to quirks of calculus, small changes in the natural log of X are equivalent to percent changes of the same numerical value. For example, if ln(X) rises by .01, X rises by almost precisely 1%. That works until changes of around 20%. I believe only natural logs work that way.

          Math detour: if we take the first derivative of the natural logarithm of x, it turns out that d[ln(x)]/dx = 1/x . Rearranging the terms, this means that d[ln(x)] = dx/x. In practice you can treat the differential terms (e.g. dx) as deltas – changes in values – we wind up with dx/x = percentage change in x (e.g. a change of x=$1000 when x=$100,000 is a 1% change), and thus the change in the log of x equals the percent change of x.


  2. D. C. Sessions says:

    Taxing capital gains as ordinary income is a common-sense policy that is going to be hugely popular with the enormous share of the population that works for a living.

    However, there is one modification that really ought to be included and that’s derating gains for inflation. That’s the one thing that really nicks the population at large, since the general population are investors rather than traders and their #1 investment is in their homes over the course of decades.

    Derating gains for inflation would be a pretty fair trade for losing the mortgage interest deduction, too — possibly the only sweetener that the middle class would consider worth the exchange.

    Now, if you want to be sneaky at the high end, use a derating factor other than CPI. Like, for instance, median hourly wage.


    • StreetEYE (@StreetEYE) says:

      Indexing for inflation is an excellent point.

      Additionally, for stocks, it’s important to note that the 15% tax on dividends and capital gains is the second bite of the apple, after the 35% statutory corporate income tax. (effective rate something like half that, after all the deductions and dodges are taken into account)

      If you tax dividends and capital gains as ordinary income, I think there is an excellent case to be made for eliminating the corporate income tax. Legislators and lobbyists love it, since it creates rent-seeking opportunities and voters always think someone else pays it. But retaining the corporate income tax while taxing dividends and capital gains as ordinary income would tax income from investing through corporations at a higher rate than other sources and create a disincentive for investment. And eliminating the corporate income tax, which brings in only 12% of federal revenue, would make an army of accountants, tax lawyers and lobbyists for repatriation tax holidays redundant and increase the efficiency of the tax code.

      Eliminating separate treatment for capital gains, and corporate income taxes too, would be a pretty big win in simplicity and transparency.


      • joe says:

        only 12% of federal revenue? That’s a lot of revenue lost.

        Double taxation can be avoided by forming a Subchapter S rather than Subchapter C. When Republicans talk about “small business” that file as individuals, they are talking about corporations like Bechtel that are Subchampter S corporations. Corporations use the double layer of taxation to reduce their tax liability. GE shareholders would face a higher tax liability if the GE was a pass through.


      • ronbo hagen says:

        I would agree that corporate taxes need adjusting. But to keep taxes progressive and not regressive (a flat tax by the way is regressive on the whole of society), income taxes should be very progressive on any type of income. Capital gains is a cool way to shift income onto the value of a stock for the purpose of avoiding taxes. Corporations then split their shares to hide this income shift. So owners should then be taxed equally for capital gains as they are for dividends.

        Now, to fix the corporate taxes, taxes should not be a flat rate like they are. They should be adjusted for the cost of the corporation to society (build roads for commuters, police for protection, support of internet infrastructural, etc). We also need corporate taxes to compensate for consumption of natural or national resources.


    • Another Scott says:

      I commented on this topic over at Kevin Drum’s blog – http://motherjones.com/kevin-drum/2011/08/great-capital-gains-charade . As I said over there, I don’t like the idea of indexing capital gains for inflation and treating it differently from the indexing of ordinary income tax brackets.

      Sales that result in capital gains have nothing to do with inflation. The price is set by an agreement between willing buyer finding a willing seller – full stop. It has nothing to do with the CPI, how long the investment has been held, or what it cost the original owner, so why should a CPI deflator automatically be applied?

      When my dad bought 100 shares of XYZ Corp 30 years ago, he didn’t do it because he knew there was going to be beneficial tax treatment when he sold it. He did it because, at the time, it made sense to him.

      When we bought our house, the price had nothing to do with what the owners paid 10+ years previously. The price was set by supply and demand in the particular location. The price isn’t set by the buyer’s cost + inflation +/- some premium. Markets don’t work that way.

      In extraordinary cases (selling a primary residence; settling an estate), maybe it makes sense to allow a large gain to taxed over a few years (maybe 3-5, not 10-40). But otherwise treat the gain as ordinary income.

      To do otherwise is to invite distortions as people finagle ways to pay less in taxes. And it effectively devalues work by ordinary people who end up paying a higher rate than they would otherwise. There are already plenty of incentives to invest – people don’t build wealth from wages, they do it from savings and investment. Everyone (eventually) wants to build wealth – no matter the tax system.

      Income tax rates should be progressive and adjusted in ways that prevent the rich from taking an ever larger share of national income. But using the tax code to favor “investment” over wage income distorts things too much. The world didn’t end when credit card interest deductions ended. It won’t end if the home interest deduction ends, either. If things are done properly (a big if, I know), the country will be much better off without the home interest deduction.

      My $0.02.

      Cheers,
      Scott.


  3. Jeff says:

    I understand how attractive this argument appears on the surface, but what about some in the middle class who have struggled to finally be able to save some money to invest in the stock market. This group is not rich by any means and they were counting on realizing capital gains that would be taxed at a lower rate than that of their income.

    Isn’t this a bit like changing the rules in the middle of the game?


  4. Robert says:

    Jared,

    Let’s first talk about the purpose of taxes. My understanding is that taxes are a primary tool of fiscal policy to regulate aggregate demand. When aggregate demand is anemic, the government may choose to cut taxes and increase deficit spending. Conversely, when aggregate demand exceeds the limits of productive capacity, the government may choose to raise taxes and cut deficit spending.

    Now, if we can agree on the purposes of taxes, we should then consider whether there are a valid economic arguments for differentiating tax rates on the basis of the sources of income — earned, rented, inherited, distributed, etc. IMHO it doesn’t matter what the source of the income is, but rather the amount of that income because the amount represents the propensity to fuel aggregate demand. So, yes, I’m in favor of taxing capital gains and dividends as ordinary income. In addition, I believe tax rates should should be indexed progressively to levels of income and pro-cyclicly to the degree of inflation in the economy.


    • joe says:

      The article addresses your claim that taxes regulate aggregate demand and disagrees.

      “I’ve simply never seen compelling evidence that tax increases significantly hurt growth, labor supply, jobs, wages, or that rate decreases provide much of a boost the other way.”

      “And once again, we have a great quote from Warren Buffett:

      “I have worked with investors for 60 years 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.”


      • Robert says:

        Thanks Joe for responding to my comment.

        “The article addresses your claim that taxes regulate aggregate demand and disagrees.

        ‘I’ve simply never seen compelling evidence that tax increases significantly hurt growth, labor supply, jobs, wages, or that rate decreases provide much of a boost the other way.’ ”

        I confess I don’t have data to point to that backs up my claim that the level of taxes can influence aggregate demand. I’m simply coming at this from the national accounting relationship between aggregate spending and income. From the perspective of the users of the national income we have the familiar equation: Y = C + S + T; where Y is GDP (income), C is total consumption spending, S is total saving, and T is total taxation. For a fixed Y and an increase in T, the sum of (C + S) must decrease.

        Assuming the article is correct, that would imply that C is less likely than S to diminish in a rising T environment. In other words, private households would be more inclined to reduce their net saving than their level of consumption. Increasing taxes further, net saving could go negative and households would have to borrow to maintain their level of consumption. Nevertheless, at some point, when credit is maxed out, higher levels of taxes would eventually cause consumption (aggregate demand) to decrease. This would necessarily impact production capacity and increase unemployment, etc.


  5. Allen Edwards says:

    I plotted the top income tax rate vs GDP growth. The top tax rate, as you know, was above 90% several years ago. I plotted a trend line. It slopes up meaning that the higher the top tax rate, the higher the GDP growth. While this may not prove that higher taxes lead to higher GDP growth, I think it shoots a pretty good hole in the idea that higher taxes lead to lower growth.


    • Jim Timmy says:

      If you were to plot the top tax rate vs Revenue as a percentage of GDP, you would be able to “shoot a pretty good hole” in the idea that higher taxes lead to more revenue.


    • ronbo says:

      Remember word problems in math? I blame the American education system for failing to teach you basic reasons why we use log scales and not linear scales. This is an excellent example of when we should use log scales (of any base). Your plot simply tells us that tax rates are lower now then they use to be while inflation has continued on.


  6. DARREN HUTCHINSON says:

    Thank you for this analysis. I was just having a conversation about this recently.


  7. Fred Beloit says:

    The people who argue for gay “marriage” go to court on the basis of equality before the law. I don’t agree with that, but if the majority of voters, through their representatives, want to vote it in, fine.
    But can anybody tell me how the government has been able to get away with inequality before the tax law, soaking some, exempting some, and actually paying others?


  8. Jeff H says:

    “Much of the [revenue] windfall from higher capital gains rates could be offset by cutting the rate on ordinary income.”

    I don’t know that that was a slip up so much as a pure BS move. It’s the same nonsense we have all heard from the Paul Ryans of the world. Take away the tax code spending so you can lower the rates.

    I have an idea, why not increase taxes, like you suggest with gains, and pay down the deficit!?!?!?!

    The rest is silly talk. One moment we are being told the sky is falling (the deficits are going to get us) and the solution is tax cuts… Oye Ve!

    Thanks for making sense of this crazy talk.


  9. Fred Beloit says:

    Here is just one reason raising taxes is the worst thing we could do, the Government will just throw the money away. How? Here is one way the Dept. of Agriculture us doing its share:
    http://www.cnsnews.com/news/article/usda-spends-28-million-more-taxpayer-dol


    • Robert Noonan says:

      I read the article. It described a program of subsidies for help for farmers to encourage farming practices that will protect habitat for sage grouse. This is a worthy role for government. Any economic endeavor can have both benefits and negative effects. If government can help farmers farm profitably without wiping out a desirable game species, that is a win-win for both farmers and hunters (and businesses that serve hunters)
      .


      • Fred Beloit says:

        Wonderfully generous of you Noonan, but suppose you pay for it. Hunting organizations are voluntary grouse savers. What has hunting got to do with the Dept. of Agriculture anyway? Don’t you think there should be any limits on what the government can spend your and other peoples money on?


    • Michael says:

      Something tells me you aren’t against the enormous waste of money which is the Afghan War.


      • Fred Beloit says:

        Mike, are you talkin’ to me? Are you talkin’ to me? Obama owns the Afghan War for oh about two and a half years now. I strongly recommend you ask him about it. He’s knocking off those people far below at a pretty good clip. He could be using the money for that to save all the species of grouse.


  10. Fed Up says:

    “James Stewart has a great piece in today’s NYT asking this question. The usual objection to increasing the rate on capital gains—that’s the money you get when you sell an asset for more than you paid for it—is that it will discourage investment.”

    I believe you need to dig into the details of what caused the capital gain.

    What if the capital gain was caused by lowering wages, firing workers, and/or outsourcing their jobs? What if the capital gain was from raising prices? What if the capital gain was from creating and/or using more debt?

    Should those types of activities be discouraged?


  11. Michael says:

    We should index for inflation; my grandfather has owned his land as a farmer for 40 years but is locked into holding it, because he doesn’t want to pay capital gains taxes on 40 years of inflation.

    That said, the income tax is the lifeblood of the modern industrial economy. Industrial economies need large governments, because productivity requires specialization, and specialization requires help with the inherent risk. But that requires large taxes, and the only large tax we’ve found that has almost zero effect on behavior is the income tax. The income and substitution effects seem to cancel almost exactly.


    • Jeremy says:

      Michael:
      You (and your grandfather) are overlooking the fact that 40 years of inflation would increase the amount of money he would make from the sale, not just the taxes. If you index for inflation, and the property only increased in price b/c of inflation and not b/c of any actual improvements, then that is basically the government subsidizing long-held property and encouraging the hoarding of property for long periods of time. The longer you hold it, the lower the tax rate will be. This is probably a bad incentive.


  12. Richard H. Serlin says:

    From an expert well versed in this literature, MIT economist Jonathan Gruber:

    Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation.

    – “Public Finance and Public Policy”, 2nd edition, 2007, page 734


  13. inyourhouse says:

    Why are you looking at the statutory rate rather than the effective rate? The latter is the relevant decision variable for economic actors, so surely that’s what you should be looking at?


  14. RMGHicks says:

    What if the trade itself was taxed? Say a couple of pennies per share. This would allow the small time investor to benefit from lower taxes when they bought or sold stock with their hard earned money. But it would definitely throw a monkey wrench into these huge movements that hedge funds engineer at the expense of the rest of it. Even a few pennies a share matters if you are moving thousand of thousand of stocks in one shot. Such a tax might help stabilize volatility.


    • Chigliakus says:

      This is a fantastic idea not just for the reasons you mention, but because it could make high frequency trading a lot less desirable. Ideally it would kill the practice entirely, since it’s essentially just gaming the system for the benefit of the few firms wealthy enough to build data centers next to the NYSE. The stock market exists for the benefit of humans, and I haven’t seen any compelling arguments that the computers doing the HFT are benefitting anyone other than their owners, and that they aren’t acting to destabilize markets. Arstechnica has a number of good articles about the practice, for example http://arstechnica.com/tech-policy/news/2010/04/sec-looks-to-rein-in-trading-battlebots-maybe.ars


      • RMGHicks says:

        Thanks Chigliakus –
        I agree that such a mechanism would kill all the wild trading that is going on. This is a 100% nonproductive way to make money from money and has nothing to do with the fundamentals of the company itself. Average Americans and GOOD companies get creamed by all this volatility while a few laugh all the way to the bank skipping over the debris they created.

        Wouldn’t it be wonderful if we could invest in the stock market based on the fundamentals of the companies that we buy shares in? Now there’s a refreshing concept.


  15. davesnyd says:

    It’s interesting that the people who push “flat tax” almost always want no tax on capital gains.

    What about calling their bluff? Propose a flat tax– with a high exemption: say, pegged at twice the poverty line or the median family income or four times the cost of a mortgage on the average house or something like that.

    Make capital gains and inherited income all just income for purposes of that tax.

    Corporate taxes can go one of two ways– either down (to zero, maybe?) to make America more competitive with the rest of the world or up– if they keep saying “corporations are people” why aren’t they taxed like us? Same rates, no real deductions. I don’t know which way is better, economically.

    Maybe keep the payroll tax for FICA; maybe add a VAT.

    Can we get “equality” in the system, a true simplification of the tax code, an increase in the amount paid by the billionaires, and a tax decrease for the rest of us???


  16. Robert Weiler says:

    Capital gains should be taxed at ordinary income tax levels. The one caveat I would make is that if we were to do so, we should bring back income averaging so that one isn’t forced into a higher tax bracket for the one year that they took the gain when in fact the gain was realized over multiple years. This not only raises revenue but should reduce volatility by increasing the incentive to buy and hold.


  17. Jim Timmy says:

    “I’ve simply never seen compelling evidence that tax increases significantly hurt growth, labor supply, jobs, wages, or that rate decreases provide much of a boost the other way.”

    I suppose you weren’t convinced by Nobel Prize Winner Ed Prescott or Raj Chetty on the Labor Supply Question.

    As far as growth goes, I would also have to assume that you are not affected by the numerous cross country regressions showing a negative relationship between Taxes and Growth.

    Looking at the Capital Gains Tax, there is strong evidence that Capital Gain Realization is highly responsive to taxation. That would explain why the 1997 and 2003 Capital Gains Tax Cuts both led to more revenue than the CBO projected without the tax cuts.


    • beowulf says:

      “There is strong evidence that Capital Gain Realization is highly responsive to taxation.”

      An excellent argument for taxing unrealized capital gains annually. better yet, levy a net asset tax, the constitutional restrictions on direct taxation may or may not apply to real estate holdings (there are legal scholars on both sides) , but its irrelevant point. Personal property (including financial assets) clearly are not direct taxes. But it doesn’t really matter, for political reasons, any net asset taxes collected on real property would be rebated to the States anyway (the National Governors Association would issue a Fatwa declaring Jihad against Uncle Sam if it stepped on their property tax collections). So trade them a cut of net asset taxes at the same time Medicaid is federalized (or better yet combined with Medicare) on condition deposit current Medicaid state funding ($175 billion or so) is transferred to Medicare Part A trust fund.

      Right wing (unbelievably right wing) commentator James Bowery had an interesting idea. Tie Net Asset tax rate to 3 month Treasuries. That would put the CBO on the horns of dilemma, how do they score something that would either zero out net interest cost or raise hundreds of billion in tax revenue or both :o)
      http://mysite.verizon.net/res10kjcq/ota/others-papers/NetAssetTax_Bowery.txt


      • Jim Timmy says:

        That’s a lot harder to do in practice. If unrealized Capital Gains were to be taxed, then less people would invest in Capital Gains at all.

        Of course, the whole idea of investment taxation is to tax “gains”. If they are unrealized, then they are not “gains”. Basically, this would distort behavior greatly.


  18. max says:

    The Tax code reveals America’s true values. High taxes if you work for a living. Low taxes if you manipulate money.

    simple.


  19. Colin Cooper says:

    Here are the problems that Buffet did not talk about. What about capital losses? Do they become immediately deductible? He also did not mention the fact that no one forces you to sell an asset and recognize a capital gain. That is quite different than having a salary. The 2012 election is coming up and Buffet is backing Obama. I would not take anything he says more seriously than any other political pundit.


  20. Marion Delgado says:

    This is a very good summary and it explained a point I was trying to make on a chat quite well. The issue is BEHAVIOR. In essence, if you tax ordinary income at a high rate and capital gains at a low rate, it’s a “sin tax” on ordinary income (wages, dividends that are ordinary income, etc.). People with capital and a desire for high incomes will behave accordingly.


  21. Lenore Garman says:

    Reducing taxes are usually the number one ojective for high incomers as that is typically their biggest expense. Nothing influences like money, so therefore tax laws will always support those with lots of it – always has, always will.


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