More on Cap Gains and Investment

January 20th, 2012 at 11:04 am

A couple of posts back, I referred to earlier work debunking the link between low capital gains tax rates and real investment (and please don’t give me “what, you don’t think taxes matter?!”  I do, but the actual elasticities—in this case, investors’ responses to tax changes–are far, far lower than the claims).

Here, I’d like to tackle something else that came up in that post: the idea that what really gets investors going is not the cap gains rate itself…it’s the difference between it and the rate on ordinary income.  The figure below shows the differential between the top rates on cap gains and ordinary income.

Source: CBO

Now, in this case I’m the first to say that this tax difference affects behavior, but it’s not real economic behavior—the stuff that generates investment, jobs and good stuff like that.  It’s tax lawyer fun-and-games designed to label everything a cap gain so you can take advantage of the rate differential.

First, if you plot real business investment against the gap between the cap gains and the ordinary rate, you certainly don’t see much of a correlation between the tax gap and real investment.  In fact, the correlation between the tax gap and investment growth is .04 and that between the change in the tax gap and investment growth is 0.12, neither of which are statistically significant.

Source: BEA, TPC

What’s that?  I’m not capturing the dynamics of the relationship?  A handy statistical way to do that is to throw the taxgap and investment growth (and unemployment, to control for the business cycle) into a VAR (a statistical procedure that just lets you see how different variables affect each other’s growth over time).  You can then ask: what would happen to investment if you “shock” the tax gap grew (e.g., the ordinary income rate is made higher than the cap gains rate)?  The trickle downers, and this represents the views of all the R candidates for president, argue that this is precisely the way to generate more investment, jobs, and incomes for the middle class.

But, alas, it fails to do so, at least in this simple exercise.  The figure shows the reaction of real investment to such a boost in the tax gap (the x-axis represents years, the y-axis shows percent change–0.01=1%–in real investment in response to a larger tax gap), and investment responds not at all (the confidence intervals are wide and cover zero, meaning these impacts are again statistically insignificant).  If you substitute the change in the tax gap instead of the level, you get the same result.

Caveats abound—these are all simple correlations, and micro-investor behavior is a lot more complex than I’m capturing in these macro variables.  But I can tell you from decades of experience in crunching such numbers that if it’s this clearly not showing up in the simple correlations, it’s probably not going on in the real world.

And thus once again, we conclude the trickle down is BS, serving only to exacerbate economic inequality, which in turn stifles mobility, while starving the federal government of revenues it needs to achieve budget sustainability and to fulfill the roles we need it to both now and in coming years.


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8 comments in reply to "More on Cap Gains and Investment"

  1. MarvyT says:

    The logic behind a preferred rate for capital gains just doesn’t pass any real world test. If I have $100,00 to invest I would look at the risk/reward ratio first. Why would an investor pass up a chance for a 10% gain (7.8%) after taxes rather than a 2% return on savings? The goal of investing for most people is to maximize returns. Not investing your money gives zero returns. So even a 28% rate on Cap gains will return more than a mattress. Options trading involves huge amounts of money but because they’re short-term trades they are not eligible for preferred tax treatment. That certainly doesn’t deter options trading. The federal government got it right in 1987 when the tax code was changed to treat all income the same – wages, capital gains, and dividends (I’m sure there were some loopholes). Of course, lobbyists started working right away to undermine this equality and succeeded to distort the system the way it is today.

  2. Rick Schaut says:

    “And thus once again, we conclude the trickle down is BS…”

    Or, as the elder Galbraith might have said, the oats don’t even pass through to the road for the sparrows.

  3. aceroinox says:

    This is not rocket science. The tax on capital gains is lower because those gains have already been taxed at the corporate level. ‘Nuff said!

    • Chigliakus says:

      ‘Nuff said? Look, either corporate taxes are passed on to employees and customers (the argument that always gets trotted out to justify the extremely low taxes corporations currently pay), or they’re born entirely by the investors (as you suggest here). Which is it? You can’t have it both ways.

    • Jean says:

      Capital Gains have nothing to do with taxes at the “Corporate Level”. You are confusing that with Dividends.

      Capital Gain/Loss is the money one makes on an investment — house, securities, art, sole proprietorship, that kind of thing. The money you invested in the first place to buy said item was taxed when you earned it. And I believe that is true for corporations as well as people. The difference between what you bought it for and what you sold it for is the Gain/Loss. That money has never been taxed.

  4. save_the_rustbelt says:

    Couple of thoughts:

    Given globalization and changes in business models any data before about 1990 is really irrelevant to this question. Or perhaps 1987 is as far back as we should go.

    By taxing long term capital gains at ordinary rates the government would be taxing inflation at ordinary rates – good for the government, bad for investors – a very quiet tax.

    Hating on business is easy these days, but you also want business to crate jobs. Hate them or love them?

  5. readerOfTeaLeaves says:

    Capitalism is an economic system that seeks to concentrate wealth among private property owners – irrespective of whether the property (ie, ‘capital’) takes the form of intellectual content, real estate, securities, or other forms. There is an obsession on ‘capital’ as *the* primary generator of wealth.

    But as “The Spirit Level” shows, there are other factors than ‘capital’ involved in wealth creation. These include public goods like good public education, electricity, and other infrastructure — as well as epherma like ‘trust’ among social networks.

    But there is nevertheless some strange obsession about ‘capital’s role’ in wealth creation, as if ‘capital’ is the sole factor in generating wealth.
    But it isn’t.
    Which is why the whole hullaballoo around capital gains rates and the fear-mongering about what dire things will befall us all if those rates are lowered is intriguing. What about ‘wealth creation’ do these people not stop to consider…?

    I take the fear of lower capital gains rates as a symptom that the financialization of the economy has produced a culture that is now so overwhelmingly obsessed with concentrating, managing, and manipulating ‘capital’ that one explanation for lagging innovation and economic activity may be due to the obsessive attention to ‘capital’ at the neglect of the social and physical infrastructure documented in ‘The Spirit Level’.

  6. Th says:

    Thanks for the charts. Shows what I would have guessed.