Should the Capital Gains Tax Rate Be So Low?

Paul Krugman investigates the history of the capital gains tax rate, and looks into whether or not the arguments for the current low rates hold up to scrutiny. Spoiler Alert! They don’t:

Defenders of low taxes on the rich mainly make two arguments: that low taxes on capital gains are a time-honored principle, and that they are needed to promote economic growth and job creation. Both claims are false.

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And the economic record certainly doesn’t support the notion that superlow taxes on the superrich are the key to prosperity. During that first Clinton term, when the very rich paid much higher taxes than they do now, the economy added 11.5 million jobs, dwarfing anything achieved even during the good years of the Bush administration.

Kevin Drum goes into more detail, in a post that is well worth your time. The following chart, which I have stolen from Drum, shows the capital gains tax rate in blue, and the realized gains in red:

Drum explains:

Do you see a correlation? I don’t. What you see are two things. First, when people know rates are about to go up, they sell their assets quickly to beat the tax man and take advantage of the current rates. You can see that in 1968 and 1986. Second, capital gains skyrocket during investment booms. You can see that during the dot-com bubble of the late ’90s and the housing bubble of the aughts. When you remove those artifacts, there’s pretty much nothing left. No matter what the tax rate is, the level of capital gains pokes along at about the same rate. The same thing is true if you lag the results by five years, and you can see a similar result here, in a chart that compares capital gains rates to total investment levels in the US economy. There’s simply no correlation. All taxes have deadweight costs, and it’s likely that capital gains taxes have some impact on the economy, but all the evidence, both in the US and internationally, suggests that it’s pretty modest.

Simply put, there’s really very little evidence that an increase in the cap gains rate dis-incentivizes investing, as folks like Mitt Romney would have you believe. This makes sense if you think about it. Lets say I’ve identified an investment opportunity that will allow me to earn 100 dollars in profit. At the current cap gains rate, I’ll take home 85 dollars. Doubling the cap gains rate to 30%, I’ll take home only 70 dollars. But if I don’t make the investment because I want to avoid taxes, I’ll take home 0 dollars.

Jared Bernstein, in another good article, quotes Warren Buffet (who’s not exactly bad at investing)  making this argument:

“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.”

Matt Yglesias, in responding to Drum’s piece above, makes the point that the cap gains rate doesn’t exist in a vaccum, and the policy changes that come with it matter:

If we reduce taxes on investment income and increase taxes on fancy horses, the claim that the Romney family will shift money away from horses and into investments makes perfect sense. If we borrow a bunch of money in order to reduce taxes on investment income, then the behavior response of the Romney family is unclear and the net effect on the national savings rate could easily be negative. What’s more, the horse tax option doesn’t have regressive distributional consequences but the borrow-the-money option does. If you see the regressive distributional consequences as a feature rather than a bug, then of course borrow-the-money may look appealing, but if not there’s no reason to embrace it.

Drum concurs, and then gets at one of my pet peeves:

Hauling out an Economics 101 argument is almost never enough to shed much light on any public policy problem that’s controversial enough to be interesting. Will a tax cut incentivize certain behavior? Sure, probably. But how much? If the effect is small, does it get swamped by other things? And how does it compare to alternate proposals? Unless you can get halfway plausible answers to those things, you’re just being sold snake oil.

Yes! Any time you hear an argument that relies entirely (or almost entirely) on “if we raise / lower the whatever tax, then people will /will not do whatever” you should be very skeptical, because these arguments may sound convincing, but are rarely backed up by evidence. I think people have a tendency to over-attribute behavior to changes in the tax code. I’m not suggesting that changes to the tax code do not have some effect. At the margins, there probably is behavior change. Certainly for those that have the luxury to do so, changing your habits in such a way as to minimize your taxes makes sense. But the majority of people are not in that situation. Most folks do what they have to do to get by. They live where they live because it’s where their job / family / spouse / favorite sports team is, not because the property taxes are slightly lower.

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