Low Capital Gains Tax Rates Hurt The Economy

UPDATED BELOW

So the big news over the weekend was the leaking of President Obama’s proposed “Buffett Rule.”  Details are sketchy at this point, but he seems to be proposing that anyone with an annual income of $1 million or more face a minimum income tax rate at least comparable to that paid by middle-class Americans.  The name is derived from a NYT op-ed that gazillionaire investor Warren Buffett recently authored in which he decried the fact that – because investment income is subject to only the 15% capital gains tax rate – he and his fellow “mega-rich friends,” who derive most of their income from investments, often pay a lower tax rate than does his cleaning lady.  

Well, hell – it’s about damned time someone suggested this, and not only because it is obscene that hedge fund managers like John Paulson (who would be in jail on fraud charges if he worked in any field other than the American financial industry) can make more than a thousand million ($1B) dollars a year and pay a lower tax rate than a firefighter or a school teacher.  But also because taxing investment income at a lower rate than earned income hurts the economy by sucking money out of economically productive enterprises.  

And we really shouldn’t be doing that.

I’ve long thought that the vagueness of the language used to describe economic policy is one of the reasons it seems so confusing.  It is similar to the muddled understanding many people have regarding “the theory of evolution.”  In common, everyday English a “theory” is just idle speculation, something that your drunk college roommate comes up with in a late night dorm room bull session.  But as used in science, the term denotes much more:

[A] theory is an explanation or model based on observation, experimentation, and reasoning, especially one that has been tested and confirmed as a general principle helping to explain and predict natural phenomena. . . .  Before a theory is given any credence in the scientific community, it must [also] be subjected to “peer review.”

So, y’know . . . a little more rigorous a term than the know-nothings and Creationists would have one believe.

A similar flavor of confusion arises with the use of the term “investment.”  In common, everyday English when people talk about their “investments” they are usually referring to some portfolio of bonds and/or stocks or other instruments that produces a stream of income (stock dividends, interest payments, etc.) and that may increase in value over time.  These are financial investments.

But “investment” means something quite different in economic terms.  Economically speaking, an “investment” is money spent acquiring goods or other advantages that can then be used for future production.  Purchasing a factory, buying a machine, training workers . . . all of these are “investments” because the thing purchased will result in the future production of valuable goods and/or services.  This is economic investment, and because of the “multiplier effect” it is crucial to growing a prosperous economy.

The Importance of Economic Investment

The multiplier effect is the reason that spending money has an economic impact greater than the initial amount of money spent.  It results from what is called the “marginal propensity to consume” (MPC), which is just jargon-speak for the amount of money people tend to spend rather than save.  For example, someone with an MPC of 0.80 spends 80 cents of each dollar he or she receives and saves the other 20 cents. 

To see how the multiplier works just imagine that everyone’s MPC is 0.80, you go out to dinner, and the total bill including tip (‘cause you’re not a jerk) is $100.  The restaurant owner and server now have $100 in income, of which they spend 80 percent -- $80 dollars – going to the movies or buying groceries or whatever.  The increased spending of $80 becomes income to others, who also spend 80 percent of that $80, or $64 dollars, on other goods or services, and then the people who receive the $64 dollars spend 80 percent of that, etc., etc., etc.  When all the effects are totaled up, total economic output will have increased by $500 because the value of the output multiplier is equal to 1/(1-0.80) = 5.  So an initial $100 increase in demand results in a total increased economic output of $500:

TABLE 1
Round	Initial Change in Investment	Change in Output	Change in Consumption
1	$100	$100.00	$80.00
2	0	$80.00	$64.00
3	0	$64.00	$51.20
4	0	$51.20	$40.96
5	0	$40.96	$32.77
6	0	$32.77	$26.21
7	0	$26.21	$20.97
8	0	$20.97	$16.78
9	0	$16.78	$13.42
10 to inf.	0	$67.11	$53.69
Totals	$100	$500	$400.00

Now, the more likely one is to spend all or nearly all of one’s money the greater the multiplier effect will be.  This is why getting money into the hands of less affluent people provides a greater boost to the economy than does cutting taxes for rich people; rich people are doing fine already, and therefore don’t really have an incentive to spend additional money.  Cut taxes for the rich and that additional money in their hands tends to get saved, not spent.

But the way in which money is spent can change the multiplier effect as well.  In the example above, the initial $100 was spent on pure consumption – a nice meal.  Once the meal was consumed, its purchase provided no additional benefit to you or to anyone else.  But what if you spent that money on something that would provide additional future benefits?  Answering this question inexorably leads to distinguishing between “investment” and “spending” (a distinction the GOP likes to pretend it is incapable of recognizing).

For example, suppose there are two towns directly opposite each other on the Mighty Mississippi.  The two towns might want to trade with each other, but there is no ferry and the nearest bridge is an hour’s drive south.  That means that any trading to be done entails at least a 4 hour round trip between the two towns.

But suppose that in the grip of the Lesser Depression the government came in and spent $100 million building a bridge between these two towns such that travel time was cut from a 4 hour round trip to a 40 minute round trip.  Using the same MPC as in the previous example, the initial spending of $100 million to build that bridge would itself boost total economic output by $500 million.  But it would have a further effect as well because now there’d be a bridge.  The existence of the bridge makes trade between the towns less costly, which makes economic activity more efficient, which in turn continues to boost economic activity at least for the future economic life of the bridge.

Generally speaking, spending money on anything boosts economic output, but spending money on economic investments like a new bridge, or better roads, or a more efficient energy grid, or a new factory, or retraining workers, etc., etc., etc., provides an even bigger bang for the buck because such investments continue to generate economic activity into the future.  And this is precisely the type of investment that the tax code should be used to try to incentivize.  If we can use the tax code to spur investment of this sort then that seems like a good idea.

Unfortunately, our current capital gains tax law pretty much does the exact opposite.

Our Lower Capital Gains Tax Rate Rewards Non-Economic Investment

To be sure, the main justification that is claimed for taxing capital gains at a lower rate is that doing so boosts “investment”:

 

The United States government wants to encourage long-term investment in our nation’s economy.  This treatment of long-term capital gains versus regular taxable income makes profits from investments more attractive than profits from actively working.  Although it may seem unfair that a well-heeled, white-collar investor pays a lower tax on profits earned from selling shares of stock than a hardworking plumber, the theory behind it is that the money put to work in the business by the investor is going to create, ultimately, far more jobs because it will be used by the company in which he invested to build new factories, hire new secretaries, managers, executives, and mail room clerks, paint the walls, install new phone lines, launch new products, and much more. (emphasis added)

Did you get that?  The justification for using the tax code to “make profits from investments more attractive than profits from actively working” is to stimulate economic investment – that is, capital investment in things that actually grow the nation’s economy.  But when one examines the actual way in the tax code works, it turns out that the vast majority of income subject to the the capital gains tax does not result from economic investment – which means the asserted justification for this preferential treatment kind of falls apart.

For example, income earned on “collectibles” – fine wine, rare stamps or coins, antiques, art, etc. – are subject to a preferential capital gains tax rate, which clearly makes no sense if the purpose of this lower tax rate is really to stimulate economic investment.  If I were to purchase an antique car for $100,000, store it in my garage for a year and then sell it to another collector for $120,000, then my mere possession of that car for a year in no way would have done anything to boost the economy.  Still, the $20,000 I made would be considered “investment income” and would be taxed at the preferential capital gains tax rate.

But what about investments like stocks and bonds?  This is where the important distinction between economic investments and financial investments that was mentioned earlier needs to be kept in mind.  The truth is that purchasing stock or corporate bonds is only a financial investment and does not, in and of itself, necessarily constitute an investment in the economy.

Now, it is true that when a company or project needs to generate investment income to grow its business, or build a new factory or what have you, that company generally does so either by borrowing the money through the issuance of corporate bonds or by selling company stock to new investors.  When a company first issues bonds or stock to attract investment capital, the bonds and/or stock are said to have been sold on “the primary market.”  Technically, purchasing a corporate security – even on the primary market – is not, in and of itself, an economic investment.  However, because the money is going directly to fund the company’s further economic investment we are generally justified in eliding over that fact and can treat the purchase of corporate securities on the primary market as an economic investment.  So if the point of granting preferential tax treatment is to stimulate the economy, then doing so to incentivize the purchase of corporate securities on the primary market does make sense.

But the vast, vast majority of securities are not sold on the primary market – they are sold on the “secondary market.”  That is, they are sold on the market that is created by financial investors after the securities were first issued by the company. 

For example, if you decide you want to buy 1,000 shares of Google stock you don’t write to Google and offer to invest money in the company in exchange for 1,000 shares of new stock.  Instead, you go into the stock market and pay whatever the current market price is for those shares, and that money goes to whoever sells you the stock at, say, $100/share.  All that happens is the ownership of the stock has changed, but no new money gets invested the company itself.

Now suppose you hold that stock in your investment portfolio for a year and then decide you want to unload it.  So you go back into the secondary market and sell it at the new market price, which is $120/share.  You’ve just made $20,000 for holding that stock for a year and your ownership of that stock had exactly the same stimulative effect on the national economy as did my garaging an antique car for a year – none whatsoever.  Nevertheless, the tax code is going to tax your financial profit at the preferred capital gains rate for the claimed purpose of promoting “economic investment.”

None of this makes any sense.

Toward an Appropriately Limited Application of Capital Gains Tax Rate Preferences

Now, don’t misunderstand me . . . I’m not claiming that buying and selling antique cars or shares of stock on the secondary market, etc., etc.,  has no economic impact whatsoever.  In both examples the asset in question – the stock or the antique car – was sold twice, and both times one can assume that the person who sold the asset spent the money he or she received on something.  But the actual economic impact flowing from either example only comes from the seller’s spending the money – not from the buyer’s purchasing and holding the asset.  And it is the purchasing and holding of the asset that is being rewarded under current capital gains tax law.

In fact, most of what constitutes “investment activity” under our current tax code is activity that provides no direct boost to the economy at all.  This almost certainly is why even those who argue that our lower capital gains tax rates do spur economic investment nevertheless have to acknowledge that any evidence actually supporting their claim “is iffy at best, and [that] there are better way to spur investment, like, say, the [direct] investment tax credit.”

In fact, I would go further and suggest that the current treatment of capital gains by our tax code probably hurts our economy. 

For example, suppose a small business owner with a top marginal income tax rate of 36% has $100,000 to invest.  After careful analysis this entrepreneur believes that if he invests that money in expanding his business he will realize $5,000 more in profit over the next year – a return of 5%.  After accounting for income tax, that $100,000 economic investment will leave him with $3,200.  Perversely, he could just invest that same money into a stock portfolio that he expects to increase in value by 5% over the year.  After accounting for the capital gains tax, that $100,000 financial investment would leave him with $4,250. 

Clearly, the preferential treatment given to capital gains income means the hypothetical small business owner has a greater incentive to make a financial investment than he does to make an economic investment.  In this way, the existing tax code tends to suck money out of economically productive ventures and into financial ventures that do not, in and of themselves, contribute to the economy.

For these reasons, I’ve long believed that all income – whether realized through investment or through hard work – should be taxed at the same rate.  If the government wants to use the tax code to provide an incentive for companies to make economic investments, it can do so by issuing tax credits to businesses that actually, y’know, make economic investments. 

(At most, perhaps it makes sense to provide preferential treatment to individuals who purchase stocks and bonds in the primary market . . . but once that first sale of corporate securities has been concluded, there is simply no need to keep rewarding people who make money trading those securities in the secondary market, who make their money trading title to things instead of going out and doing something to build the actual damn economy.)

* * *

As I mentioned at the beginning, I haven’t seen President Obama’s specific proposal for how this “Buffett Rule” is supposed to work.  My guess is that when he says people earning over $1 million a year should at least pay as much as the middle-class means that they should be subjected to an aggregated income tax rate of at least 28%.  If I’m right, this means that the Buffett Rule doesn’t go as far as I’d like toward equalizing the treatment by the tax code of passive investment income and active labor income; ideally, I'd like to see all passive investment income taxed at the same top marginal tax rate that these millionaires would be required to pay if they were actually working for a living.

But it’s a start.

UPDATE:  From Kevin Drum:

I've never seen any compelling evidence that higher capital gains rates have more than a minuscule effect on investment. Changes in rates can have short-term effects as investors rush to sell assets before new rates takes effect, and high rates can also produce a modest "lock-in" effect, in which investors hold on to assets in order to avoid taxation.

But the long-term effects appear to be very small, and low rates have a serious drawback: they spur a huge amount of unproductive tax sheltering as wealthy taxpayers spend time trying to figure out how to redefine ordinary income as capital gains. This is not just useless, it's positively damaging. What's more, capital gains already get favorable tax treatment just by virtue of the fact that gains can accumulate year after year tax free. You only have to pay taxes when you sell, and the net effect of this is a low effective tax rate compared to income that you have to pay taxes on as it's earned.

My own take is that capital gains rates should, perhaps, be a bit lower than ordinary income rates, but only a bit. Maybe 30% or so, compared to 35% or 40% for ordinary income. I'd sure like to hear the case that a lower rate really has any significant long-term negative effects on investment or capital formation.