The Bush Capital Gains Tax Cut after Four Years: More Growth, More Investment, More Revenues

NOTE: since Obama doesn't understand the basics of economic theory, maybe a current example would be helpful for him. Subway sandwiches has a special promotion for any footlong sub for $5. In some cases, that saves up to about $1.70 on a footlong sub. What has that done? According to the store where I have bought more sandwiches than usual, the amount of subs they are selling has increased dramatically. A similar paradox for this lowering of price to increase revenue works with taxes. Lowering taxes raises the revenue to the treasury. It is amazing how that works. If Obama doesn't understand that simple economic reality, he has no business holding any elective office, especially the presidency of the United States.

How is it that lowering capital gains taxes leads to more revenues? As noted before, the capital gains tax is a voluntary and easily avoided tax. When the tax rate is high, investors simply delay selling assets — stocks, properties, businesses and so forth — to keep the tax collector away from their door. When the capital gains tax is cut, asset holders are inspired to sell. Moreover, because a lower capital gains tax substantially lowers the cost of capital, it encourages risk-taking and causes the economy to grow faster, thus raising all government receipts in the long term. So the torrent of new revenues into government coffers was really no mystery at all; in fact, it was predictable.

“The capital gains tax is voluntary — investors can avoid it by holding on to assets.”

An Increase in Tax Revenues. There are now at least three years of data to test the effect of the capital gains tax on capital gains receipts. Figure I shows that from 2002 through 2005, capital gains receipts nearly doubled (from $55 billion to $100 billion). The latest estimate for receipts in 2006 is $110 billion.7 This is an increase of more than a 100 percent over four years.

These gains in tax receipts were not expected by the Congressional Budget Office and the Joint Committee on Taxation, which officially score tax changes. Figure I compares capital gains revenues with the forecast made when the tax cut was proposed. Again, a lot of the increase was due to the sizzling stock market over the past three years. But a lower capital gains rate increases the after-tax return on capital, helping create the strong market.

The lesson here is that the impact of tax changes cannot be properly predicted without assessing how the tax policy changes will influence the behavior of workers, entrepreneurs and investors. The static economic models used by the Joint Tax Committee and the Congressional Budget Office have had limited predictive powers.

Stimulating Investment and Capital Formation. Virtually all economists agree that capital formation is an essential component of a strong U.S. economy. So it is worth investigating whether the 2003 tax cut had a positive effect on the rate of business investment and capital formation.

In theory, one would expect lower capital gains tax rates to inspire a chain reaction of greater investment spending and higher asset values. When Congress chops the capital gains tax, it increases the after-tax rate of return on real assets (like plant, equipment and technology), and thus the value of the stock rises. Remember: a capital gains tax is merely a punitive second layer of tax; the value of a capital asset is no more nor less than the discounted present value of the revenue stream it produces. A rational tax system would tax the income stream or the asset value, but not both.

“Capital gains revenues more than doubled over four years, following the 2003 tax cut.”

U.S. industry experienced a rise in the cost of capital as a result of changes in the 1986 Tax Reform Act. Although a number of factors (including the institution of the corporate alternative minimum tax, changes in depreciation allowances and elimination of the Investment Tax Credit) have contributed to rising capital costs in the United States, one of the most important tax penalties on capital was the hike in the capital gains tax.8 Altogether, the added tax burdens imposed on capital investments in 1986 widened the gap between the income derived from a capital project, such as investment in a new plant, and the after-tax return to the firm and its stockholders.

America’s unfavorable tax treatment of capital investment after 1986 caused an observable slowdown in the rate of growth in U.S. capital formation. Between 1986 and 1992, business fixed investment fell by half. Business investment in equipment fell by one-third over the same period. Investment rebounded somewhat beginning in 1992, but really accelerated with the 1997 cut.

After falling again at the beginning of the current decade, investment increased sharply following the 2003 tax cut, as shown in Figures II and III. Business investment experienced a U-turn. For two years, 2001-02, business investment in equipment and software was negative, but in 2003-06 the numbers were highly positive, with an average annual increase in business investment of more than 10 percent.

Many of the economic models had predicted this recovery in business capital spending. For example, the model for a U.S. Chamber Foundation study, which estimated the impact of rolling back the capital gains tax to 15 percent, predicted that the cost of capital to the corporate sector and noncorporate business sector would fall, and the tax-exempt bond rate would rise.9 The researchers found that those economic responses to the tax cut would have the following consequences for capital formation:

The size of the business capital stock, both corporate and non-corporate, expands relative to the size of the capital stock devoted to housing and consumer durables and to state and local capital. In the present model with a fixed aggregate capital stock, these results imply that the business capital stock increases and the other elements of the capital stock decline. In a growth context, of course, the business capital stock would simply grow faster than other components of the capital stock.10

That is almost exactly what did happen after 2003. The evidence supports the supply-side theory that lower capital gains rates stimulate more capital investment and growth.

Improving U.S. Global Competitiveness. One indication of which nations will prosper economically in the future and which will fall behind is the flow of international capital. In the 1980s, after marginal income tax rates were reduced by more than one-third, the United States attracted a net of nearly one-half trillion dollars of foreign capital. That is, foreigners invested $520 billion more in the United States than U.S. citizens and companies invested abroad. In recent years, nations have dramatically cut tax rates to become more competitive. The average income tax rate is 20 percentage points lower than in 1985 and the average corporate tax rate is almost 25 percentage points lower.

“Investment in technology (net of depreciation) went from negative to positive.”

How does the U.S. capital gains tax rate compare with that of other nations? Today the United States, even with the 2003 rate cut, still has a higher capital gains tax than many industrial nations. Table IV shows that many of America’s principal trading partners have lower rates on capital gains than the United States. In fact, many of our major international competitors — including Germany and Switzerland — impose no tax on long-term capital gains. Australia and the United Kingdom have higher capital gains tax rates, but because both those nations allow for indexing the value of the base asset to account for inflation, the effective tax rate may still be lower than the U.S. tax rate.

What is of even greater concern is that if the United States were to repeal the Bush tax cuts, the U.S. capital gains rate would be well above the international average, according to data from the American Council for Capital Formation. As Figure IV shows, returning to the 20 percent capital gains rate might repel foreign direct investment in America by increasing the cost of investment here.

"W isn't a supply sider. He's a demand sider who likes lots of government spending, a weak dollar, illegal alien slave labor, and high commodity prices. His record on regulations isn't so great either."

Nobody said GWB was Reagan, but think of what Gore or Kerry would have done, instead of what GWB did.

Could we do better? ALWAYS! Was GWB the best alternative to the socialists Gore and Kerry? ABSOLUTELY.

Even Reagan, AT BEST, battled government spending to a stalemate, GWB has played the best he could with a weak hand dealt to him by the American people who elected a limp, socialist and communist bunch of representatives.

So an increase in capital gains receipts because of a lowering of the rate is a bad thing? No, the bad thing is too much spending.

GWB has played the best he could with a weak hand dealt to him by the American people

You mean the American people who held firm and demanded he start enforcing immigration law no matter how demeaning he was to us? Or the American people who convinced him to drop Harriet Miers?

Even if Obama understood this perfectly well, which is highly doubtable, there is no way he would change his position. Maximizing revenue is not as important as being perceived by the Democratic base as someone who will inflict pain on the rich for the sin of having money.

-ccm

People’s lack of economic understanding is staggering

One of my coworkers fit this discription. He caught on fairly quickley when he jumped into the 28% bracket when his wife took a lump sum vacation payout at retirement, etc..

The increase in debt is not a consequence of increased tax receipts.

You are correct that the increase in debt is not a consequence of increased tax receipts. The increase in capital gains tax receipts is a consequence of increased borrowing to make up for the shortfall in general revenue when the tax burden is lowered. The effect of more money in peoples pockets plus the same or higher spending by the government stimulates the economy leading to higher tax receipts but never enough to make up for the increased borrowing. Some day, we will have to pay the piper and it will be ugly.

The increase in capital gains tax receipts is a consequence of increased borrowing to make up for the shortfall in general revenue when the tax burden is lowered.

I don't buy that explanation either. The revenues increase as a consequence of increased economic activity by parties who sit on the sidelines when the rates are higher. If there is increased borrowing, it is from the same numb skulls that are engaged in the increased spending. Politicians only care about getting re-elected.

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