While there are many hot-button topics on the table for the presidential election, I wasn't exactly expecting taxes to be one of those topics. Bernie Sanders, for instance, wants to substantially increase taxes. Just with his health care plan alone, the American people would be given a bill that would amount in the trillions, thereby adding to the already high-deficit. One of the taxes that he intends to increase is the capital gains tax. The capital gains tax is levied when an investor sells capital, e.g., stocks, bonds, property, for a price that is higher than the initial purchase price. The capital itself does not trigger the tax, but rather the sale of said asset. Sanders wants to tax capital gains the same as income from work, which would de facto tax capital gains at a 65 percent rate. Republican presidential nominee Marco Rubio, on the other hand, wants to do away with the capital gains tax all together. This repeal would be a departure from past establishment Republican candidates. Last week, the Tax Policy Center published a research paper on Rubio's tax plan, finding that the plan would cost the government $6.8T over the next decade, create a deficit of $8T over the same time period, and would disproportionately provide the rich with more after-tax income in percentages. The Tax Foundation came to a similar conclusion regarding Rubio's tax plan. However, repealing the capital gains tax is only part of Rubio's tax plan. His plan also includes such policies as increasing the child tax credit, repealing any taxes related to Obamacare, and converting the income tax into a consumption-based tax. Since the analyses of his tax plan do not isolate the effects of repealing the capital gains tax, it begs the question: what sort of effect would a repeal have on the economy?
A higher capital gains tax rate has many disadvantages, as this Cato Institute policy bulletin illustrates. In addition to collecting revenue, the primary effect of taxation is disincentivizing behavior. In this case, the capital gains tax discourages savings and investment because the effective tax rates on saving for future consumption are higher than for current consumption. Given that the marginal propensity to consume is at an astonishingly high 90-98 percent (although the Congressional Research Service found that the savings rate went from 12.1 percent in 1951 to -1.9 percent in 2009 [p. 3]), the United States could actually use more of an incentive to save. Capital formation is a such an essential component of economic progress that even someone as anti-capitalist as Karl Marx recognized its potential for economic growth. In order to invest properly, the savings rate that the tax code allows affects how much we save, as the head of the National Bureau of Economic Research has found (Poterba, 2004).
Since capital gains taxes are accrued on a realization basis, the capital gains tax leads to what is referred to as the lock-in effect (Bauer, 1990). The St. Louis Federal Reserve Bank brought this up back in its 1995 analysis of the capital gains tax, and pointed out that being less likely to sell securities [and pay the capital gains tax] is problematic for small, start-up companies since it incentivizes them to hold onto previous investments instead of selling them in order to build up their business. Generally speaking, this effect makes it more difficult to reallocate capital in low-performing investments to more profitable ventures. There is also a double taxation effect of the capital gains tax, at least in the United States, since the profits of corporations are first taxed at the corporate level, and then at the stockholder level (CBO, 2014, p. 17). When looking at tax rates, we would need to look both at corporate income tax and the capital gains tax. This is more troublesome given inflation. Under the current tax code, it is entirely possible to be taxed solely or mostly based on the "gains" caused by inflation. This could be solved by either indexing the tax for inflation or compensating with a lower tax rate, but those alternatives have yet to be implemented in an American context to address inflation.
There are also government revenues to consider. Historically speaking, the capital gains tax revenue has amounted to about 2-4 percent of GDP during most years, which is to say that it's a small, but not insignificant amount considering that general tax revenue as a percent of GDP is usually somewhere between 15 and 18 percent. In 2012, the Congressional Budget Office (CBO) found that long-term responses to capital gains realizations is quite significant, which is to say that revenue would not be anywhere near as high as anticipated due to the elasticities. As such, there is a general positive correlation between pre-tax rates of return and lower tax rates (Sikes and Verrecchia, 2012). When looking at historical data on capital gains tax rates and revenue as percent of GDP, this phenomenon would help explain why capital gains tax revenues as a percent of GDP actually increased when President Bush reduced the capital gains tax rate. A professor at Ohio State University found that the optimal percentage in terms of revenue collection is just under 10 percent.
One of the downsides, at least during an election cycle that's emphasizing income inequality, is that a capital gains tax cut or repeal would be regressive in the sense that it would disproportionately affect the rich. As the Tax Policy Center shows from analyzing capital gains tax preferential rates from 2012, the policy would disproportionately affect those in the upper socioeconomic quintile. This makes sense, considering that richer people are more likely to own capital [in larger quantities] (CRS, 2010, p. 8). The question is whether reducing or repealing the capital gains tax would help or harm economic growth.
In 2008, the Right-leaning Heritage Foundation released a paper postulating how an increased capital gains tax would reduce capital stock, employment, personal incomes, and the GDP. As the Tax Foundation also points out, realized gains as a percentage of GDP increase when the top capital gains tax rate falls. The American Council for Capital Formation, which is an organization representing a wide range of businesses, published an economic analysis in 2010 finding the negative effects that higher capital gains tax rates have on economic growth (also see Congressional testimony here). The Right-leaning American Enterprise Institute also published a 2013 report on the adverse effects of the capital gains tax, and why a consumption-based tax would be preferable. The positive outcomes can also be observed in Canada when Canada decided to lower its capital gains tax (Clemens et al., 2014).
Conversely, the Left-leaning Center for Budget and Policy Priorities (CBPP) finds opposite results from those of the Heritage Foundation, and that lowering the capital gains tax would be inequitable, costly, and would not help with economic growth. Another argument against lowering the capital gains tax is that the fluctuation of capital gains tax rates along with lowered income tax rates makes it more difficult to determine the efficacy of lower capital gains tax rates (CRS, p. 4). This does not automatically negate the argument that higher capital gains tax rates are problematic, but rather that income taxes have larger effects on economic growth since they are taxed at a higher rate. This still does mean, however, that lower tax rates (in this case, capital gains) would be helpful both from a standpoint of revenue collection and economic growth. The Congressional Research Service also published its 2010 report on the economic effects of the capital gains tax, and finds that enough of the claims for a lower capital gains tax rate are tenuous.
Ultimately, the United States government can repeal the capital gains tax, lower the tax rate, or implement some policy reforms so that the adverse effects of the capital gains tax are not so bad (see here and here). There are countries, such as Switzerland, South Korea, the Netherlands (has some exceptions, but generally exempt), New Zealand, and Turkey, that do not have capital gains taxes, so it's not as if it can be done or as if tax revenues could not be collected on income to supplement tax revenues. An argument can be made for a zero-percent capital gains tax rate, and an argument an be made for a significantly lower capital gains tax rate. One thing that can easily be argued is that that the capital gains tax rate is currently too high, and it would be nice to see that this discussion results in a lower capital gains tax.