Argument For and Against Capital Gains Tax Cuts

BY Paul Solman  December 5, 2012 at 2:07 PM EDT

CQ-Roll Call Group
Co-chairman of the National Commission on Fiscal Responsibility and Reform former Sen. Alan Simpson, R-Wyo., left, and Erskine Bowles, former White House chief of staff recommend taxing capital gains as ordinary income. Photo by Bill Clark/Roll Call via Getty Images.

Paul Solman answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here is Wednesday’s query:

Reuben Pasquini: Hi Paul! I’d enjoy hearing arguments for and against taxing capital gains at a lower rate than income from labor. In favor of a lower tax rate, I found ideas like these:

Making Sense

  1. Capital gains are not adjusted for inflation. But why not just allow consideration for inflation in the tax calculation?

  2. A lower capital gains rate encourages savings and investment. But I’ve also read there’s no correlation in the data, and intuitively, someone with capital would want to invest regardless of taxes.

Anyway, all the talk about Romney’s tax returns got me thinking about this, and Simpson-Bowles apparently recommends taxing capital gains as ordinary income. Does Obama favor that?

Thanks for the great work!

Paul Solman: Thanks for the exclamatory enthusiasm, Reuben, and cheers to you too. As to substance, you raise the relevant issues.

With regard first to inflation, let’s take an extreme case to make the point. You invest $10,000 in a friend’s start-up. It struggles for a decade but in its tenth year it takes off and your share catapults in value to $110,000. You sell and pay capital gains on the $100,000 gain. At the old capital gains rate of 28 percent, you would pay $28,000.

Let’s further imagine, darkly, that rampant inflation has begun to rage, returning us to the double-digit rates of the late 1970s. The dollar lost about half its value in the decade from 1970 to 1980. If history dittoed itself with regard to inflation, your $100,000 gain would only be worth $50,000. So you pay $28,000 on a “gain” that is worth, in real (ie, inflation-adjusted) dollars, only $50,000.

(Note, however, that because of inflation your $28,000 tax payment is also much lower than if paid earlier.)

You suggest the simple fix that would solve the problem of overtaxation due to inflation: index capital gains to inflation, just as we index Social Security and all sorts of other benefits via “cost-of-living” adjustments (COLAs) that account for inflation. We even inflation adjust our Social Security taxes: the ceiling on taxable income changes with the inflation rate. Index the capital gains tax rate in like manner and voila, problem solved.

Your second point: the benefits to growth attributed to capital gains tax “reform.” The argument is that if you lower the tax on capital gains, those who have them will keep more of their money and save it, which will inevitably find its way into investments that, on the margin, will add to economic growth. This seems especially true of folks with capital gains, since they are more wealthy than average Americans, and therefore figure to save more of any extra income — for the simple reason that, after they’ve earned a lot, there is less and less to spend the extra money on.

This story seems true. How could it not be? But this no more proves that a capital gains cut is a net positive for the economy than giving money to rich people is a way to increase overall investment. Come to think of it, that’s what a capital gains tax cut boils down to: handing back to rich folks the money that would otherwise have come to the government in the form of taxes because of a tax rate previously considered legitimate.

The lack of correlation you refer to is failure to find, in the data, a growth spurt in the wake of a capital gains tax cut. In fairness, economic growth depends upon many factors. Any correlation analysis has to hold the main variables constant before pronouncing on a statistically significant relationship between two variables like a tax cut and growth. And even a statistically significant correlation does not prove a causal connection. The sun rises every morning and so does yeast; 100 percent correlation, but so what?

In short, the burden of proof that capital gains tax cuts lead to economic growth falls on those who espouse the cutting.

And it’s a funny thing; I can think of a more obvious reason than growth to explain such espousal: cash on the barrelhead for the cuttees. But hey, if you buy the argument, I’ve got another proposal for your consideration. How about a tax cut for PBS economics reporters? We should be particularly good at choosing wise investments to grow the economy and lift even your boat, don’t you think?

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions