Here is an interesting article from the Washington Post concerning debate on capital gains tax. While the authors discuss some interesting points, they fail to touch on a few key issues:
1. As far as tax revenue goes, the S&P 500 is down about 12% over the last 5 years and up only about 2% over the past 10 years, so raising the capital gains tax will generate little additional revenue in the short-term (assuming the S&P 500 is a good proxy). Furthermore, the authors imply that capital gains is responsible for the widening wealth gap over the past 10 years but this evidence suggests there’s more to it than that.
2. Equity prices are a function of after-tax expected future returns (based on perceived levels of risk). All else equal, if the tax rate is raised, equity prices must adjust downward to maintain the same level of expected return. In other words, raising cap gains taxes should send the market down. Even those with tax-exempt accounts would experience these effects due to those with taxable assets who own the same stocks/investments.
3. Private equity managers that only pay capital gains tax do so because they are not paid a salary. Instead, they risk their own capital by investing alongside the limited partners in the fund. In other words, these managers have significant capital at risk, just like other investors that pay capital gains taxes.
-Bill Ray Valentine
I referenced Barrow’s paper in a previous post. It is an academic paper so it may be difficult to comprehend totally. Here’s an oped piece he wrote in the WSJ that distills the analysis done in his paper on the multiplier effects of (government) spending and changes in tax code. Worth the read.
I found this study to be very interesting. In a nutshell, it finds that unanticipated tax cuts most effectively juice the economy. The authors also consider temporary cuts and anticipated tax changes. The findings show the effects of temporary cuts are less significant. If you can’t stomach the entire whitepaper, at least read the summary and check out the charts on page 41 which show the effects of a 1% tax liability cut on output, consumption, investment, hours, and real wages…… all positive.
The prevailing tug-of-war throughout the debt ceiling debate had to do with taxes: is it better to tax and (government) spend or cut taxes so money remains in the pockets of the American consumer/businessman/investor. I found this blog post from Greg Mankiw dated late 2008 that does a good job of summing up what we know. In theory, tax and spend should pay dividends, but the empirical evidence shows that the multiplier is less than one in most cases, and may even be negative. In contrast, studies show that there is a significant multiplier effect for permanent tax cuts (click on the Romer and Romer study link embedded in Mankiw’s blog). Another study by Harvard professors Robert Barro and Charles Redlick published in February 2010 show tax increases do have a significant negative multiplier effect, while government spending (specifically defense spending) has a multiplier effect that is less than 1x. In summary, most work done on this topic suggests tax cuts may generate more profound economic growth, while the returns from government spending are diminishing. This is significant work politicians should read given the current debate and the fragile economic times in which we live.