Wednesday, August 17, 2011

Could We Raise the Capital Gains Tax Rate without Hurting Investment?

Berkshire Hathaway Chairman, Warren Buffett, recently wrote an op-ed for the New York Times that has set off a bit of a firestorm.  It was featured on the main page of the Huffington Post and it seems as though all of my friends shared the op-ed on Facebook.  Buffett urged Americans to "Stop Coddling the Super-Rich," in our tax policies.  He explained that he paid a lower rate of taxes than many of his office mates, despite the fact that he earned much more than them.  This would seemingly go against our graduated (or progressive) system of taxation where we tax higher earners more than we tax lower earners.  How did that happen?

Warren Buffett and President Barack Obama (photo: Pete Souza)

He argues that because the long term capital gains tax is much lower than income tax rates it is a lower tax that allows many wealthy Americans to not pay their "shared sacrifice."  He points out that many wealthy investment managers earn their "daily labors" as a result of "carried interest" (long term capital gains) and then are taxed at only a rate of 15%.  The main thrust of his argument is that those who "make money with money" should have higher taxes.

He is correct that long term capital gains are taxed at a much lower rate than income or short term capital gains which are broken down into six brackets: 10%, 15%, 25%, 28%, 33%, and 35%.  Long term capital gains are taxed at two rates: 0% and 15%.  He is correct that if a stock trader makes 5 million or 5 billion dollars income from long term capital gains (investments longer than one year) they will only pay a 15% tax as opposed to the 35% they would be taxed if it was a wage or a short term capital gain.

Buffett has long argued that this tax rate could and should be raised.  This argument has gained some steam because of the large budget deficit and mounting debt of the U.S. government.  Part of recent debt ceiling negotiations involved potential tax increases or the elimination of tax deductions and loopholes.  It does seem that Democrats are willing to get somewhat creative in potential tax hikes.

Buffett also argues that raising the capital gains tax will not have an adverse effect on investment.  "I have yet to see anyone - not even when capital gains tax rates were 39.9% in 1976-77 - shy away from from a sensible investment because of the tax rate on the potential gain.  People invest to make money, and potential taxes have never scared them off."  This sounds like a very good observation from a credible witness.  So, is he correct?  Is there any economic literature on this?

One thing that is important to remember is that investment is a form of demand much like it's counterpart, consumption.  Investors purchase investments, such as stocks, just like a consumer purchases toys and food.  The important difference being that investments are productive by definition.  To the extent that they fail and are less than productive they become consumption.  In a depressed economic environment, such as a recession, policy makers have to be careful not to dampen any forms of demand.  This is why increased taxation is not encouraged, because it keeps prices high (er) and perhaps out of reach of purchasers (who are only able purchase them at lower prices).  Decreasing prices is natural in a recession and should not be discouraged.  The market needs to clear and discover its new equilibrium (in a macro sense).

There is an important relationship between how much a society consumes and how much it invests in the future.  I don't know that there is any sort of optimized relationship between these two, but many societies such as the United States are criticized for consuming too much.  Fewer societies, such as Japan, are criticized for investing too much.  Finding that balance is important, and most governments offer lower taxes on investments as a way of incentivizing it.  In the United States, home owners can deduct their mortgage and students can deduct their student loan payments.  Both of these are meant to function as incentives to invest in our own homes and human capital.  Fewer incentives are given for consumption, because consumption is somewhat inevitable.  We all need food, but we don't all need a degree in economics or any degree at all.

Brief Literature Review

A study by Janet Meade is titled "The Impact of Different Capital Gains Tax Regimes on the Lock-In Effect and New Risky Investment Decisions" for The Accounting Review.  She argues that capital gains taxes in general discourage investment because of the lock-in effect.  The lock-in effect proposes that investors stay with investments longer because they are already committed to certain amounts of taxes, and that increased capital gains taxes can create higher transaction costs.  She states that investors hold their assets even after accrued gains begin to lag other potential investments because they are already locked into the tax (and may also be attempting to wait out capital gains tax in lieu of the simple, so-called death tax).  This lock-in effect discourages investment in riskier and more profitable investments instead of current investments.

Martin Feldstein wrote an article titled, "Inflation and the Taxation of Capital Gains" for Challenge arguing that nominal inflation coupled with tax rates was effectively creating larger tax rates and that this would discourage investment and capital formation.  He wrote this article in 1978; a period of high inflation and high capital gains taxation.  During this period taxes were 100% or more on the real rates of returns for investors.  Inflation has a significant effect on returns.  Inflation (and I could argue, the threat of inflation) also potentially acts in confluence with tax rates to discourage long term investment.

Yves Balcer and Kenneth Judd studied this subject in 1986 with their article "Effects of Capital Gains Taxation on Life-Cycle Investment and Portfolio Management" in The Journal of Finance.  Their study somewhat agreed with Buffett, "These calculations show that capital income taxation has an impact on capital structure, but not as stark a one as typically hypothesized.  Individual investors will demand both assets over the life cycle, choosing the one which is best for investment at the moment." (755)

As you may have noticed, none of the studies that I could find directly studied Buffett's idea.  I have a hard time believing that the effects of capital gains tax rates on the amount of investments has been overlooked by finance academics, but I was searching all of JSTOR and these were the closest I saw.

The main argument against higher taxation in general (above basic, pure public goods, and other cost benefit passing functions of government levels) is that taxation creates dead weight losses, thereby reducing economic activity.  The lock-in effect is generally one of the stronger arguments against (specifically) capital gains taxes.  The idea is that it discourages new investments over held investments.

The Non-Conclusion

Warren Buffett goes after the rich in his title and his intent, but his plan is plainly targeting the capital gains tax rate.  I've focused on the idea rather than the hyperbole.  Buffett's main idea needs more study if it is to be pursued.  Perhaps these studies exist and I am not aware of them (please post them in the comments if you find any).  I am still somewhat skeptical of his idea but this would be the question I would pose if I were to start a research project on the subject: Is it possible that taxes are less disincentivizing on stochastic equilibriums such as investments than on determined equilibriums such as consumer products?  If the answer is yes, then raising the capital gains tax might be a decent option if Congress decides to raise taxes.


  1. I thought that the benefit of low tax rates on capital gains was that it incentivized selling investments therefore increasing spending. I thought nothing was worse for the economy in bad times than people hanging on to their investments. Lower taxes, and people started selling to realize their gains and then spending it, therefore stimulating the economy. Or do I have it wrong? What say you, economist? Sandra Raup

  2. As I indicated above investment and consumption are both forms of demand. So increasing either of them is generally very good for a recession. It is very good for individuals to keep on investing during a recession, but they should do so in their own interest and not for the sake of the national economy as it is their own risk and responsibility. Nothing is worse for the economy in bad times to sit on money. That is, to neither invest it nor spend it, because then it exits the demand equation altogether. JW

  3. Adam Millsap via LinkIn:

    The answer Mr. Ward gives is well thought out and prudently exercises caution when making a conclusion.

    Mr. Buffet's statement however, is outrageous. His inductive reasoning that just because he has never seen it it must not exist is childlike at best, though methinks he sounds like a fool.

    Mr. Buffet is not thinking like an economist, that is, thinking about the margins. Saying that a raise from 15% to 25% does nothing begs the question, what about 25 to 26? Then 26 to 27? The only logical conclusion one can reach based on Mr. Buffet's broad idea that taxes on potential gains have no effect on capital investment is that people would still invest if the tax rate was 100%! Surely Mr. Buffet himself would not invest if any gains he made were to be taken from him by the tax man. Again, one can think about the margins and work backwards from 100. A 99% tax rate would get more investment than a 100% rate, all else equal. 98% more still. And so on and so on down to 0, which would surely get the most investment.

    People can genuinely debate how many individuals are affected by a change in any given level of taxation, but to take the ridiculous stance that raising and/or lowering taxes from any level does nothing is to defy common sense.

  4. Steven Landgraf via LinkedIn:

    Is the effect on capital gains tax linear or non-linear? That question is just as important. Of course investment would be curtailed at a 100% rate, but could increasing a low tax rate to a slightly "less lower" rate (say from 15% to 25%) have the same effect as increasing it from a high rate to an even higher rate (say from 75% to 85%)? That is to say, is there a threshold, where investors find capital gains taxes to be too burdensome and switch almost everything to some alternative to maximize utility?

  5. Adam Millsap via LinkedIn:

    Thanks for your comment Steven. Are you referring to some version of the Laffer curve? What effect are you talking about? Government revenue? Absolute levels of investment? Some other effect? Perhaps there is a high level of taxation that yields the same govt revenue as a low level of taxation, as implied by the Laffer curve. As far as absolute amounts of investment go, I do not see how, holding everything else constant, that an increase in the price of investing would actually increase investment, which was my main point. I know of no upward sloping demand curves.

  6. Steven Landgraf via LinkedIn:

    I'm thinking more along the lines of balancing an increase in gov't revenue with disincentivizing investment. I think along all possible tax rates an increase in the rate will disincentivize investment by /some/ degree, but that degree could possibly not be constant along all rate levels. I use "degree" here in a highly abstract manner.

    I guess I am thinking of some Laffer-type curve. Buffet's argument that a sensible investment is still sensible whether it is at a 15% or 25% tax rate rests on the assumption that at those lower rates, there opportunity cost of saving/investing is worth making an investment, i.e. the alternatives are not as "sensible." At a 100% tax rate, there would obviously be a multitude of better options than something that would incur a capital gains tax. The trick is finding a middle-ground.

    Buffet (indirectly) is implying that a 25% rate provides benefits of increases in gov't revenue and more equal income distribution that is greater than the costs to society of reduced investment (i.e. the reduction in investment is inconsequetial compared with the "benefits."

    Whether that is actually true rests on emprical tests and the social welfare function.

  7. Adam Millsap via LinkedIn:

    Sure, I understand your point and I agree that the true effect of an increase in tax rates can be relatively large or small. Empirical tests can help find the approximate answer.

    This is just my opinion, but I do find the idea of a social welfare function very strange. To say that one should maximize govt revenue or maximize the equality of income distribution is an odd goal. As Friedman and Hayek said, societies do not have preferences, people do, and I am not sure how aggregating up the preferences of individuals can lead to some grand welfare function. It is a curious objective to maximize "social welfare" in my eyes, but I do know a lot of people like to do it, perhaps including Mr. Buffet.