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.

The Debt Ceiling

The world of politics keeps on spinning and as a student of economics I try to learn as much as I can and to a large extent keep my mouth shut because I, by definition, don't know everything yet.  The situation is that the U.S. government has already reached the limit for the amount of money that it can borrow and has been using some internal creative accounting to finance expenditures over that amount.  On August 2nd, they will have exhausted those means for acquiring money and will not have enough money to pay their bills which include the U.S. Treasury bonds that come due.  If they do not pay those Treasury bonds in a timely fashion, we will have defaulted on our debt and there will likely be substantial fall-out.

Most or all Democrats say that we should raise the debt limit immediately.  Republicans have more mixed feelings about it.  Some are opposed to raising the limit no matter what.  Others want to extract substantial spending cuts and some would even like to vote on a balanced budget amendment to the Constitution.  Financial experts are warning that a U.S. default would have dire consequences for the domestic and international economy, so why is Congress cutting it so close?

In part, it is because they disagree about fundamental aspects of the debate including whether we will actually default.  Many Republicans assert that on August 2nd, when money runs short, the Treasury department can pick and choose which programs to fund and which not.  It is assumed, in this first scenario, that no matter which programs get chosen for no payments or delayed payments, the bonds will be paid.  This is an enormous assumption because it would be completely unprecedented.  The second scenario is the President can simply ignore the debt limit citing the 14th amendment to the constitution:

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

I think both of these scenarios would be challenged in the courts on Constitutional grounds.  Obviously if the President ignores the Debt Ceiling law, he will be sued (by Congress? or members of Congress?) and it will probably get an express train to the Supreme Court.  I have no idea what they will say about this, but it doesn't seem like a great scenario if we haven't struck a deal by the time the Supreme Court has to give an ultimate ruling.  Former President Clinton has said that he would pursue this course of action if he were in office.

The first scenario is also fraught with risk.  For one thing, government expenditures and income are very uneven.  We risk not having working capital for the day to day operations of critical elements of our government (military, courts, and debt.).  The reason that August 2nd is the day is because we have an enormous amount of checks to pay out on August 3rd (mostly for Social Security).  Will this mean that Social Security must be cut for this option?  Many Republicans are bringing up the various sillier parts of the federal budget like research grants for this and that, foreign aide, the national parks, etc.  They insinuate that we can simply choose to cut those out.  What if those aren't the checks that are due that day?  What if it's checks for V.A. hospitals, or soldier's pay checks, or the electric bill at the U.S. Congress building.  What if any of those are the ones that push us over the limit?  It seems likely that the Social Security checks on August 3rd will be the ones that we will not have the means to pay.  If that is the case, are Republicans really comfortable cutting Social Security with no warning?  That would mean a lot of people on fixed incomes would not get a check, and there would be consequences to that.

Many people say that we should cut spending, including Social Security, and that this is a way to do that.  That may be true, but this would be perhaps the worst way to cut Social Security... even if it were simply a temporary cut.  Most Americans that receive Social Security completely depend on it for their means of survival.  Major changes to this program would require a lot of advance notice and would cause major changes in our entire economy.  For many Americans, it would be completely impossible for them to resume working, and it is morally unfair not to give them retirement benefits which they have been paying into their entire working lives for.

That's not even the worst case for the first scenario.  The worst case is that the Treasury department decides that it does not have the Constitutional authority to make spending decisions and simply continues to pay the bills as they come in until they have no more money.  Then, as soon as a U.S. bond comes in without any working capital in the U.S. account, we will officially default for the first time.

I agree with other financial experts that a U.S. default would likely be the worst bankruptcy of all time.  It would make the Lehman Brothers collapse look like a minor event.  I don't care to go to much into the speculation, because it's impossible to truly speculate on what that event would be like, so I'll simply call it a "game changer" for the global economy.

For my entire life, I've wondered why the U.S. government spends so much money.  I've always been for cutting government expenditures and have never really understood why we even ran a deficit on such a regular basis.  I support passing some version of a balanced budget amendment even if it's watered down and has opt outs in times of war.  Still, I think Republicans might be risking a default just to make a point about the deficit and debt, which is nonsense.

It seems that the general public, which has handed elections over to Republicans since President Obama's historic win has also grown doubtful over Republican handling of this impasse.  So, please, Democrats, Republicans... MAKE A DEAL!