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.