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The · Psychohistorian

Capital gains taxes and revenues, part 1 of 2

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Everyone seems to agree that capital gains should be taxed at a lower rate than wages - even if some would put it as taxing wages at a higher rate than capital gains. However, there seems to be some confusion about the economic reasons for this.

One claim is that lower capital gains tax rates stimulate the economy. That is true, but lowering marginal tax rates on earned income - wages - also stimulates the economy. Economic stimulation may be an argument for low capital gains tax rates, but it's not really an argument for keeping those rates below the tax rates on earned income.

A stronger claim is that lower capital gains tax rates - percentages - actually result in larger capital gains tax revenues - dollars. Obviously if capital gains are taxed at 0%, the tax will generate no revenue, and nearly as obviously, if capital gains are taxed at 100%, the tax will generate no revenue: no one will bother to sell property at a gain if they don't get to keep any of the gain. Between a 0% tax rate and a 100% tax rate, we expect some positive amount of tax revenue, which means that there's some percentage in between at which tax revenue is maximized.

What is that percentage? Well, here's a graph of capital gains tax rates versus capital gains tax revenue over the past half a century or so:

Source: http://www.econlib.org/library/Enc/CapitalGainsTaxes.html#lfHendersonCEE2-019_table_006

The squared off dashed line is the capital gains tax rate, and the continuous line is the revenue. Most of the gradual increase over the course of the graph is due to growth in the economy. However, there are also two fairly clear surges in revenue following substantial cuts the the capital gains tax rate to 20% after 1981 and 1997, as well as a notable decline in revenue when the rate was increased to 28% in 1986 - following a brief spike which may be people selling assets off early to avoid the incoming higher rates.

This rather strongly suggests that the optimal capital gains tax rate is below 28% - even if we're just optimizing for maximum tax revenue, and ignoring the effect on the economy. 20% actually looks pretty good - although it couldn't prevent the falloff from the peak during the internet bubble before 9/11. A few more years of data after 2005 would be needed to assess how the current 15% rate stacks up, but if we're going to use a fixed percentage of nominal capital gains, somewhere in the 15-20% range looks like a good place to be.

Part 2 of this series:
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On February 25th, 2012 07:07 pm (UTC), izmirian commented:
There's an interesting article I saw it referenced recently which looks at the effects of marginal tax rates (not specifically capital gains) in the period between World War I and World War II. Apparently during that period the tax rates were changed dramatically several times so it potentially provides a good time frame for this type of analysis.

I was also amazed at some of the history of the US tax system. Apparently at one point 95% of the income tax was paid by the top 0.2% of the population.

Edited at 2012-02-25 07:08 pm (UTC)
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On February 26th, 2012 03:51 am (UTC), psychohist replied:
I can't get to your link, but when the 16th amendment was passed, the income tax was envisioned as not affecting ordinary Americans, similar to the duties and excises that were already allowed. Keep in mind that the federal government was far smaller back then - around 10% of GDP, versus 40% now.

The father of a friend of mine, who recently died at 95, said that at the time they considered adding "which shall not exceed 5%" to the 16th amendment. But then they said, "nah, no one would ever raise the income tax that high on ordinary citizens."

Edited at 2012-03-04 12:04 pm (UTC)
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