Do Capital Gains and Top Marginal Tax Rates Cuts Spur Growth?

The GOP asserts the prima facie quite believable presumption that:

• Tax cuts for the wealthy, particularly, tax cuts on capital and the rich encourages investments and results in growth; and

• Tax cuts on the poor does not generate nearly as much growth, partly because the poor are not a big part of the economy.

The logic of lower taxes on capital gains and higher income is that it encourages risk taking, which leads to investment and subsequent growth at higher multiple than simple consumption led growth.  This makes sense, right?  

Let's look at what the data tells us.  I'll divide this into five questions:

• Do Capital Gains tax cuts lead to growth?

• Does cuts in peak marginal tax rate lead to growth?

• Does cuts in Capital Gains taxes lead to increases in savings?

• Are tax cuts to poorer people more likely to result in larger consumption increases?

• Is consumption by poorer people significant enough for the tax cuts to matter?

OK, so here's some data:

• Here is a chart plotting Capital Gains tax rates and economic growth in the US:

There is +ve correlation between Capital Gains tax rate and growth - i.e. it seems that the higher the Capital Gains tax, more the growth.  This, in my view, is coincidence.  I think, however, it does suggest that there is no clear strong relationship between the two.

• What about the top marginal rate?  Well here's the chart of top marginal rate of tax and GDP growth rate in the US:

Again, we can see no correlation between the two.  There is simply no evidence that taxes on the very rich has any impact on growth.

• Let's examine a more fundamental assumption, the savings rate trend.  Capital gains taxes were cut - early 1990s and again early 2000.  Reagan actually raised it in the late 1980s.  The trends are actually very mixed at best as to what the effect of these changes were.  Slate examined other countries and found similar questionable effects.  As an aside, personal savings in the US is currently at an all time high.  The problem at the moment is that government cutbacks are offsetting this.

• .     Are tax cuts to poorer people more likely to result in larger consumption increases?  The chart below shows the marginal propensity to spend per unit dollar in post tax income.  As you can see, the propensity to spend per unit dollar in income keeps dropping.  As this chart shows, if you give someone with less than ~$40K in income a tax cut, 100%+ will be spent.  If you give the same tax cut to a $100K+ spender, less than 65% of it will get spent.      

• 2.   Finally, do these poorer people spend enough for it to matter? The portion of consumers who account for under $40K income account for 25% of total US consumer spend.  In fact, the marginal propensity to spend does not drop to under 80% until you get beyond $70K in income, which means it covers 47% of all spend.  That's a LOT of spend.  To put it in perspective, consumer spending is about ~70% of US GDP.  This would suggest that the lower income people account for ~$4.7+ trillion in spend.  This does not include the effect of velocity of money, which would increase the effect.

  

These charts are only directional.  (The top marginal rate impact is less controversial, I assume). For a more thorough analysis, you can read the CBO's analysis of Capital Gains taxes.  Here is their conclusion on the effect on growth:

"The JCT’s and OTA’s cost estimates include the feedback effects that gains tax rate changes exert on the tax base through the realizations response. But they do not include the revenues that might result from the effects on overall economic activity. That omission has been criticized as a failure to perform “dynamic” scoring. Critics often claim that the omitted feedback effects on output, and thus revenues, are substantial, and that not taking them into account both biases policy against cuts in capital gains taxes and contributes to large forecasting errors. Yet feedback effects on growth are likely to be small, and their omission from cost estimates has no bearing on the accuracy of CBO’s budget projections, which include growth effects.  In general, there is significant consensus that broad-based reductions in taxes on capital have the potential to boost economic growth over the long run. Reductions in capital taxation increase the return on investment and therefore the formation of capital. The resulting increase in the capital stock yields greater output and higher incomes throughout much of the economy.  But the potential for big growth effects from a capital gains tax cut is much smaller than it is for a more general cut in the tax on capital. For example, Congressional researchers estimated that a cut of the magnitude proposed in 1990 or enacted in 1997 (25 percent to 30 percent) would reduce the tax on corporate capital by only 2.7 percent and would decrease the cost of capital by less than 1 percent.

Some additional reduction in the cost of capital might result from the salutary effects of improved liquidity as a consequence of less lock-in. But such an impact would also be small. One reason for those limited effects is that about half of gains are not taxed anyway because they are associated with assets whose basis is stepped up at death. A second reason is that although a cut in capital gains taxes helps reduce the cost of capital, it only affects the cost of a portion of a firm’s financing. It has no effect on the roughly one-third of corporate investment financed through debt.  And it does not affect the estimated half of the return on equity-financed capital that comes in the form of dividends, which are subject to regular rather than capital gains tax rates. A third reason is that the tax rate on gains is already low relative to regular rates, so even a large percentage cut in the gains rate would have a relatively small effect on the cost of capital. Reducing the taxes imposed on the return from capital raises investment demand, but an increase in the capital stock depends as well on how much of its resources an economy makes available for investment—that is, how much it saves and how much capital it attracts from abroad. Analysts disagree about the effect on saving of cutting taxes. And the availability of resources would also depend on how the government financed any loss in revenue resulting from a tax cut. If the loss was offset by reduced spending, the outcome would be increased economic growth. If it was not offset, the cut’s overall impact on the economy might be negative: its growth-promoting effects on investment demand could be insufficient to overcome either the decline in investment resources resulting from additional government borrowing or the effects of the government’s need to raise taxes later to make up for the lost revenue."

A few points to think about:

• If there is no demand, would you invest?   The problem with the "investment cost" theory to begin with is that the cost of investment is only a secondary consideration in growth.  It only matters if there are a huge number of investment opportunities that people are walking away from because of cost of capital reasons.  However, when there is a growth problem, it is usually the case that there are no attractive investment opportunities.  Capital cost cuts don't help. 

• Secondly, and this is a critical component usually missed in the usual critique of the constrained investment theory, taxes are not a very material part of the cost of investments. Let's say you invest at a pre-tax rate of return of r.  Now your pre-tax hurdle rate for investing is say i and the tax rate is tc for capital gains and ti for interest (to simplify matters I am assuming it’s the same for investments and cost of funds).  Then it's profitable for you to invest as long as: (1 + r*(1-tc)) / (1 + i*(1-ti)) >1.  So, a rise in the tax rate (tc) will reduce the attractiveness of the investment.  But, here's what people miss.  All other things are NOT equal.  The attractiveness decrease could be offset by adjusting the cost of capital, i.  The cost of capital is very closely monitored and controlled by the Fed by controlling money supply.  The effective cost of capital depends on monetary policy.  So, as long as Capital Gains tax or tax on the rich is within reason, monetary policy can completely offset any constraining effect the tax has on cost of capital.

• A final point that the CBO report touches on might be worth calling out as reporters seem to miss this - capital gains tax is not a tax on capital, it is a tax on appreciation of excess parked funds.  So, much of what people think of as investments are NOT covered.  Consider the following:
• IRA accounts are not subject to capital gains tax;
• 401K and pension fund withdrawals are taxed as ordinary income, not capital gains;
• Investments by institutional investors, e.g. hedge funds, most banks, etc. are taxed as corporate income from ordinary sources, because investments held for trading purposes cannot be considered capital.

I call this out because while I don't have the statistics, I imagine that a sizable portion of investments actually do not qualify for capital gains tax relief. 

As an aside, there is one place where tax on investments does have an impact and that is the stock market.  There is evidence that the stock market tends to go up if you cut capital gains taxes (have not shown the data here, but have seen it before).  However, again, this is a short term effect.  Ultimately, the Fed can manage this too through monetary policy.