When Mitt Romney disclosed in his tax return that he earned most of his money from investment income, the revelation put a political bull’s-eye on the lower tax rates for capital gains and so-called carried interest.
It’s a perennial argument among experts—whether that 15 percent rate encourages investment, boosts the economy, and leads to bright spots like job creation. The huge gains that Romney saw from this type of taxation just highlighted the lack of consensus surrounding the question.
“It’s an unsettled issue in the economic profession,” says Roberton Williams, former deputy assistant director for tax analysis at the Congressional Budget Office and a senior fellow at the Urban Institute. “There is very little evidence that people change their behavior because of it.”
Conservatives have long viewed lower tax rates on investment income as a given part of a vibrant economy. Romney’s financial disclosure form shows the wide range of investments he held in U.S.-based companies such as Apple, Google, Boeing, Nike, Staples, and Bank of America. Goldman Sachs selected, bought, and sold these stocks on behalf of Romney in an account called a blind trust that Romney could not control and whose contents he couldn’t see.
Still, Romney made cash off many of these investments when Goldman Sachs sold them for a price higher than they originally commanded. Any money he earned from these sales, called capital gains, was taxed at a 15 percent rate—a steal compared with the typical individual income tax rate of 39.5 percent for top earners.
Aficionados of supply-side economics have long argued that entrepreneurs and wealthy people such as Romney need the lower tax rates on investment because it spurs them to do productive things, such as start businesses, purchase stocks, hire workers, or buy big-ticket items that, in turn, boost demand.
That has been the mantra of the Republicans on the campaign trail. Romney would like to permanently keep the capital-gains rate at 15 percent, although the rate is slated to rise at the end of 2012 along with a host of other expiring tax provisions.
On the other side of the political aisle, liberals argue that the low tax rates on investments disproportionately favor the rich, or simply push the wealthy toward elaborate tax planning—moves that don’t help economic growth unless you’re an accountant or tax lawyer.
There remains little evidence that draws a straight connection between lower tax rates on investment income and economic growth, particularly if history offers a guide. Romney’s tax returns are the latest example that dredges up the difficulty in trying to ascertain, from lengthy financial documents, the economic or job-creating benefits from stocks bought and sold.
“We don’t have the tools to separate the effect of capital gains compared to what else was going on at the time,” says Alan Auerbach, the Robert D. Burch professor of economics and law at the University of California (Berkeley).
The political and economic idea of a lower capital-gains rate was not always a given. In fact, the 15 percent rate has not been this low since the Great Depression, and the economy has done both poorly and well under periods of low tax rates.
After the 1986 tax reform under President Reagan, the tax rate on capital gains jumped from 20 percent to 28 percent. The year that followed offered economic growth in the form of increased exports and an unemployment rate that dropped from 7 percent in October 1986 to 5.7 percent in December 1987.
Under President Clinton’s watch in 1997, the capital-gains rate was reduced to 20 percent. That year, the national unemployment rate fell to 4.7 percent, the lowest level since October 1973.
President George W. Bush lowered the capital-gains rate further to 15 percent. Yet, over the last decade, the economy has been hugely volatile with the 2008 global financial crisis; the bursting of the housing bubble; and prolonged job losses not seen since the Great Depression.
That level of ambiguity hardly gives economists, or politicians, evidence to prescribe low rates as a must for economic growth. Instead, it relegates the argument to one of fairness, especially since wealthy people disproportionately benefit.
“The main reason people say that low capital-gains rates are good for the economy is because they have a lot of capital gains,” says Len Burman, the Daniel Patrick Moynihan professor of public affairs at the Maxwell School at Syracuse University. “The low rates are good for their capital gains.”
The final tricky part about tying capital gains to economic growth is that people are not under any deadline to sell long-term stock holdings. Investors can act based on favorable tax rates, or opt to hold onto the stocks until they die and pass their holdings to their children.
This makes it even harder to pinpoint a cause and effect. Sure, people may sell more stocks in the year leading up to an increased tax rate, but that’s only a temporary move. It would not prohibit people from investing money in a company or stock they perceive as a good deal.
“The argument to keep the capital-gains rate low really begs the question of why we set our sights so low,” Auerbach says. “We can do a lot more to reform capital gains rather than lowering the rate.”
Since both sides of the political aisle agree on the need for tax reform, the capital-gains debate may recede in favor of bigger battles over corporate tax rates, or the tax code’s reliance on breaks called tax expenditures.
Still, the underlying question of the type of tax policy needed to boost the economy will remain a critical underpinning of any discussion. Romney’s tax returns, the size and length of a Russian novel, are just the latest flash point in an age-old debate.