Almost a decade ago, President Bush signed into law a bill that dramatically cut taxes on investment income. The Jobs and Growth Tax Relief Reconciliation Act of 2003 slashed the maximum rate to 15 percent on capital gains (down from 20 percent) and dividends (down from nearly 40 percent). Now GOP lawmakers who refuse to raise income-tax rates are hunting for new revenue to reduce the deficit. If they target investment income, they can rest easy: Higher rates are unlikely to hurt the economic recovery.
Although economists widely agree that taxes on investment income influence investor behavior, there's little clear evidence that previous changes to the rates have had much impact on the economy's overall performance. And other components of a deficit-reduction deal may offset any aftershock of a tax hike in this realm.
Proponents of higher taxes on investment income point to evidence that lowering them contributes to economic inequality. "Changes in capital gains and dividends were the largest contributor to the increase in the overall income inequality [between 1996 and 2006]," a report by the nonpartisan Congressional Research Service found last December.
Opponents argue that low rates spur job creation and spending by removing a "double tax" on corporate profits (taxed first as earnings and again when the payoff comes from dividends or investment gains) and by encouraging risk-taking and investment. "Raising taxes on the returns to investment does appear to depress the amount of investment," says Alan Viard, a resident scholar at the conservative American Enterprise Institute. The Tax Foundation, a D.C.-based research group, estimates that raising the rates on investment income would knock just over 2 percent off of gross domestic product over the next five to 10 years.
But economic research is far from clear about how much the 2003 rate cuts affected the economy — and, by extension, what raising rates would do to the 2013 recovery. Income inequality would probably have risen a decade ago even without tax-policy changes, the CRS study concluded. A Treasury Department report in 2006 argued that there was "little doubt" the 2003 tax cuts helped stimulate the economy in the months that followed. But it also said that the impact of these tax cuts on the labor market was "difficult to quantify" and that they were only one of "numerous factors" (albeit probably an important one) that led to the rise in stock prices.
The Center on Budget and Policy Priorities, a left-leaning think tank, picked up on these caveats that year and cited many predictions in early 2003 that the economy was going to take off anyway, with or without the investment-income tax cuts. "While the dividend and capital-gains tax cuts were indeed correlated with the upturn in the recovery, they were not the cause of the improvement," the center's Aviva Aron-Dine and Joel Friedman wrote in a report.
The correlation disappears over the long term. Leonard Burman, a public-affairs professor at Syracuse University's Maxwell School and former director of the independent Tax Policy Center, charted the top tax rates on long-term capital gains and economic growth from 1950 to 2011 and found zero statistical relationship between the two. "Does this prove that capital-gains taxes are unrelated to economic growth? Of course not," he told a joint hearing of the House Ways and Means and Senate Finance committees in September. "But the graph should dispel the notion that capital-gains taxes are a very important factor in the health of the economy. Cutting capital-gains taxes will not turbocharge the economy and raising them would not usher in a depression." None
Greg McBride, senior financial analyst at Bankrate.com, says that the biggest risk to the economy from raising taxes on capital gains and dividends would be through the stock market, not through any slowdown in spending from the wealthiest segment of the population, who would feel the higher rates most acutely. "The biggest economic impact of those two specific changes is the damage to consumer confidence that comes from the resulting price correction in the stock market," he says.
Stocks are already expected to tread on rocky ground between now and the end of the year. The twin threats of tax hikes and spending cuts scheduled to kick in on Jan. 2 threaten to throw the economy back into recession in 2013. A "grand bargain" to sidestep the fiscal cliff would remove the cloud of uncertainty and prevent recession, experts say. "A credible fiscal plan to put the federal budget on a longer-run sustainable path could help keep longer-term interest rates low and improve household and business confidence, thereby supporting improved economic performance today," Federal Reserve Board Chairman Ben Bernanke told lawmakers in the summer. In that way, the salutary effect of a deficit-reduction deal on the economy could blunt any negative short-term effects of a hike in investment-income taxes.
Down the line, output and income will be higher if deficits are smaller, the nonpartisan Congressional Budget Office said in an August report. As the short-term boost to the economy could mitigate the immediate impact of higher taxes on investment income, so the long-run benefits of lower deficits could help offset the impact of such taxes in years ahead.
This article appeared in print as "Investment Math."