Higher Investment-Tax Rates Won’t Slow Economic Recovery

Lawmakers may raise capital-gains and dividend taxes as part of a deficit deal. If so, they needn’t stress about the economic aftershocks.

National Journal
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Catherine Hollander
Nov. 15, 2012, noon

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.”

Greg McBride, seni­or fin­an­cial ana­lyst at, 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.”