Economic Growth: Is Playing With Taxes the Answer?

Posted September 17, 2014 at 5:18pm

Heading into the midterm elections, both parties are hammering home their economic messages against a backdrop of stagnating wages and surging corporate profits.

Some Democrats, touting an economic agenda based on a “fair shot,” are focusing on the distribution of federal taxes, and the tax breaks they say have helped skew the code unfairly to the upper-income earners and major corporations. Republicans, meanwhile, argue that the Obama administration’s policies have hampered economic growth across the board.

A Federal Reserve survey released earlier this month found that economic inequality grew significantly between 2010 and 2013, with the bottom 20 percent of earners seeing their average annual income drop 8 percent, while those in the top 10 percent experienced a 10 percent gain. According to Standard & Poor’s, income inequality is hurting economic growth and state revenue collections.

The tax code’s role in the trend is up for debate, since the wealthy do pay higher taxes. Even before the Bush-era tax cuts for upper-income taxpayers expired, for example, the top 20 percent of earners paid 69 percent of all federal taxes while taking home 52 percent of pre-tax income. Still, taxes have done little to keep the gap between rich and poor from growing: Between 1979 and 2010, the bottom 20 percent of households saw their real after-tax income increase by 49 percent, while the top 1 percent’s after-tax income grew 201 percent over the same period, according to the Congressional Budget Office.

In light of the widening income gap, the preferential tax treatment of capital gains compared to ordinary wage income — and the variance in rates over the years — has drawn renewed focus among policy analysts and academics, since many of the highest earners draw much of their income from investments.

Most economists say that there is a sound economic case for taxing capital at a lower rate than wages, to encourage saving and investment and to avoid double-taxing money that’s invested. But a dramatic spread between the top individual income tax rate and the top capital gains rate can encourage people to use tax shelters and other mechanisms to have their income counted as capital gains.

When an investment is held for more than a year, it is considered a long-term capital gain and taxed at a lower rate — currently 20 percent plus a 3.8 percent surcharge above a certain income threshold — than the top individual income rate of 39.6 percent. According to the Tax Policy Center, the highest 20 percent of people on the income spectrum realized more than 90 percent of the long-term capital gains in 2010, with the top 1 percent realizing almost 70 percent of the gains.

The capital gains rate has jumped up and down over the years. The 1986 tax overhaul eliminated the preferential rate, bringing the capital gains rate up from 20 percent to the top wage rate of 28 percent. But it fell below ordinary income again in 1990, when taxes on wages were increased but those on investments were not. In 1993, there was a similarly lopsided income tax hike, and the capital gains tax was then cut from 28 percent to 20 percent in 1997.

The rate was slashed again, from 20 percent to 15 percent, in 2003, and remained at that level until Congress, in the “fiscal cliff” deal in early 2013, restored a 20 percent rate. The 2010 health care overhaul included a 3.8 percent surtax on investment income for top earners, making the top rate nearly 24 percent as of 2013.

Meanwhile, capital gains have steadily played a more significant role in building wealth over time. Realized long-term gains amounted to 1.6 percent of gross domestic product in 1977, according to a Tax Policy Center analysis of Treasury data, and rose to 5.9 percent by 2000. They hit 6.6 percent of GDP in 2007 before the financial crisis.

But the effects of a low rate are disputed. Some research indicates the 2003 tax cut did little to spur investment or economic growth. A 2005 Brookings study indicated the combination of the 2001 and 2003 tax cuts, which were not offset by lower government spending, actually increased the cost of capital as higher deficits led to higher interest rates. And a Brookings paper released this month found that “neither the top income tax rate nor the top capital gains tax rate has a statistically significant association with the real GDP growth rate.”

That’s because a sudden change in rates, and a wider difference between income and capital tax treatment, can touch off a number of economically inefficient consequences, whether it’s a sudden sell-off of old capital or an increase in tax shelters that disguise wage income as investment.

Furthermore, as Tax Policy Center Director Len Burman noted in 2012 testimony before the congressional tax-writing committees, wide spreads between the rates can lead to distortions in the workforce.

“Since tax shelters that can pass legal muster or escape detection tend to be extremely complex, brilliant financial planners, lawyers and accountants turn their talents to this lucrative, but socially unproductive, line of work,” Burman said. “The enormous tax savings available lure too many highly productive people … away from other potentially more socially valuable enterprises.”

Supporters of a lower rate for capital gains argue that because the sale of a capital asset does not technically change the wealth of the investor or economic activity, since the asset counted toward his or her wealth before the sale, it should not be taxed in line with labor, which increases economic activity.

They also note that taxing capital gains can amount to a double tax, either on the wage income that the investor invests in the first place, or on the corporate profits that were already subject to the corporate tax. Wage workers, too, bear some of the cost of the corporate tax, but a smaller portion: According to a 2012 Tax Policy Center paper, 20 percent of the corporate tax hits wages, and the remaining 80 percent hits capital, with 20 percent going to non-stock investors and 60 percent hitting shareholders.

For the time being, the argument for spurring investment still holds more weight than those for taxing capital gains in line with wages: Nearly every country in the Organization for Economic Cooperation and Development taxes capital gains at a lower rate than labor, and 11 of the OECD countries do not tax capital gains at all.