Monday, April 28, 2008

ECON 365: Capital Gains Taxes

Sigh. Here's John McCain last week on "This Week"
Senator Obama says that he doesn’t want to raise taxes on anybody over — making over $200,000 a year, yet he wants to nearly double the capital gains tax. Nearly double it, which 100 million Americans have investments in — mutual funds, 401(k)s — policemen, firemen, nurses. He wants to increase their taxes.
There are two fundamental facts to be aware of when evaluating this statement. First, when you take your money out of your 401(k) (or you put your money into a Roth 401(k), you are taxed at your regular INCOME TAX rate (not the capital gains tax rate). So 401(k) investments are irrelevant to capital gains tax discussions.

Second, here's a chart of who pays the capital gains tax:

You'll notice that this tax is paid almost exclusively by people with high incomes. Heck, doubling the tax on people in the 90-95 percentile would cost these individuals (making over $110,000 per year) $500.

On another topic, you may hear that capital gains taxes pay for themselves (Charlie Gibson threw this little tidbit out at the recent Democratic debate). This is misleading at best. Here's the CBO:

The Response to Capital Gains Tax Rates

Because taxes are paid on realized rather than accrued capital gains, taxpayers have a great deal of control over when they pay their capital gains taxes. By choosing to hold on to an asset, a taxpayer defers the tax. The incentive to do that--even when it might otherwise be financially desirable to sell an asset--is known as the lock-in effect. As a consequence of that incentive, the level of the tax rate can substantially influence when asset holders realize their gains, as can be seen particularly clearly when tax rates change (see Figure 2). For instance, the Tax Reform Act of 1986 boosted capital gains tax rates effective at the beginning of 1987. Anticipating that increase, investors realized a huge amount of gains in 1986. Then, in 1987, realizations fell by almost as much, returning to a level comparable to that before the tax increase.

Figure 2.
The Ratio of Realized Gains to GDP and the Top Gains Tax Rate, 1952 to 2000

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of the Treasury.

The sensitivity of realizations to gains tax rates raises the possibility that a cut in the rate could so increase realizations that revenue from capital gains taxes might rise as a consequence. Rising gains receipts in response to a rate cut are most likely to occur in the short run. Postponing or advancing realizations by a year is relatively easy compared with doing so over much longer periods. In addition, a stock of accumulated gains may be realized shortly after the rate is cut, but once that accumulation is "unlocked," the stock of accrued gains is smaller and realizations cannot continue at as fast a rate as they did initially. Thus, even though the responsiveness of realizations to a tax cut may not be enough to produce additional receipts over a long period, it may do so over a few years. The potentially large difference between the long- and short-term sensitivity of realizations to tax rates can mislead observers into assuming a greater permanent responsiveness than actually exists.

Because of the other influences on realizations, the relationship between them and tax rates can be hard to detect and easy to confuse with other phenomena. For example, a number of observers have attributed the rapid rise in realizations in the late 1990s to the 1997 cut in capital gains tax rates. But the 45 percent increase in realizations in 1996--before the cut--exceeded the 40 percent and 25 percent increases in 1997 and 1998 that followed it. Careful studies have failed to agree on how responsive gains realizations are to changes in tax rates, with estimates of that responsiveness varying widely.

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