How capital gains taxes damage an economy
Gerard Jackson
Capital gains are economic profits, not accounting profits, and this is where capital gains taxes do the most damage. The tax is levied on the sale of assets, eg., businesses and shares. This has the effect of reducing the number of transactions because that is one of the ways of avoiding the tax. In other words, capital gains taxes are also transaction taxes where they are levied on realised gains.
The incidence of the tax will largely determine the rate at which individuals will transfer their savings to more productive investments. The fact that a capital gains tax is also a resource allocation tax is also neglected. The tax actually punishes people for moving assets into more productive activities. Could you imagine what would have happened in England if, for example, investors had been punitively taxed for trying to invest in railways instead of trapping their savings in canals or government bonds?
Clearly, high capital gains taxes erect a significant barrier to the movement of savings from old established companies to newer and more innovative enterprises. In fact, they become a tax on social mobility, as does a highly progressive income tax structure. It protects those (like Teddy Kennedy and Senator Kerry) who can live off their family's accumulated capital against those who are trying to accumulate capital: it is not a tax on the rich but on getting rich; it encourages those who have accumulated wealth to simply conserve it while reducing the flow of venture capital, the lifeblood of new entrepreneurs.
Furthermore, the most important factor that the capital gains tax penalises is the decision-making ability of entrepreneurs. It is decision-making ability that largely accounts for the existence of high-cost and low-cost firms in any industry. Therefore the capital gains tax also becomes a tax on entrepreneurial rent. The more successful the entrepreneur becomes in satisfying consumers' wants, the greater the financial penalty he will finally pay. This is guaranteed to restrict entrepreneurial mobility .
You cannot have a dynamic economy if venture capital is penalised, entrepreneurial mobility is severely restricted and the rewards of successfully satisfying consumers' needs are heavily taxed. What is more, high capital gains taxes are a lousy revenue raiser. In 1969, for example, President Nixon raised the capital gains tax from 28 per cent to 49 per cent. Result: revenue from the tax dropped sharply with realised gains from the sale of capital assets falling by 34 per cent, and the stock issues of struggling companies fell from about 500 in 1969 to precisely four in 1975.
High-tech companies in Silicon Valley were hit particularly hard. Yet the Treasury had assured President Nixon that the tax increase would raise $1.1 billion in the first year and then $3.2 billion a year until 1975. This is obvious proof that taxes do affect behaviour. If you think about it, capital gains taxes are a great way to soak the poor. (During a period of significant monetary expansion governments can enjoy a tax windfall. This is because monetary expansion inflated capital gains.)
In 1978 Congress slashed capital gains taxes; this resulted in an explosion in the supply of venture capital. By the start of 1979 a massive commitment to venture capital funds took place, from $39 million in 1977 to a staggering $570 million at the end of 1978. Tax collections on long-term capital gains, despite the dire predictions of big-spending critics of tax cuts, leapt from $8.5 billion in 1978 to $10.6 billion in 1979, $16.5 billion in 1983 rising to $23.7 billion in 1985.
By 1981 venture capital outlays had soared to $1.4 billion and the total amount of venture capital had risen to $5.8 billion. In 1981 the maximum tax rate on long-term capital gains was cut to 20 per cent. This resulted in the venture capital pool surging to $11.5 billion. Astonishingly enough, to conventional economists that is, venture capital outlays rose to $1.8 billion in the midst of the 1982 depression.
This was about 400 per cent more than had been out-laid during the 1970s slump. In 1983 these outlays rose to nearly $3 billion. Compare this situation to the period from 1969 to the 1970s which saw venture capital outlays collapse by about 90 per cent. All because of Nixon's ill-considered capital gains tax. But then Nixon never professed to know anything about economics, unlike most of his media critics.
In 1982 the US General Accounting Office sampled 72 companies that had been launched with venture capital since the 1978 capital gains tax cut. The results were startling. Starting with $209 million dollars in funds, these companies had paid $350 million in federal taxes, generated $900 million in export income and directly created 135,000 jobs! Professor Laffer and his supporters stood vindicated, not that you would know this from the media.
All that Professor Laffer had really said is that beyond a certain point the burden of taxation would cut investment and thus reduce, if not halt, economic growth. No sound economist would deny this proposition. And yet Laffer was lampooned, pilloried, grossly misrepresented ad nauseam — and now that I think of it, still is. Clearly, economic reasoning and history have refuted the contention that the abolishing the capital gains tax would cut national savings*.
However, I find it curious that those who claim to adhere to the untenable view that cutting capital gains taxes would cut savings have never suggested that only realised capital gains spent on consumption should be taxed.
Melbourne: Australia
BrookesNews.Com
Tuesday 25 Feb. 2003
*Whether Laffer realises it or not his curve is an extremely simple expression of Say's Law, the essence of which is that demand springs from production. A classical economist would say (Malthus and Sismondi excepted) that "supplies constitute demands". And of course supplies have to be produced before they can be exchanged for other goods. These economists would also stress that for equilibrium to be maintained goods would have to be produced in the correct proportions. (See The Theory of Political Economy, Augustus M. Kelley, 1965, p. 203.)
Gerard Jackson is Brookes' Economic Editor.
