I’m sure the Trump administration’s latest really bad tax idea — indexing capital gains for inflation, a cut that delivers 86 percent of its benefits to the top 1 percent — comes from my old pal Larry Kudlow. I mention Larry not to just to name-check him or to make the obvious point that I’ve clearly failed to persuade him on this issue. I raise it because Larry is a die-hard supply-sider, despite the pervasive lack of supportive evidence, and one argument that hasn’t been elevated enough regarding this proposal is why the administration’s main selling point — indexing gains will boost investment and growth — is wrong.
In the current system, when the owner of a financial asset sells it, she pays a tax on the growth in its value. Inflation is not considered, but tax rate on capital gains is far below that on regular earnings (for top earners, about 24 percent vs. 37 percent). By adjusting the original asset price for inflation, those paying cap gains would get a windfall amounting to at least $100 billion over 10 years. The benefits, as noted, flow exclusively to those at the top of the scale (see figure).
Critics have raised three slam-dunk arguments against indexing, which the administration has suggested it may try to do on its own, i.e., through a rule change, if Congress won’t pass indexing legislation.
- It’s highly regressive, as shown in the figure, piling on to all the existing market-driven inequality as well as the regressive tax cut passed at the end of last year.
- It’s yet another deficit booster, as noted, again on top of the $2 trillion deficit-financed tax cut.
- It’s probably illegal for the administration to make this change without Congress.
The channel they tout is the same discredited supply-side myth they used to sell the tax cuts. Lower taxes on corporations, investors and the wealthy, and you’ll get more investment, productivity, growth, incomes and wages.
In reality, the correlation between tax cuts, including capital gains, and every link in that chain is not to be found in the data. A 2010 study of this very issue by Tom Hungerford for the Congressional Research Service found that capital gains “tax rate reductions appear to decrease public saving [raise deficits] and may have little or no effect on private saving … many analysts note that capital gains tax reductions likely have a negative overall impact on national saving …[and] are unlikely to have much effect on the long-term level of output or the path to the longrun level of output (i.e., economic growth).”
My own empirical work finds no relationship between changes in capital gains rates and investment, findings confirmed by leading tax experts including Joel Slemrod — “there is no evidence that links aggregate economic performance to capital gains tax rates” — and the Tax Policy Center (TPC), which finds “no statistically significant correlation between capital gains rates and real growth in gross domestic product (GDP) during the last 50 years.”
Jeffrey Brown, an economist who worked for the second Bush administration, has a smart, balanced Twitter thread on this question. He concludes that “there are many other policy tools available that would do more for growth & spread the benefits more equitably than indexing cap gains. I’m left feeling this is a ‘solution in search of a problem.’ ”
I asked Len Burman, co-founder of the TPC and an analyst who has long and carefully examined capital gains taxation, about the potential growth effects of indexing. He emailed me back: “I’m not even sure of the sign of the growth effect,” meaning whether it would be a plus or minus for growth.
There are many reasons for the lack of such correlations. First, as Warren Buffett explains, real life doesn’t work that way: “I have worked with investors for 60 years, and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.”
Next, part of the alleged growth effect is supposed to come from unlocking “lock-in” effects, but TPC analysts have shown that only a quarter of stock shares are now held in taxable accounts (the rest are held mostly by nonprofits, retirement funds and foreigners). So, whatever “elasticity” (investment response) is in play here applies to an increasingly small share of capital.
Moreover, even before the recent corporate tax cut, which was also sold as pro-investment, capital was already cheap, pumped up by high levels of corporate profits, global savings feeding robust capital flows, and low interest rates. Just look at all those share buybacks underway, and the empirical case that the cost of capital is what’s holding back investment is revealed to be extremely weak.
Look, we could have a serious discussion about indexing the whole tax code (to do so only for cap gains invites tax shifting/avoidance) or, better yet, taxing capital gains as they accrue, not when they’re sold. That has always been viewed as too complex to pull off, but given the digitization of finance, it’s now worth a close look.
But to do indexing solely of capital gains by administrative fiat is nothing but another inequitable, wasteful gift to their donor base. It’s Trump and the Republicans showing us as clear as day who they’re really fighting for.