Oct. 4 (Bloomberg) -- For a certain kind of person -- the kind, say, who invests often and well -- capital gains hold a special place in their hearts, not to mention their wallets.
So imagine their reaction when, just before leaving Washington to go campaigning, the Senate Finance and House Ways and Means Committees held a joint hearing on what they called the “treatment” of capital gains.
That’s political speak for “taxation.” And it offers the strongest sign yet that the individual rate on long-term capital gains, which has been at 15 percent since 2003, may be up for negotiation in budget discussions after the election, Bloomberg Businessweek reports in its Oct. 8 issue.
Since 1950 capital gains have generally been taxed at a lower rate than income, to spur investment. The top rate under President George W. Bush went from 20 percent to 15 percent -- the lowest ever -- and was billed as a way to stimulate the economy.
If nothing is done by Jan. 1 to change tax and budget provisions already passed by Congress, the top rate will rise to 23.8 percent, a scenario Republicans and some Democrats want to avoid.
Republican presidential nominee Mitt Romney wants to ditch capital gains tax altogether for people earning less than $250,000.
President Barack Obama, in his Patient Protection and Affordable Care Act, increased the rate by 3.8 percent for high earners beginning in 2013, and has proposed the so-called Buffett rule, which would, among other things, end an accounting interpretation that allows private-equity and hedge-fund managers, and Romney, to save money by paying tax on their earnings at the capital gains rate.
Neither candidate, though, contests the Bush administration’s basic logic: that a lower capital gains rate encourages investment, which creates jobs and helps the economy grow.
That doesn’t mean they’re right. Leonard Burman, who teaches economics at Syracuse University’s Maxwell School, presented a graph at the joint hearing that plotted capital gains tax rates against economic growth from 1950 to 2011.
He found no statistically significant correlation between the two. This was true even if Burman built in lag times of five years. After several economists took him up on an offer to share his data, none came back having discovered a historical relationship between the rates and growth over those six decades.
“I certainly did throw the gauntlet down for the true believers,” says Burman. “If they found the relationship, they’re saving it for a special time.”
More proof that the rationale behind the Bush tax cut doesn’t hold up comes from the Congressional Research Service, a nonpartisan group run by the Library of Congress. In mid-September CRS released a paper that analyzed economic growth and changes to the top marginal tax rates, both for personal income and capital gains, from 1945-2010.
“The reduction in the top tax rates appears to be uncorrelated with saving, investment and productivity growth,” it concludes. “The top tax rates appear to have little or no relation to the size of the pie.”
It hasn’t always been a foregone political conclusion that the capital gains rate should be lower than that for income. The 1986 tax overhaul ushered in by President Ronald Reagan pegged capital gains at the same rate as the highest personal income bracket, which was reduced from 50 to 28 percent.
David Brockway, who served as the chief of staff of Congress’s Joint Committee on Taxation during the negotiations for the overhaul, says that wasn’t an ideological decision.
Rather, it had been decided that the overhaul would be revenue-neutral, and bumping up the capital gains rate seemed an easy way to raise money.
In 2010, members of the bipartisan commission led by former Republican Senator Alan Simpson of Wyoming and Erskine Bowles, a former chief of staff to President Bill Clinton, also drafted a proposal to make the rates identical. This suggests that, in a closed negotiation, higher taxes on gains may not be a deal-breaker.
Brockway, who now works as a tax lawyer in Washington, still agrees with that approach. He says that any difference between the rates will always drive people to come up with creative ways to hide income as an investment.
“Allegedly, a mouse can fit through a crack in the wall a quarter-inch wide,” he says, “and if you leave a sixteenth of an inch, you get cockroaches.”
Harald Uhlig, an economics professor at the University of Chicago, warns against drawing any conclusions from a correlation between tax rates and growth, or the lack of one illustrated in Burman’s and the CRS’s studies.
It’s possible that lower rates on capital gains do drive growth, Uhlig says, yet that the effect is too small to see among the wars and recessions of the 20th century.
Most economic models incorporate an argument made in a 1985 paper that higher taxes on gains encourage people to shift future consumption to the present, not to invest.
There’s a caveat, though, Uhlig says: “You really want to avoid taxing the capital income that comes from investing in the future, but not from capital that’s already there.”
In other words, if you get rich by investing, a low rate encourages you to keep deploying your money. If you’re born with a rich portfolio, you have to keep investing it no matter what because there’s only so much you can consume in the present -- the tax rate won’t affect your investment decisions.
Both candidates are suggesting fiddling around at the margins. A much more straightforward approach would be to take a page from Reagan and Simpson-Bowles.
The problem is, the taxpayers most affected are the very rich. Data from the Tax Policy Center shows that 70 percent of long-term capital gains go to the top 1 percent of earners, and that 47 percent goes to the top 0.01 percent.
Romney would alienate his base and his donors by acknowledging that low rates don’t necessarily spur growth. If Obama insisted that capital gains be taxed at the same rate as personal income, he would open himself up, more than he already has, to allegations of class warfare.
After the election, Congress will have to wrestle with the politically awkward possibility that tax rates on the portfolios of the richest Americans might not have much effect on growth.
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