Economics, Pethokoukis

Yes, low capital gains taxes help growth. And this chart shows why


The left keeps banging away at the preferential tax treatment of capital gains income. And that may be good politics. But is it good economics? Here is Tino Sanandaji, explaining the meaning of the above chart from his must-read, must-follow blog:

Again we see a remarkably strong association between the capital gains tax and Venture Capital Investments. Following tax cuts in the late 1970s Venture Capital fund-raising explodes. The tax increase a decade later is followed by a decline in committed fund. Investments again increased when Clinton cuts the capital gains tax in the late 1990s. The Bush-tax-cut – which the left claims had no effect – is also followed by an uptick in Venture Capital investments as a share of GDP. …

Paul Krugman declared that there is “no evidence” that capital taxes have hurtful effects on economic activity and that “the economic record certainly doesn’t support the notion” that low taxes are beneficial for prosperity. Either our eyes and systematic empirical research are misleading us, or Paul is not being his usual trustworthy self.

Tino notes that the analysis is crude, but it is also typical of the sort of analysis the left uses to attack the preferential treatment given investment income.

Tino also give a nice explanation on the fairness issue, pointing out that corporate taxes and capital gains/dividend taxes create a rather high integrated tax rate:

Regardless of the economics, isn’t it unfair to tax “unearned” capital gains at a lower rate than wages? First, capital gains of entrepreneurs are hardly “unearned”. Innovative entrepreneurs produce more economic value in relation to their income (even if the income is in billions of dollars) than other groups in the economy. This furthermore ignores double taxation. The capital gains tax is only part of the total tax burden, the company where capital gains are generated also has to pay taxes at the corporate level. The effective corporate tax rate is estimated at 27%. When Mitt Romney pays a visible capital gains tax of 15%, his total tax burden including the corporate tax is on around 38%. The impression that capital gains taxes are unfairly low is based on the government hiding much of the statutory capital tax burden through fiscal obfuscation.

Also check out Sita Slavov’s recent AEI post on the fairness of taxing capital income.

9 thoughts on “Yes, low capital gains taxes help growth. And this chart shows why

  1. Do I read this chart right? The suggestion that dropping the Cap Gains Rate by 8 points caused the internet bubble, a hugely wasteful exercise in bad investing?

    Or is the message that the 1980s rate that produced 0.1% venture investing was too low, so a point higher rate caused the 2000′s blowout?

    Or, combining the points: is the message that 10% size change in cap gains rates can trigger indeterminate, short-run changes in investing, on the order of a few tenths of 1% of our economy, and so is a hideously expensive way to finance our future investing? How much of those forgone cap gains actually went somewhere as productive as VC?

    “Inquiring Minds Want to Know!”

  2. this chart is laughable as proffered “proof”. Jeeze!

    Nice try but no wonder we don’t see many like this – it pretty much destroys your basic premise.

    how do you explain all the places that contradict your premise?

  3. I’m all in favor of lower taxes on everything, but I can’t buy the argument that a lower capital gains rate does that much to boost investment and grow the economy.

    My analysis isn’t based on ivory tower think tanks who have access to lots of data but lack understanding and appreciation for how things work in real life.

    The reasons:

    1 – Obviously, taxes reduce the net return on an investment. But the key is that an investment has to be worthwhile on a pre-tax basis or it wouldn’t get made no matter how low the capital gains rate was. There are going to be very few investments that provide an acceptable return with, for example, a capital gains rate of 15% that aren’t going to do so if the rate was raised to 25%. The reverse holds true: there are few investments that don’t make sense with a tax rate of 25% that would make economic sense if the rate was only 15%.

    2 – Most of the ‘investment’ that is subject to the capital gains rate is not investments in start up companies but rather buying stock of already public companies. If the goal is to stimulate investment, there’s no logical reason I should get the same tax rate for buying a share of Google on the open market as does someone who invests in the likes of a Google as a start up company.

    To the extent that cuts in capital gains tax rates is connected to economic growth, I believe the reason lies less with the actual cut in tax rates and more with the message that such a cut sends to businesses and individuals who are sitting on their money that they not going to need their cash reserves to cover tax hikes. Freed of this fear, businesses and individuals are more comfortable spending that money… and increases in the amount of money that is spent is what translates to economic growth.

  4. I’ve worked in a private equity fund for the last 15 years, and I spend much of my time with people who run the big funds. Trust me, capital gains taxes matter. They are not the primary determinant of investment, but they are important. If you were in this industry, you’d know that investors are highly concerned about impending rate increases that the current administration has talked about. It’s been much harder to raise new funds, and will continue to be until the threat is lifted (and I’m not totally convinced that a Romney administration wouldn’t as well end up affecting capital gains rates as part of major tax reform ).

  5. Venture Capital investment was clearly lacking in the 70′s. That’s why supply-side economics made sense in Reagan’s era. But it seems pretty obvious that the last few cuts have had little effect.

  6. @Walt French “Do I read this chart right? The suggestion that dropping the Cap Gains Rate by 8 points caused the internet bubble, a hugely wasteful exercise in bad investing?”

    No, you do not read the chart right. If you read the article, you will find out that it is a response to Leonard Burman’s even cruder graphing of capital gains taxes against aggregate GDP, not an argument that dropping the capital gains tax caused the internet boom / bubbe (probably one of the most productive bubbles ever, but that´s besides the point).

    @LarryG”how do you explain all the places that contradict your premise?”

    No one is arguing that capital gains taxes are the sole determinant of venture capital investment. But most likely they are one determinant.

    @ “There are going to be very few investments that provide an acceptable return with, for example, a capital gains rate of 15% that aren’t going to do so if the rate was raised to 25%”

    But some would certainly fall into that category. Or, to use a more illuminating (and historically relevant) comparison when discussing the absolutist claims about there being “no evidence” that “this effect is at all important”: How about 50 percent vs. 15 percent?

  7. This is pretty weak, if you ask me. I mean, a reduction from an already-low 29% rate to just 21% (only 8 points lower) led to an EXPLOSION in venture capital investment?? Um… ok.

    WHO KNEW that just reducing taxes 8% from already-low rates had THAT MUCH of an effect…


    I mean, there MAY be a slight correlation between lower CGT and “higher growth”, but you guys are REALLY exaggerating it here. And one ALSO has to keep in mind that in the 70s, we had TWO TOUGH RECESSIONS, did we not?? With high inflation and unemployment in the latter years of the 70s, so I’m not THAT SURPRISED that investment was lower. Not sure it was simply, “Investors were scared off by CGT rates”

    I mean, why is the explosion in growth MUCH LARGER when going from a 29% to 21% rate as opposed to ALMOST HALVING it from 40% in the 70s?? If the “stimulative effect” of lower CGT rates was SOO strong, it should show up more clearly in the graph.

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