Taxing Evidence 

President Nixon once noted that, although honesty isn’t always the best policy, it should be tried now and then. When it comes to taxes, politicians fall back on ideological/philosophical bromides and seldom refer to the data. Now and then it is worthwhile to look at the data. In particular, what actual evidence supports a relationship between capital gains tax rates and economic growth? I’ve selected the capital gains tax because it has it has the most quasi-religious ideology attached to it. Since the political ascendency of supply-side economics (mid 1970s), politicians have focused on marginal tax rates for ordinary and capital gains income. They have asserted that economic behavior is highly sensitive to minor changes to the tax rates. Much of this discussion has been economics by assertion (hysterical evidence) rather than to actual data (historical evidence).

Academic economists have remained largely immune to the more extreme supply side arguments, i.e. any assertion by Arthur Laffer. Why? The reason is simple: the data do not support the assertions. One would expect the data to reveal a strong negative relationship between the capital gains tax rate and economic growth. As rates go down, the “job creators” would engage in a feeding frenzy of new investments and economic growth would soar. Conversely, increases in the rate would dramatically reduce investment and economic growth would slow to a crawl. Statistical investigations of the macroeconomic data for the last 50 years do not reveal this asserted behavior.

There are, at least, two explanations for these results. First, other economic factors overwhelm the tax rate affect. The tax rate affect may exist but is not strong; the noise drowns out the signal. A second reason may be that capital gains taxes are poorly targeted and reward behavior that isn’t related to real investment and growth. Growth requires investment in plants, equipment and people; not the financial churning that characterizes much of the activity in stock and bond markets, let alone real estate. Many financial transactions have little to do with risk taking investment in productive assets, but are eligible for the capital gains tax rate. For example, I can go to my broker and purchase $1000 worth of stock from a seller and, if I hold it long enough and the value of the stock increases, I can sell it and be taxed at the capital gains rate rather than the income tax rate. I’ve been rewarded for taking financial risk but the risk is not directly related to the creation of real productive assets. Lucky me! Only if the stock is an initial public offering (IPO) or is newly minted by an existing firm to raise capital, is a stock transaction related to real investment.

Finally, even though the real economic benefits of the capital gains tax are ambiguous at best, it does have one clear effect: it widens the income and wealth gaps between the rich and poor. Over a 20 year period from 1991 until 2011, 80% of capital gains income went to 5% of the population. Actually the result is even more skewed. The top 0.1% of income earners garnered 50% of the total capital gains income. So the tax slices the pie without encouraging its growth.

I am not writing this piece as a partisan ideologue. I am not a member of either major party. I do believe, as did President Nixon, that honesty should be tried now and then. This means that assertions should be buttressed by actual facts. Ideology should not triumph evidence.