Why Obama is Wrong to Raise Capital Gains Taxes

President Obama has recently called for a capital gains tax increase of $320 billion to pay for new initiatives like tripling the childcare tax credit and free community college, which he spoke about in his State of the Union address. This is part of his new middle class economics which I guess is a new economic theory he just conjured up because it has never existed before. While making community college free would mean the federal government would have to subsidize rising costs in institutions where only 20 percent of students transfer to four-year schools, I would like to focus on the point of raising the capital gains tax rate all.

Last month, I published a post about supply-side economics and income tax reductions. One of the central ideas of this economic policy is the Laffer curve. The Laffer curve has become more of an economic law than theory because it has been proven to be real. Even before Arthur Laffer’s time, other tax policies had been implemented with the concept that lower tax rates lead to more tax revenue because people will have incentives to do more work, businesses will have incentives to expand, and investors will have incentives to invest more capital into the economy. This is especially the case with capital gains taxes, which I would argue is the most reactive to a change in the tax rate because smart investors move their money fast in response to federal policy. In order to see what capital gains tax hikes and tax cuts would do, we must look at the history. Here’s the data from the Tax Policy Center :

1981 Capital Gains Tax Cut

In 1981, President Ronald Reagan signed large tax cuts to revive the American economy. The capital gains tax rate was among one of the tax cuts in his bill. It was reduced from 28 percent to 20 percent. Here’s a look at revenues directly from capital gains taxes before and after the tax cut:

1979: 11.8 billion

1980: 12.5 billion

1981. 12.9 billion

1982: 12.9 billion

1983: 18.7 billion

Two years before the capital gains tax cut went into effect, revenue was on a slow increase, but after that it really propelled forward thanks to experienced investors who want to make more money and new investors who now had the opportunity to invest.

1986 Capital Gains Tax Increase

Reagan’s presidency involved a lot of negotiating and compromises with a Democratic House of Representatives and later a Democratic Senate as well (the roles have flipped today, but the difference now is that little gets done). Reagan liked cutting the income tax the most because it effected the most Americans, so the compromise for more income tax cuts he raised the capital gains tax rate back up to where it started when he entered office. Let’s see what happened:

1984: $21.5 billion

1985: $26.5 billion

1986. $52.9 billion

1987: $33.7 billion

1988: $38.9 billion

The huge capital gains revenue boom slowed down after this capital gains tax increase. The federal government still saw more revenue than it did before Reagan became president overall because of income tax cuts, but capital gains revenue could have been higher had Reagan kept the rate low. While tax revenue was lower after the tax hike than before it, the compromise was necessary to lower income taxes and reform the tax code. As is typical with tax increases, there is a quick burst in revenue in the short term, which we can see from the first year the new tax rate was put into effect, but after that revenue slows down.

1990 Capital Gains Tax Increase

President George H.W. Bush declared at the 1988 convention that there would be no new taxes. However, in order to compromise with the Democratic Congress, he decided to raise taxes while getting spending cuts. The result was less revenue:

1988: $38.9 billion

1989: $35.3 billion

1990. $27.8 billion

1991: $24.9 billion

1992: $29 billion

The tax increase, ticking the rate up from 28 percent to 29 percent, encouraged less investments again as the economy moved into a recession. Bush’s election fortunes declined and he lost the 1992 election.

1997 Capital Gains Tax Cut

The capital gains tax rate barely changed until President Bill Clinton made a compromise with the Republican Congress (again, much better negotiating from both sides than today) in which he signed a capital gains tax cut changing the rate from 29 percent to 21 percent, a tax cut of identical size to Reagan’s 1981 cut. Just like in 1981, tax revenue boomed from capital gains:

1995: $44.3 billion

1996: $66.4 billion

1997. $79.3 billion

1998: $89.1 billion

1999: $111.8 billion

This capital gains tax cut helped fuel huge economic growth in the internet and the economy continued to get better. This was the first time in the history of the United States that capital gains tax revenue exceeded $100 million. This was part of the Contract with America that the Republicans under Speaker of the House Newt Gingrich promoted.

2003 Capital Gains Tax Cut

The economic boom created a bubble in internet businesses, but as expected, it inevitably burst leading to a quick and simple market correction (9/11 also hit the economy). George W. Bush cut capital gains taxes from 21 percent to 16 percent in 2003 and added small trims over the next few years that brought it to 15 percent. Here’s a look at the revenue:

2001: $65.7 billion

2002: $49.1 billion

2003. $51.3 billion

2004: $73.2 billion

2005: $102.2 billion

After this capital gains tax cut there was more tax revenue for the United States. Throughout Obama’s presidency, the capital gains tax rate has been raised from 15 percent to 20 percent and then to 24 percent. Now he wants it back to 28 percent. We won’t have an exact look at the result of those tax increases until the end of his tenure, but looking at the trend it is likely capital gains tax revenue is going to decrease or grow very little. Obama’s rhetoric is no different than in any other speech. He believes there should be higher taxes on the wealthy to support others, but that hasn’t been proven at all to close a wealth gap. As Alan D. Viard of the American Enterprise Institute writes :

Raising millionaires’ taxes may seem fair — they can obviously afford to pay more. But, this policy has significant economic costs. Higher taxes will encourage millionaires to report less taxable income, limiting the revenue inflow. And, the higher rates will discourage saving by the group that finances much of the business investment on which economic growth and wages depend. Fortunately, Obama’s tax plan has little chance of getting passed.

Bibliography of Sources Linked Above

1. Allen, Nick. Barack Obama Goes after the One per Cent with Proposed $320 Billion Tax Hike. The Telegraph. Telegraph Media Group, 18 Jan. 2015. Web. 25 Jan. 2015.

2. Middle-class Economics. The Economist. The Economist Newspaper, 24 Jan. 2015. Web. 24 Jan. 2015.

3. Burke, Lindsey. Why Free Community College Is Anything But Free. Daily Signal. The Daily Signal, 09 Jan. 2015. Web. 25 Jan. 2015.

4. Graber, John. The Success of Supply-Side Economics. JohnGraberBlog.Blogspot.com. The Graber Blog, 18 Dec. 2014. Web. 25 Jan. 2015.

5. Historical Capital Gains and Taxes.www.taxpolicycenter.org/taxfacts/displayafact.cfm?Docid=161>.

6. Kudlow, Larry. Obama Flunks Common Sense Economics: Kudlow. CNBC.com. CNBC, 24 Jan. 2015. Web. 25 Jan. 2015.

7. Viard, Alan D. Do Taxes Narrow the Wealth Gap? AEI.org. American Enterprise Institute, 19 Sept. 2011. Web. 25 Jan. 2015.