The Perils of Increasing the Capital Gains Tax: Entrepreneurship and Economy Suffer

By SBE Council at 27 September, 2024, 8:30 am

by Raymond J. Keating -

The capital gains tax ranks as one of the most economically destructive taxes that can be imposed. Yet, there are unrelenting calls for increasing this levy. Vice President Kamala Harris, for example, who is the Democratic Party nominee for president, supports a dramatic increase in the capital gains tax.

Harris Proposed Capital Gains Tax Increase

Vice President Harris wants to increase the top individual capital gains from 23.8 percent (20 percent plus the 3.8 percent Medicare tax, or net investment income tax) to 33 percent (28 percent plus a 5 percent Medicare tax).

Over the past quarter-century-plus, the top long-term capital gains tax was reduced from 28 percent to 20 percent in 1997. And in 2003, the rate was reduced to 15 percent. In 2013, however, the rate was increased to 20 percent, with the Medicare tax added on, for a total top rate of 23.8 percent.

Oddly, the Harris campaign seems to be trying to take credit for not proposing to increase the capital gains tax as much as President Biden - i.e., the Biden-Harris administration - has. That is, to 44.6 percent (increasing the capital gains tax to 39.6 percent plus a 5 percent Medicare tax).

In the end, the Harris 33 percent rate would be the highest capital gains tax since the 1970s.

Real Capital Gains Tax Rate

It must be kept in mind, however, that capital gains are not indexed for inflation, so taxpayers wind up getting taxed on illusory gains due to inflation. That means the real capital gains tax is higher than the stated nominal rate.

Let's consider an example.

An investment of $10,000 in a business was made in January 2022 and then sold for $12,000 in July 2024. That's a return of $2,000, or 20 percent. At the current total capital gains tax rate, the capital gains tax would be $476. At the Harris capital gains tax rate of 33 percent, the tax paid would come in at $660.

Now, as measured by the Consumer Price Index, inflation registered 11.2 percent over this period. When adjusted for inflation, the nominal gain of $2,000 turns into a real gain of $877. Therefore, in this example, the current nominal capital gains tax rate of 23.8 percent turns out to be a real capital gains rate of 54.3 percent. And the nominal Harris rate of 33 percent would jump to 75.3 percent.

Even under a lower inflation rate, the real capital gains tax rate can move up considerably, and it's also not unusual, especially when inflation is elevated, for an investor to pay capital gains taxes on a real capital loss.

Direct Tax on Entrepreneurship and on Investing in New and Expanding Businesses

The key reason why I argue that the capital gains tax ranks as one of the most destructive levies that government can inflict is that it is a direct tax on entrepreneurship and investment. That is, the capital gains tax reduces the returns on entrepreneurship and investment.

Entrepreneurship and the investment needed to start up and build businesses are central to innovation, and to productivity, income, employment and economic growth. It is essential to understand that economic growth is not driven by, for example, government spending or subsidies, but instead by entrepreneurs who, for example, bring forth new and improved goods and services; new technologies; new business models, tools and production methods; and fill or create market demands.

While vital to the economy and its vibrancy, starting up, building and investing in businesses are endeavors loaded with risk and uncertainty. So, the capital gains tax reduces the incentives and resources available for such essential activities, and the higher the capital gains tax rate climbs means the greater the disincentives and the fewer the resources. The capital gains tax ranks as a clear negative for the economy.

It's worth noting that coming out of the Great Recession, President Obama and Congress jacked up the capital gains tax rate from 15 percent to 23.8 percent (again, higher in real terms). That was exactly the wrong decision at the wrong time, and it tells part of the story as to why U.S. economic growth has under-performed since the Great Recession. Now, as U.S. economic growth has continued to languish and we're still trying to fully emerge from the pandemic fallout, President Harris is proposing to push the capital gains tax even higher.

Multiple Layers of Taxation

The individual capital gains tax also is a layer among multiple layers of taxation. Consider the full picture. Individuals pay taxes on income they earn, and then choose to either save, invest, or consume after-tax dollars. The federal government generally does not tax consumption, but it does tax the returns on saving and investing. Also, the earnings of corporations are taxed, and then individuals pay taxes on capital gains derived from the sales of investments in such corporations. This creates a bias in favor of consumption over investment.

The Labor-vs.-Capital Falsehood

The political case for increasing the capital gains tax often rests on the grossly mistaken idea that in a free enterprise system, labor, or workers, are pitted against capital, or business owners. This economic falsehood springs from essentially Marxist assertions or assumptions. In reality, labor is powerless without capital, and vice versa. People need places to work, and assorted tools and technologies with which to work. And of course, business owners need good employees.

So, both labor and capital, if you will, should support lower capital gains taxes that incentivize and expand resources for entrepreneurship and investment, which, in turn, drive productivity, incomes and profits forward.

Why Tax Capital Gains at Lower Rates Than Wages?

Many politicians and commentators who favor increasing the capital gains tax assert that no reason exists for differing tax treatments between capital gains and, for example, wages. In reality, there are striking differences between earning a salary or wage as an employee, and capital gains resulting from owning and investing in a business where gains only come from the growth and appreciation of investments.

As already noted, entrepreneurship and investing in businesses are endeavors fraught with formidable risks and uncertainties. That's most obviously the case with startups and small businesses. These essential ventures with high levels of risk and uncertainty must at least present the opportunity for high returns. Obviously, higher capital gains taxes work against the essential endeavors of building and investing in businesses.

Why Not Limit a Lower Capital Gains Tax to Certain Investments and for Certain Holding Periods?

While seeking to drain as many resources as they can from the private sector to feed government, politicians often will fall prey to carveouts. Why not carveout lower capital gains tax rates for certain investments held for a minimal amount of time, while imposing a higher rate on what politicians believe to be less valuable or for a time period deemed too short? This is a static view that disregards the basic idea that investors can and will shift in and out of assets seeking the best investments.

Limiting a lower capital gains tax to certain types of assets and/or assets held for a certain period time suffer from two main problems.

First, such carveouts simply amount to industrial policy. That is, rather than allowing individuals and businesses in the marketplace to determine where resources are best invested, government officials inject political biases or assumptions into the process.

Second, by limiting the kind of assets and/or setting time mandates to which a lower capital gains tax rate applies, fewer resources are freed up for new investment in general. Indeed, requiring that certain kinds of assets be held for a certain number of years before a lower capital gains tax rate can apply comes from the mistaken assumption that markets generate short-term thinking. Beyond misguided rhetoric, no evidence exists that markets suffer from short-term thinking, or that political thinking somehow works better than individuals and businesses creating, investing and working in a competitive market to serve others.

A Competitiveness Issue

Policymakers should be working to make the United States the best place on the planet to startup and invest in businesses. A higher capital gains tax obviously works against that. Why make it more costly via an increased capital gains tax to create, build and invest in businesses in the U.S.? This is especially bewildering given that entrepreneurship long has been a clear competitive advantage for the U.S. in the global economy.

Conclusion

As I hopefully have made clear, increasing the capital gains tax undermines the entrepreneurship and private investment that are central to innovation, and to productivity, income, economic and employment growth. Rather than seeking to increase the individual capital gains tax rate by 39 percent - i.e., from 23.8 percent to 33 percent - candidates and elected officials should be working to spur entrepreneurship, investment and our economy forward via capital gains tax relief.

If unwilling to take the most pro-growth step of simply eliminating capital gains taxes, then the next best scenario would be a two-part policy change.

First, reduce the top total capital gains tax rate to 10 percent, or at most, to the recent Bush-era rate of 15 percent.

Second, index capital gains for inflation, so that illusory or inflationary gains aren't taxed.

If candidates and elected officials truly care about the economic well-being of Americans today and into the future, then they need to put aside pandering politics, and embrace policies rooted in actual economics, and central to that must be substantive capital gains tax relief.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council. His latest books on the economy are The Weekly Economist: 52 Quick Reads to Help You Think Like an Economist, The Weekly Economist II:52 More Quick Reads to Help You Think Like an Economist and The Weekly Economist III: Another 52 Quick Reads to Help You Think Like an Economist.

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