A certain Flip has declared that my post from last week about the Congressional Budget Office and capital gains taxes contained the “Worst Argument of the Day.” I’m totally honored, except that I didn’t actually make the argument for which he condemns me, which was that the decline in tax revenue from 2000 to 2004 was proof that capital gains tax cuts don’t increase revenue. (This would indeed have been a really stupid argument, given that the capital gains tax rate was cut in 2003.) I have argued that the decline in real capital gains tax receipts between the business cycle peak of 2000 and the likely peak of 2007 was perhaps an indication that the tax cut hadn’t paid its way. But that was a different blog post (and it wasn’t a stupid argument).
I guess I could just declare Flip’s post to be a case of the “Worst Reading Comprehension of the Day” and leave it at that. But this capital gains thing keeps nagging at me. There are a few things I feel confident saying about capital gains tax rates and government revenues:
(THE REST AFTER THE BREAK)
1) Revenues almost invariably go up the year a capital gains rate cut is enacted, which proves only that investors aren’t idiots. Who wouldn’t try to find a way to realize their gains right after a tax cut goes into effect rather than right before? It’s free money!
2) The general trend of U.S. tax receipts is upward, because the general trend of the U.S. economy is upward. Looking at revenues before a tax cut and after and declaring that, because the second number is bigger than the first, the cut paid for itself (this is a specialty of Stephen Moore‘s) is nonsensical. You have to make the case that revenue is higher than it would have been otherwise.
3) For the regular income tax, it’s not all that hard to get around this problem. Larry Lindsey makes the case in his book The Growth Experiment that the 1981 cut in the top marginal income tax rate from 70% to 50% (it’s now 35%) more than paid for itself, and I believe him. The Reagan income tax cuts as a whole certainly did not pay for themselves, though: From 1982 through 1989 (I figure it makes the most sense to lag by a year to give his policies a chance to take effect), personal income tax receipts rose at an inflation-adjusted average annual pace of 1.8%. From 1978 through 1981 (Jimmy Carter’s term, lagged by one year) they rose at an average annual pace of 4.9%. The difference is even more dramatic if you don’t lag by a year (1.8% vs. 6.5%).
4) Estimating what capital gains tax receipts might have been in the absence of a tax change is much harder because capital gains realizations, and thus capital gains tax revenues, are so volatile. They’re volatile because financial markets are volatile, and it’s really hard to sort out whether their ups and downs were affected by taxes or not. Those who claim that there’s strong evidence that capital gains tax cuts increase revenues are relying, whether they know it or not, on the assumption that pretty much the only thing that moves stock and bond and real estate prices is the capital gains tax rate. And that’s a mighty dodgy assumption.
5) This market volatility also makes it hard to claim with great confidence, based on the data, that capital gains taxes don’t increase revenue. So economists (by which I mean people with Ph.Ds in economics, not your Larry Kudlows and David Malpasses and Brian Wesburys) end up relying heavily on theoretical models. Those models tell them that capital gains tax rate cuts generally don’t increase capital gains tax revenue, which is what I was writing about in that CBO post. There’s no way to know for sure that this is correct, of course. But it is what you could call the scientific consensus. Even economists who really like capital gains tax cuts only go so far as to predict that under the right circumstances, at the tax rates we have in the U.S. now, a rate cut might generate enough extra capital gains to replace about half the lost revenue.
6) There is surely a capital gains tax rate above which revenues decline, and it’s probably significantly lower than the regular income tax rate at which such Laffer Curve effects ensue. But it’s higher than zero. There are those out there who argue that bringing the capital gains tax down to zero would cause such an explosion of economic activity as to pay for itself with increases in other tax revenues, less need for government programs, etc. There’s at least some basis for this argument in economic theory. But in economic reality, not taxing capital gains while taxing other income would cause most Americans (or at least most Americans who can afford tax lawyers) to get most of their income classified as capital gains. That’s what the private equity guys do now to take advantage of the differential between the 15% capital gains rate and the 35% top income tax rate. The way to get around this would be to move to a pure consumption tax like the FairTax, but let’s not get into that here.
Now I don’t see how any reasonable person could contradict any of these six points. They don’t amount to an argument against cutting capital gains taxes, or taxes in general. But they do mean you’re being a joker if you claim–as Charlie Gibson did back in that Democratic debate that got me started on this whole argument–that when you cut capital gains tax rates, revenues go up. Gibson was a non-expert who I assume had simply been misinformed, possibly by the editorial page of the Wall Street Journal. But what’s up with the people who make a career of spouting this nonsense?