Are Capital Gains Taxes Irrelevant?

President Obama proposes to raise the top capital gains tax from 15% to 23.8% in general and to 30% under the Buffet rule for high income earners. Because of this, economists on the left have launched a campaign arguing that there is no evidence that the capital gains tax harms economic activity
Paul Krugman argues that the argument that low taxes “are needed to promote economic growth and job creation” is “false”, and that “the economic record certainly doesn’t support the notion that superlow taxes on the superrich are the key to prosperity”. Krugman writes elsewhere “the case for low rates on capital gains is that by taxing investment income as ordinary income, we effectively discourage saving…There is, however, no evidence that this effect is at all important.”

First, note the straw-man. A reasonable criterion for a not raising the capital gains tax is that doing so would hurts the economy relative to the revenue it brings in, not that the current rate it is “the key” to prosperity or “needed”. If we look at the period 1970-2008, capital gains were on average only 3.4% of GDP and capital gain tax revenue on average only 0.6% of GDP. Obviously small taxes like this will not singlehandedly determine growth or job creation even in cases where they are too distortive to be worth the revenue.    

Bloomberg News recently wrote“Leonard Burman, who teaches economics at Syracuse University’s Maxwell School, presented a graph at the joint hearing that plotted capital gains tax rates against economic growth from 1950 to 2011. He found no statistically significant correlation between the two. This was true even if Burman built in lag times of five years. After several economists took him up on an offer to share his data, none came back having discovered a historical relationship between the rates and growth over those six decades.”

This methodology is overly crude. Growth is determined by variables such as the rate of technological innovation, population change, the business cycle and the overall policy environment. We would not expect a tax which on average constituted one half of one percent of GDP during the period to drive growth to such an extent that the effect is visible in a graph. 

But if Professor Burman insists on this graphing-correlation-over-time methodology, let me take up his offer. Instead of looking at GDP, let’s look at a variable theorized to be more directly affected by the capital gains tax, namely funds invested by Venture Capitalist in entrepreneurial ventures. 

In an influential 1998 study Harvard Professor (and Obama supporter) Josh Lerner and his coauthor Paul Gompers found that capital gains tax cuts increased venture capital investments, driven by higher rates of entrepreneurial activity. They measure investments as how much money Venture Capital funds raise each year in commitments. The link between the capital gains tax and venture capital commitment is so strong that it is visually detectable, which is rare in economics. Here is the graph, which only goes up to 1994. 

Let me update the Lerner, Gompers graph through 2012. I will use Venture Capital investments as a share of GDP rather than the absolute amount (results are unchanged if the absolute amount is used). I will rely on the left-leaning Tax Policy Center for the historic long-term capital gains tax. Data for total U.S Venture Capital commitments is from the textbook Entrepreneurial Finance up to 1995 and from PricewaterhouseCoopersuntil the first half of 2012 (both are based on Thomson Reuters).

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. 

This methodology is as I mentioned crude. I use it because Professor Burman used an even cruder method (correlating capital gains taxes with GDP as a whole). By the standards left-of-center economists themselves have defined, I can indeed detect a strong negative correlation between capital gains taxes and a strategically important component of economic activity

 The correlation between the capital gains tax rate and VC-investments as a share of GDP 1970-2012 is -0.45. (The correlation is even stronger if the outlier year 2000 were to be excluded). 

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.

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.

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