1. One of the most controversial aspects of the US taxation system has been the capital gains tax. Since, for any economy, capital gains represent rewards for entrepreneurial activity, a commonly found proposal by business advocates is to reduce capital gains tax envisaging, or rather projecting that it will lead to increased entrepreneurial activity and thus shall stem growth. Attestations to such beliefs can be found in facts like the technology boom of the 1980s being attributed to capital gain taxes being cut in the later part of the 1970s (Forbes, Jan 18, 1993, p: 26) or like a capital gains tax hike in 1987 being identified by Senator Mack as an act of throwing away “the key to investment and economic growth” (Wall Street Journal, August 29, 1995, p: A14). Such views are in effect results of beliefs grounded in the apparently appealing intuitive logic of a capital gains tax cut ably stimulating investments since that will reduce the tax burden imposed on firms investing profitably and thereby enhance the incentives to invest. Thus, according to the supporters of such ideas, while a cut in capital gain tax rates should increase investments through positively stimulating the motivations for investing, a hike shall have the opposite effect.
However, the validity of assuming that capital gain tax cuts have such effects, or in effect, any effect at all on investment activity has been questioned by certain authors. Fazzari and Herzon (1995) have analyzed the possible effects of a capital gains tax change on investments as well as growth and challenged the intuitive idea showing that such tax rate alterations may have no net effects on the incentives to investments thereby nullifying any possibility of influencing investments.
In what they identify as the case of “tax rate independence”, the authors show how a fall in a capital gains tax rate may not have any influence on a firm’s investment decision at all. They identify the fact that in firms where managers take investment decisions with the objective of maximizing shareholders wealth, though a higher capital gains tax rate compared to a lower one implies reduced value for the shareholders, the project will be invested in as long as it generates positive value for the shareholders implying the investment being not undertaken only in the case of a hundred percent tax rate.
The authors also show that it is not possible to unambiguously specify whether investments will increase or fall as a consequence of a capital gain tax rate deduction due to the presence of uncertainty and varying degrees of risk aversion. While it may be true that investments may be stimulated, the opposite can hold true as well. However, with risk-averse owners being likely to diversify the portfolios and resultantly the business environment being one where managers are generally risk-neutral such outcomes are less likely compared to the “tax rate independence” outcome as well as the opposite result (Fazzari and Herzon, 1995).
General researching pursuits on the capital gain taxes and their effects also isolate “the lock-in effect” as a determinant of its impacts. This effect is identified as one resulting from holders of older and relatively lesser profitable assets shifting to newer and more profitable ones due to being dissuaded by the potential rise in the tax burden due resulting from the shift. It is thus predicted that reducing tax rates on capital gain earnings will possibly release such locked in incomes and increase investments (Wall Street Journal, August 29, 1995, p: A14). However, as has been identified by authors like Minarik (1992, P: 20), a large bulk of financial investment is undertaken by authors who are not subject to capital gains taxes due to being non-taxable US institutions or alternatively foreign entities not subject to US capital gains taxes. Thus it can not be necessarily implied that the unexploited potentially profitable opportunities are significant enough to be realized through reductions in capital gain taxes. Further, even if the lock in effect held true for all investors aggregative, it is questionable whether rather than reducing tax rates on capital gains investments could be more stimulated by converting to a tax levied on accrual instead of the realization based capitals gains tax, since the existence of the lock in effect results from realizations rather than accruals of capital gains.
Thus what emerges is that the apparent charm of the simple intuitive explanation based on incentives and disincentives, which predicts a rise in investments in the case of a capital gains tax rate reduction may not necessarily hold.
2. Since the predicted impacts of a capital gains tax change occurs mainly through the channel of investment, it is to be expected in light of the debate presented above that the results themselves regarding the aggregative economic impacts shall also most likely be debated.
It is posited that a high capital gains tax generates a high cost of capital and thus leads to lowered investments. Such notions therefore lead to predictions of increased investments which thereby promote economic growth (Graetz, 1995, Auten & Cordes, 1991).
However, it has been argued using the Neoclassical Solow Growth Model since it is the rate of growth of the labor force and the rate of technical progress that finally determines the long run rate of growth (Solow, 1956), capital gains taxation rates, even if effective in causing changes in the cost of capital, will not be able to affect the rate of growth of an economy (Fazzari and Herzon, 1995), albeit the lowered cost of capital may result in increased demand for capital and investment thereby raising the productive capacity of the economy.
However, with Chirinko (1993) as well as Farazzi (1993) finding negligible effects of changes in cost of capital on investment, such considerations do get significantly undermined.
Another debated aspect of the capital gains tax is whether reductions in these rates are in essence regressive. Since it is the top section of the income classes in the population that constitutes the most significant part of the people on whom the tax is levied upon, cuts in the tax rates therefore will benefit only the rich class. Thus, such tax cuts are accused of being potentially regressive. This is supported by authors like Feenberg and Summers (1990), who find more than half of the capital gain income to be accruing to the top one percent of the income ladder. Therefore, it is likely that irrespective of other impacts, a capital gains tax rate reduction is to alter the distribution of income against the poorer sections of the economy.
3. In light of the two sections above it does seem that the predictions of capital gains tax cuts being significantly investment and growth generating to lack strong validation. As has already been pointed out, generating growth through capital gains tax cuts is not likely to hold true particularly as it may have no significant influences on the direct determinants of growth. Investments may not be influenced at all. However, it may be argued that the neo-classical model of growth takes technical progress as exogenous and if capital gain tax cuts stimulate investments which trigger technical progress, then growth may result. But such lines of arguments also fail to hold strong particularly when one considers the fact that to promote technical progress reducing a capital gains tax would be certainly one of the most indirect routes the efficacy of which would significantly depend upon the efficient and effective unidirectional functioning of certain linkages. Thus, it remains debatable as to how much growth engendering potential is actually present within a policy of cutting capital gains tax rates.
Auten, Gerald E. And Joseph J. Cordes. 1991. “Cutting Capital Gains Taxes,” Journal of Economic Perspectives, volume 5, 181-192.
Graetz, M.J. 1995. “Distributional Analysis of Tax Policy” edited by David F. Bradford. (Washington D.C.: The AEI Press, 1995), pp. 15-78.
Minarik, Joseph J. 1992. “Capital Gains Taxation, Growth, and Fairness,” Contemporary Policy Issues, volume 10, pp. 16-25.
Chirinko, Robert S. 1993. “Business Fixed Investment Spending: A Critical Survey of Modeling Strategies, Empirical Results, and Policy Implications,” Journal of Economic Literature, volume 31, pp. 1875-1911.
Fazzari, Steven M. 1993. “The Investment-Finance Link,” Public Policy Brief, number 9, Jerome Levy Economics Institute.
Fazzari, Steven M. & Herzon, B. 1995.“ Capital gains, Tax cuts, investment and growth.” Levy Economics Institute Working Paper No. 147.
Available at SSRN: http://ssrn.com/abstract=109968 or DOI: 10.2139/ssrn.109968
Solow, Robert. 1956. “A Contribution to the Theory of Economic Growth,” ,Quarterly Journal of Economics, volume 71, pp. 65-94.