Death and… Capital Gains Taxes

A new year, a new US budget.  This year, the name of the game is payback – paying back for all the extravagant government spending over the past year.  On President Obama’s budget agenda is a variety of tax revisions and increases following Bush tax cut expirations aimed at Wall Street and America’s affluent in order to fund the on-going expensive public spending, aimed at pulling America out of the global recession.  While much of the American public is occupied with the move to reinstate higher progressive taxes for the upper-end earners (as high as 39.6 percent for singles earning more than $200,000 a year), that isn’t the only major change Obama is looking to make.

Obama is looking to implement progressive increases in capital gains tax.  The plan would initially raise the tax from 15 percent to 20 percent.  But what does this mean for the market?

Capital gains tax is traditionally viewed as a method by which the government can encourage more long-term investments.  The classic example of a capital gains investment is the purchase of property.  By offering investors a lower rate of tax, the government can effectively stimulate these supposedly more-secure, longer term investments.  The low capital gains tax was one large factor leading to the build up of the housing market boom.  But now, we are facing the aftermath of the housing market bust.  People aren’t buying and selling at pre-recession rates.  In fact, the IRS says that income from capital gains is down 40 percent since the 2008 stock market crash.

So the big question is what will the effect of the increase of capital gains tax be?  That is a matter still up to debate.

Intuitively, one would think that raising the capital gains tax would be linked with fewer capital gains investments being made.  Based on this logic, Obama is proposing to cut capital gains tax for small businesses.  He hopes this will help to stimulate their growth.  This means that the raise in the capital gains tax could be a bitter blow to the fragile market of individual investors who will now be taxed more for their capital gains investments, and may therefore discourage them from making these further investments.  Newt Gingrich has called for the US to follow the footsteps of countries like Austria, Belgium, Germany, Greece, Luxembourg, Mexico, New Zealand, Portugal and Turkey by effecting a total abolition of the capital gains tax. He writes that elimination of the capital gains tax would incent economic growth, encourage job creation, create capital and venture capital funding.  Increasing the capital gains tax would do just the opposite.

But Gingrich’s view isn’t the only one out there.  Another possible effect of raising the capital gains tax is also… nothing.  Clinton Deputy Commerce Secretary Robert Shapiro suggests, “This increase will not just have no severe effect on the economy but have almost no effect except higher revenues.” The argument is since it will have no impact, positive or negative, on the market, it’s just money ready to be collected for the government.   The government has already lost 6.2 percent of its tax revenue due to overall income losses during the recession.  It certainly has a lot of ground to recover to just break even and start paying down the national debt.

But is that a fair analysis?  Should the government make any and all tax increases to raise revenue when there is no overall immediate effect on the market?  Or should the government only make tax increases or tax cuts in an effort to affect taxpayer behaviour or to offer them a subsidy?  With a recovering economy starting to show new signs of life, is recouping taxation money a justification for the method in which they seek to generate income, or does the government have a higher duty in its taxation policy?   While this may seem like a purely political question, it concerns the fundamental underpinnings of the taxation system.

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