Raising Taxes on Capital Hurts the Middle Class

In his Tuesday State of the Union address, President Obama will propose raising top tax rates on capital gains and dividends to 28 percent, up from the current rate of 24 percent. Prior to 2013, the rate was 15 percent. Mr. Obama seeks to practically double capital gains and dividend taxes during the course of his presidency, a step that would have negative effects on investment and economic growth.  

Raising capital gains taxes will never pass the Republican Congress. Mr. Obama knows this, and he is putting forward the proposal to make it appear that Republicans are protecting the rich while he stands up for the middle class.  In reality, the middle class would be harmed by higher capital gains tax rates, because capital would be more likely to go offshore. 

With the proceeds, Mr. Obama wants to provide an additional tax credit to two-earner couples; to reduce student loan payments; and to end tuition payments for attendance at community college. Some of these are worthy goals. But higher capital gains tax rates rarely result in more revenue, because capital gains realizations can be timed.  When rates go up, people hold on to their assets rather than selling them, expecting that rates will go down at some point.

In addition, higher rate would have negative effects on the economy by reducing U.S. investment or driving it overseas. If firms pay more in capital gains taxes in America, they would make fewer investments -- especially in the businesses or projects that most need capital -- and they would hire fewer workers, many of them middle-class. 

Higher capital gains taxes would reduce economic activity, especially financing for private companies, innovators, and small firms getting off the ground. Taxes on U.S. investment would be higher compared with taxes abroad, so some investment capital is likely to move offshore. There are good reasons for taxing capital gains and dividends at lower rates than earned income. 

First, dividend income has been taxed before at the corporate level. The statutory federal corporate tax rate is 35 percent, although effective tax rates vary by firm, depending on the amount of plant and equipment purchased, among other factors. The tax is taken out of gains distributed to shareholders. If a company pays dividends out of net income, then a 35 percent corporate tax rate plus a 28 percent individual tax rate on dividends adds up to a total federal tax rate on dividends of 53 percent—and state and local taxes can add an additional 13 percent, as is the case in California.

Second, capital gains have a lower tax rate to encourage the risk taking involved in investment. Investors supply the financial capital essential for investments that spur innovation, improve productivity, and expand capacity. It is beneficial for the government to encourage this risk taking and tax the proceeds of capital at a lower rate.  Returns from capital are not the same as getting a weekly paycheck, where the amount is predictable and will not vanish if the market tanks.

Finally, a portion of capital gains comes from inflation, because many people hold on to capital for years before selling it. Rather than calculating the inflationary gains from each stock, Congress taxes those gains at a lower rate. 

Higher taxes on capital gains are likely to result in fewer realizations—in other words, fewer sales of capital assets—and less investment in capital. Historically, increases in capital gains taxes have been associated with declines in revenues from capital gains, and vice versa, because those who hold capital can choose when to time their gains. 

Capital gains tax revenues rose after 1997, when the rate was reduced from 28 percent to 20 percent, and again after 2003, when rates were reduced further to 15 percent and double taxation of dividends was ended.  The decline in rates resulted in higher tax receipts from owners of capitals, as they sold assets, giving funds to Uncle Sam. 

In addition to raising rates, Mr. Obama wants to get rid of “step-up in basis,” a tax provision that reduces the taxation of inherited capital, because heirs do not pay tax on the capital gains that they inherit.  When appreciated capital is inherited, the capital gain disappears for tax purposes—even though the value of the entire estate is subject to estate taxes. The White House calls this “the trust fund loophole,” but this is political posturing. Many people benefit from “stepped-up basis” who do not have trust funds, and trust funds benefit from many tax provisions other than the “stepped-up basis.”

Getting rid of “step-up in basis” is not such a bad idea. It makes little sense to be able to pass on assets without paying tax on the capital gain.  But getting rid of “step-up in basis” can be done without raising capital gains taxes. They do not have to go together, even though Mr. Obama is putting them in one package.

America’s economy is doing better than Europe’s, but it is still growing at only about 2.5 percent.  President Obama should offer serious proposals to increase economic growth in his State of the Union. Raising capital gains taxes would harm economic growth rather than increase it.

Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, directs Economics21 at the Manhattan Institute. You can follow her on Twitter here.

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