This article originally appeared in MarketWatch.
You have to hand it to President Obama.
Despite Democrats’ loss of the House of Representatives in 2010 and the U.S. Senate in 2014, as well as the loss of 16 statehouses and 10 governorships since Obama’s election in 2008, he keeps advocating for tax increases.
The latest proposal was in Tuesday’s State of the Union Address, where the president proposed raising the top tax rate on capital gains and dividends to 28% from the current 24%. When the president took office in 2009, that rate was 15%.
Obama’s capital-gains proposals are likely motivated by a desire to continue to beat the class-warfare drum. Consider that those tax increases are not part of a serious legislative agenda. Obama has not coordinated this proposal with congressional Democrats, much less congressional Republicans, as part of some tax-reform package.
Lowering taxes is more popular with the American people than raising them, and few politicians who advocate tax hikes are elected to office. Yet Obama plows ahead anyway. Give him an A for persistence, even though he gets an F in helping his party and boosting the economy.
Note also that one sensible part of Obama’s tax proposal, doing away with “stepped-up basis,” a provision that allows an asset’s capital gain to be reset to zero when it’s passed on to heirs at an owner’s death, is couched in class-warfare terms. Obama calls this “the trust fund loophole,” but this is political posturing. Most people who gain from step-up in basis do not have trust funds, and trust funds benefit from many tax provisions other than the step-up in basis. Plus, eliminating step-up in basis can be done without raising tax rates.
There are real reasons why capital is taxed at a lower rate than labor.
Dividends have a lower tax rate because corporate earnings have already been taxed. Taxing dividends, distributions from corporate earnings, is the second time such income has been taxed. Some people might say it is the third time, because the income to purchase equity in a company has already been taxed once under the individual income tax, but that is a subject for another day.
The statutory federal corporate tax rate is 35%, although effective tax rates vary by firm, depending on the amount of plant and equipment purchased, among other factors. If a company pays dividends out of net income, then a 35% corporate tax rate plus a 28% individual tax rate on dividends adds up to a total federal tax rate on dividends of 53%. State and local taxes can bring the tax higher.
Capital gains are taxed at a lower rate because, depending on when the original asset was purchased, they might have a substantial inflationary component. Many people hold on to capital for years before selling it and Congress decided that they should not be taxed on the artificial gains from inflation. Rather than calculating the inflationary gains from each stock, the Treasury taxes those gains at a lower rate. Estimating the gain net of inflation is a complex calculation involving not only the date of purchase, but also additions to capital from reinvestment. So, for simplicity, a lower capital-gains tax rate is one way to make up for inflationary gains.
Most important, capital gains have a lower tax rate to encourage the risk-taking involved in investing. Returns from capital are not the same as getting a weekly paycheck. Investments can vanish overnight, as some currency investors saw when Switzerland unpegged the franc due to changes in market conditions. Some investments never break even. Investors supply the financial capital essential for investments that spur innovation, improve productivity and expand capacity. It is beneficial for society to encourage this risk-taking and tax the proceeds of capital at a lower rate.
Rather than helping the poor, higher taxes on capital 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% to 20%, and again after 2003, when rates were reduced further to 15% and double taxation of dividends was ended. The decline in rates resulted in higher tax revenues to Uncle Sam from owners of capital, as they sold assets, resulting in sources of funding for anti-poverty programs and income transfers.
If President Obama were serious about helping the plight of low-income Americans, he would use the power of his office for real effect rather than political posturing. He could rein in the Environmental Protection Agency, which is in the process of forcing states to craft State Implementation Plans to further reduce emissions of ozone and mercury, without proving the benefits of those actions.
Obama could ask his National Labor Relations Board for the legal rationale for calling the parent of a franchise a joint employer, as the NLRB has done with McDonald’s franchises and McDonald’s USA, overturning 50 years of precedent. That step has the potential to destroy the franchise-business model in America, because McDonald’s USA will be responsible for violations of one of its franchises. Many low-income individuals get jobs at franchises, either as managers or entry-level workers.
President Obama could support charter schools and school choice, to enable children to have a better education and qualify to get into the community colleges that he proposes to make free of tuition, even though there is no evidence that the low cost of community college poses a barrier to attendance. And, if cost is a barrier, why not increase financial aid?
Although MIT professor Jonathan Gruber calls the American people “stupid,” they have consistently voted against politicians who promise tax increases. Americans know tax hikes result in slower economic growth and reduced opportunities for everyone. Disguising capital-gains tax increases in class warfare garb won’t make them more palatable.
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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