Capital & Credit Watch

The Looming Capital Gains Tax Hike

by Raymond J. Keating

A looming, large package of tax increases threatens the economy. That includes a one-third increase in the top capital gains tax rate paid by individuals.

Under the 2003 tax cut, the top capital gains tax rate was cut from 20% to 15%. In addition, the 10% capital gains tax rate was reduced to 5%, and then to 0% starting 2008. Those tax measures are due to expire at the end of 2010.

President Obama has proposed increasing the top rate to 20% for married tax filers with earnings topping $250,000 and single filers with incomes over $200,000. For other income levels, the 2009 tax rates would stay in effect.

It is critically important to understand that the current economy is suffering from a dearth of risk taking, mainly due to tax and regulatory costs and threats from government.

Entrepreneurship has suffered. For example, the number of incorporated self-employed - after rising in 2006, 2007 and 2008, for example - declined in 2009 by six percent. And the number of unincorporated self-employed has fallen for three straight years. The 2009 level was down by 2.5 percent versus 2008, and by seven percent compared to 2006. In addition, a recent survey by Challenger, Gray & Christmas found that start-up activity during the first half of 2010 was at its lowest level in over two decades.

Similarly, investment is down. For example, venture capital investment fell by 35 percent in 2009. And while venture capital was up during the first two quarters of 2010 compared to the same period in 2009, it remained well below the 2008 level.

At the same time, the capital gains tax stands out as one of the most destructive taxes in terms of the impact on the economy because it is a direct levy on risk taking. The returns on entrepreneurship and investment - which are central to innovation, economic growth and job creation - are diminished by a higher capital gains tax rate.

For good measure, capital gains are not indexed for inflation. Therefore, the real capital gains tax rate actually is higher than the stated nominal rate. So, the worse inflation gets, the higher the real capital gains tax rate - something to keep in mind given the massive expansion of the money supply over the past nearly two years by the Federal Reserve. Barring a miraculous performance by the Fed, that money growth will generate higher inflation at some point. The only real question is: When?

If policymakers are serious about getting entrepreneurship, investment and the economy moving, then the last thing they should do is hike the capital gains tax.

At the very least, the 15% tax rate should be made permanent. In addition, capital gains should be indexed for inflation, thereby making sure that real and nominal capital gains tax rates are equal, and that investors do not face ever-higher tax rates due to inflationary gains.

Ideally, the capital gains tax - given that it is a case of multiple taxation and given its negative impact on incentives for risk taking - should be eliminated.

Unfortunately, our current leaders in the White House and Congress seem far more interested in playing class warfare political games, rather than trying to implement polices that make sense for the economy.

_______

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.