David R. Henderson  

The Optimal Capital Gains Tax Rate is Below Ten Percent

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Most of the discussion by economists of the appropriate capital gains tax rate is about a very narrow criterion: the effect of capital gains tax rates on capital gains tax revenues. But in a 2009 study done for the Institute for Research on the Economics of Taxation (IRET), Ohio State University economist Paul D. Evans considers a broader criterion: the effect of capital gains tax rates on overall federal tax revenues.

What's the difference? Because capital gains taxes discourage capital formation, they also cause other tax revenues to be lower. If there's less capital formation, workers have less capital to work with and, therefore, are less productive. If they're less productive, the government collects less tax revenue from them.

Professor Evans looks at data from the overall economy from 1976 to 2004, a period in which there was a lot of variation in the marginal tax rate on capital gains. He concludes that in 2004, the tax rate on capital gains that would have maximized overall federal government revenues was 9.69 percent. But if the government taxes to maximize revenues, the ratio of the delta in deadweight loss to the delta in tax revenue is infinity. [I rewrote this previous sentence in response to a correction from Robert Murphy in the Comments section.] Therefore, if the revenue-maximizing capital gains tax rate was 9.69 percent, the optimal tax rate was even lower. So a greedy, grasping government that wants to maximize tax revenues should cut the marginal tax rate on capital gains and if that government cares at all about taxpayers, it should cut the rate even further.

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COMMENTS (17 to date)
Smiths_Hand writes:

Have you read the full study? Following the link you post I did not find any sensible description of the methodology used in Evan's study (just general statements like "time series has its own weaknesses", or he "tested the types of information present"), and this makes it difficult to determine whether this study is at all worth anything...also, a quick internet search indicated that Prof. Evans has not seriously published during the last 15 years...

Jason Collins writes:

Can a similar argument be made regarding income taxes? To rephrase your sentence:

Because income taxes discourage human capital formation, they also cause other tax revenues to be lower. If there's less human capital formation, workers are less productive. If they're less productive, the government collects less tax revenue from them.

This raises the question of what the optimal tax rates are when you consider these trade-offs across all of the forms of capital and effort.

James Reade writes:

From a blog that criticises all those with a slightly more positive view than themselves of government about using only sources that support what they previously believed (and put precise numbers on it - scientism, I think you all call it?), this is a remarkable exercise in hypocrisy. IRET is not some impartial, value free, objective vessel producing high quality research in an unbiased manner. I did used to think that at least one thing was true, even if I didn't agree with libertarians, was that they had principles. The more I read of the writings of libertarians, the less I think that. Practice what you preach.

David R. Henderson writes:

No, I haven’t read the whole study.
@Jason Collins,
Good point.
@James Reade,
If you go through my over 1,000 blog posts since I’ve started blogging on Econlog, you won’t find a single instance in which I criticized those with a more positive view of government for using only sources that support what they believe. I’ve never found that to be a good argument. If one wants to argue, one should criticize the actual argument or point out contradictory evidence from other sources. But if all one has is the argument that the person he disagrees with used only confirming sources, one has a weak argument.

Rajiv Shastri writes:

If the intention is to maximise growth, the optimal Capital Gains Tax rate is zero, as is the optimal Income Tax rate. There are enough economic models that prove it. On the other hand, if the intention is to maximise growth with distributional constraints to manage potential inequality, then one may need very different empirical studies to determine what is optimal.

To my mind, the current argument isn't purely about growth. So any attempt to make it so addresses only a part of the problem.

[broken url fixed. Please watch out for double-typing the "http" when you paste in your url.--Econlib Ed.]

Bob Murphy writes:

David, something seems a little off in this sentence:

But if the government taxes to maximize revenues, the deadweight loss from the last epsilon of tax increase is infinity.

You mean something like "the ratio of delta deadweight loss / delta tax revenue" or something, right? I mean, the total deadweight loss at any tax rate is a finite number.

David R. Henderson writes:

@Bob Murphy,
Oops. Yes. Thanks. I’ll correct in a minute.

steve writes:

"If the intention is to maximise growth, the optimal Capital Gains Tax rate is zero, as is the optimal Income Tax rate. There are enough economic models that prove it. "

Assume that the goal is sustainable growth. Are there any studies supporting such?


Joe Eagar writes:

From a political standpoint, ultra-low capital gains rates are usually scored as regressive (my favorite Paul Ryan tax reform plan was scored regressive for that reason).

Economists keep saying the capital gains rate should be lower, and nothing bad will happen if it is. Unfortunately, our tax code needs wholesale reform, and the need to build a social compact around a new tax code makes it difficult to lower the capital gains rate. Maintaining the current rate is going to be hard enough.

The fact that the last two times we had major reductions in investment taxes we also ended up with asset price bubbles gives me pause. While that probably had a lot more to do with capital inflows than investment tax rates, the tax cuts were, if nothing else, badly timed.

And finally, I'm not sure that equating physical capital with financial capital makes any sense if the dollar is overvalued, which it has been for much of the past two decades. Overvalued currencies discourage investment and encourage debt-fueled consumption. The distorted price structure causes capital to flow out of the tradables sector, often into unsustainable financing of current consumption.

Hunter writes:

The whole argument about the capital gains tax misses the point about how distorting the corporate income tax truly it.

I've never liked the way the tax code treated different income streams. Change the tax code to harmonize the tax rates between workers and investors. Don’t have a system that treats profit on a good investment favorably while treating paid overtime as different things.
Someone working an 8-5 shouldn't pay more taxes on their labor than an investor pays on profits they personally receive.
All income whether it's from interest, rents, wages, capital gains (indexed to inflation and exempted for the sale of a primary home), royalties, profits, dividends or gambling winnings for that matter should be treated as normal income and taxed at the same rate. Otherwise you're treating some people's economic activities better than others. It's picking winners and losers. And fairness demands that all income is treated equally.

As to the double taxation issue the easy solution is to just get rid of the corporate income tax. The people in control of the corporate structure don't pay it. It's a source of government corruption. It punishes the people who do the actual hiring. It impedes capital formation. And it's mostly paid for by the consumer.

Joe EAgar writes:

Hunter, I suspect the biggest obstacle to eliminating the corporate income tax is international, not domestic, politics. Other developed countries would feel compelled to follow suit (just as we feel compelled to lower our rate after they have done so), and they would not be happy (just look at continental Europe's reaction to Ireland's low rate).

James Reade writes:

But on the more substantive point, what about the accusation of scientism? Why is this study to be absolved of scientism for proposing a really precise number for the tax rate, yet others (e.g. proposing the impact of a fiscal stimulus) are slammed for it on this blog?

Joe Eagar writes:

James, I don't think the author means to present this as definitively settled science, in the sense that the NAIRU or the Taylor rule are. It's just one professor's study.

James Reade writes:

Joe - maybe, but libertarians are incredibly quick to jump on any precise number produced by a more liberal or Keynesian-leaning economist and decry it as scientism, so why shouldn't I apply the same treatment to them?

James Reade writes:

Interesting. Still no response.

David R. Henderson writes:

@James Reade,
I did respond. It’s the 4th comment. I know that you added a further comment, but it didn’t challenge anything I’ve done on the blog, which, by the way, was the point of the 4th comment.

James Reade writes:

So you have never made any accusations on scientism on here? You would disagree with all other accusations of scientism that your fellow libertarians here and at, say, Cafe Hayek, would make?

Just interested. If the answer to my first question here is in the affirmative, then you've satisfied me. If not, I would quite like an explanation of what is different about this particular precise number.

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