Basing his case on a newly released report (PDF), Chris Edwards of the Cato Institute argues in Investor’s Business Daily that capital gains tax rates ought to remain low.
The average tax rate on capital gains among the 34 nations of the Organization for Economic Cooperation and Development is just 16.4%, By contrast, the U.S. rate including both federal and state taxes will jump to 27.9% next year.
U.S. policymakers need a refresher on why capital gains tax rates should be kept low.
1. Inflation. If an individual buys a stock for $10 and sells it years later for $12, much of the $2 in capital gain may be inflation, not a real return. Inflation — and expected inflation — reduce real returns and increase uncertainty, which suppresses investment, particularly in growth companies.
One solution is to index capital gains for inflation, but most countries instead roughly compensate for inflation by reducing the statutory rate on gains or providing an exclusion to reduce the effective rate.
2. “Lock-In.” Capital gains are taxed on a realization basis, which creates lock-in. Taxpayers delay selling investments that have large unrealized gains to avoid the tax hit. As a result, people hold assets too long and forgo beneficial diversification opportunities.
For the overall economy, lock-in reduces growth because it blocks the beneficial shifting of resources from lower- to higher-valued uses.
3. Double Taxation. Corporate share values generally equal the present value of expected future earnings. If expected earnings rise, shares will increase in value, creating a capital gain to the individual. But those future earnings will be taxed at the corporate level when they occur; thus hitting individuals now with a capital gains tax is double taxation.
Dividends are also double-taxed, with the result that the U.S. tax system is biased against corporate equity and in favor of debt. This destabilizes companies and the overall economy.
Ernst & Young calculates the current U.S. combined corporate and individual tax rate on capital gains at 50.8% — compared to an OECD average of 42.0%.
Follow the “argues” link above to find three more compelling reasons.