Why increasing Capital Gains Tax could actually reduce revenues
It appears that the new coalition government remains committed to increasing the rate of Capital Gains Tax (CGT) to a level in line with income tax. There are many reasons why this is a bad idea. For example, CGT represents double taxation and also creates disincentives to save. In addition, since the tax is only levied when assets are sold, it creates a “lock-in” effect, as people stop selling their assets to postpone the tax.
As such, an increase in CGT – which is wrong in principle – may not help the government out of its fiscal black hole in practice. The link between a rise in capital gains taxes and tax yields has been studied extensively in the academic literature. The research is ambiguous in its findings. Often the best available statistical analysis of this kind of tax rise shows yields actually going down or staying relatively static.
The issue is complicated because there are both revenue gaining and losing aspects to this kind of tax increase. The tax rise could lose revenue through three main mechanisms.
1) As mentioned above, a ”locking in” effect whereby people simply do not sell assets because of the tax.
2) An increase in tax-evasion.
3) A decrease in long-run economic growth because of less saving
Lawrence B. Lindsey conducted a comprehensive study of regression analysis papers on the 1986 rate increase in America from 20% to 28%, and concluded that “the prospects that the higher marginal tax rates on capital gains in the new tax law will produce more capital gains tax revenue seem remote. …[T]he response of gains to permanent tax rate changes produces a smaller amount of revenue in four of the five models and static revenue in the fifth.”
Indeed, looking at the tax receipts in practice leads us to this conclusion. In 1990 the federal government took in 10% less revenue at the 28% rate than it did in 1985 at the 20% rate. This disappointing result was repeated in 1991 and 1992.
To take another example, the Cato Institute notes that in 1968 real capital gains tax receipts were $33 billion in 1992 dollars when capital gains tax was 25%. Over the next eight years the tax rate was raised four times, peaking at 35%. Yet with the tax rate almost twice as high in 1977, capital gains tax revenues were only $24 billion – a figure 27% below the 1968 level.
So will the proposed tax hike increase or decrease the government’s revenue? Clearly it is impossible to say for certain, since the answer is going to depend on individual circumstances. But considering the potentially harmful effect on the economy, the burden of proof is on the side of the proponents.