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.

8 thoughts on “Why increasing Capital Gains Tax could actually reduce revenues”

  1. Posted 24/05/2010 at 10:52 | Permalink

    Your analysis only scratches the surface. Whenever there is a change in tax regime that is foreshadowed there are incentives for people to arbitrage between the old and new regimes. In this case, the lower rate gives a strong incentive to crystallise gains ahead of the new regime, and also to maximise the pool of offsettable losses to be carried forward where there are no further gains to bank. The incentives to sell could trigger sharp falls in asset prices – a stock market selloff, and a house price collapse – which might make bank collateral for mortgage and business finance look inadequate, possibly triggering the next phase banking crisis.

  2. Posted 24/05/2010 at 10:59 | Permalink

    If buy-to-let landlords decide to sell up en masse, there will be a lot of homeless tenants, because it will take a long time to sell houses which will need to be in vacant possession.
    Once the new rules are effective, the incentives are to stick with existing assets unless there is an offsetting loss that can be utilised. This means that investment tends to be misallocated (as well as under-allocated), further damaging growth.
    The tax bears down on those who have to realise assets to meet bills – and thus will hit the elderly and the newly unemployed who saved for a rainy day. It will be particularly unfair on those who are taxed on purely inflationary gains.

  3. Posted 24/05/2010 at 11:15 | Permalink

    Let’s not be too quick to assume that an increase in Capital Gains Tax is intended to raise more revenue. It may be defended as an ‘anti tax avoidance’ measure, which is regarded as ‘good’ in itself. And it may be defended as part of the emphasis on ‘fairness’ (which always sends shivers down my spine when uttered by politicians in the context of taxation).

    After all, when the top rate of income tax was over 90 per cent — for forty years! — you didn’t have to be a genius to realise that it probably didn’t raise much revenue. (Admittedly, though, the 1955 Royal Commission got that point completely wrong!).

    I agree that some allowance for inflation is highly desirable, of course.

  4. Posted 24/05/2010 at 12:31 | Permalink

    There shouldn’t be any CGT on shares and so on as that is double taxation. CGT on housing is self-defeating, as you point out, the way to raise revenue is land value tax as you go along.

  5. Posted 24/05/2010 at 15:43 | Permalink

    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.

    You don’t think that might have something to do with the recession?

  6. Posted 24/05/2010 at 16:51 | Permalink

    It was Cameron himself who remarked that CGT was targetted at second houses. Of course, he is renting his own one out rather than selling it. He and Osborne (who wants house prices included in the interest rate target inflation measure) need to understand the dynamics of housing markets rather better if they wish to secure a safe landing from the bubble. Perhaps by higher CGT they intend to restrict the supply of houses for sale to re-inflate it.

    Meantime if Prof Myddelton’s idea of a moral purpose is the cause, he surely knows that financial engineers easily find “morals” (i.e. taxes) they approve more elsewhere abroad.

  7. Posted 28/05/2010 at 08:51 | Permalink

    Why does CGT reflect double taxation? When people talk about double taxation, they imply that there is some principle that money ought to be taxed only once. Of course with a bit of thought this can be shown to be nonsense since money circulates continually. Should the fact that I buy a car out of taxed income mean that I pay no VAT? Or should the salesman whose bonus is paid with the money I spend on the car pay no tax for the same reason? Of course not. You pick what you tax and what you don’t with the aims i) of doing the least damage possible to economic incentives; and ii) of a fair distribution the burden between taxpayers. ‘Double taxation’ is either universal or non-existent.

  8. Posted 18/06/2010 at 21:55 | Permalink

    Sadly prejudice is often dressed up as if it were a serious argument. As I understand it, the “double taxation argument” is that when money is invested the dividends are subject to income tax and therefore a tax on capital gains is double taxation.

    You might be surprised that such a specious argument would ever be put, but there we are. Of course if indexation is allowed while gains are taxed as income, then a share that pays a dividend steadily rising with inflation, all else being equal, will have its share price also rise exactly with inflation. Thus no CGT. But if profits are retained, the share price will rise, CGT but not income tax will be paid. No double taxation!

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