Sanity Zone 10-20-2010

In keeping with the symmetry of the date, I thought it appropriate that we discuss the a-symmetrical effects of the Bush Tax Cuts. Before anyone gets their panties in a bunch, I want to assure the readers that as an economist and policy wonk, I have no dog in this hunt, other than to see whatever policy that is enacted perform as expected. Data and facts are the non-partisan tools. Problem is, we have some on both political sides who don’t like certain facts, or any facts for that matter, and that becomes really problematic when assessing legislation like the Bush Tax Cuts . So…

Definition

Economic Growth and Tax Relief Reconcilliation Act of 2001
Jobs and Growth Tax Relief Reconciliation Act of 2003.

The Bush Tax Cuts were designed to address the budget surplus of the Clinton Administration, and not, contrary to popular belief, as an economic stimulus. A campaign promise fulfilled, the Bush administration successfully gained enactment of a series of tax rate reductions that would reduce the “unpopular” budget surpluses projected for the early part of the new millenium.

Proposal

The US system of taxation is designed to elicit certain behaviors, through incentives such as lower tax rates for certain activities, exemptions and exclusions and rebates for others. Defining certain classes of income subject to different rates of taxation than straight wages is believed to encourage (or discourage) those behaviors.

For example, lower rates on Capital Gains taxes are designed to encourage investment in New Property, New Equipment and New Technologies, as returns for these kinds of investments usually require longer periods for which the capital is tied up. The lower rate rewards people for taking risk and for taking longer periods of risk. Data has proven that Long Term Investments of this nature are extremely beneficial to the health of the US economy. Job growth is dependent on New and Growing, and is a key policy concern for elected officials.

Asset appreciation is the genesis of a capital gain. When the market value of the asset increases, the difference is what is called a capital gain. Realized capital gains occur when the holder of the asset sells the asset and receives more money than was originally outlaid. For the sake of simplicity in our discussion, our discussion on Tax Code will deal with this and assumes that all gains are realized (taxes on unrealized gains don’t affect many people and does not account for much of the total.)

Classic definition of INVESTMENT includes anything new: airplanes, bridges, buildings, factories, Research and Development. These are things that increase the capacity of an economy, create new jobs and/or lowers costs of doing business.

US Tax Code for Captial Gains also includes passive investment, such as savings vehicles like common stock and bonds. Some of these vehicles do reflect investment in NEW things. Individuals and businesses who capitalize new companies and those who participate in initial public listings and follow on capitalizations of existing companies help create growth and are counted in Investment.

Individuals and corporations who buy equities or bonds on the secondary market (after initial offering) are not considered to be promoting economic growth. These are considered savings speculation vehicles and do not add meaningfully to the economy. Under the current code, the change in asset values of these types are treated the same as those that promote growth.

Current Situation

There were 4 key rate reductions (summarizing, actual language is a bit dense):

1. Marginal Tax on Wages were reduced, with the top rate reduced from 39.8% to 35%
2. Capital Gains Tax was reduced from 20% to 15% (essentially) and tax on dividends was reduced to this rate from the marginal rate.
3. Inheritance Tax rate was phased down and the estate exemption value was phased up
4. Treatment of capital gains on Real Estate was changed from one $250K lifetime exemption per household to $250K exemption per spouse every two years.

There is not much to say about the Bush Tax Cuts relative to wages. Every American wage earner benefited (except those who were not already paying Federal Taxes – about 20% of us.) The marginal rates were reduced for everyone (see last week for discussion of marginal) and the average for all American wage earners was a net $1,400 benefit. The vast majority of the $1,400 benefit accrued to the top 4% of wage earners. They averaged over $7800 in benefit, with those earning over a $1M gaining an average of $100,000 in reduction. With 80% of Americans earning less than $104,000, the average benefit accrued to those taxpaying families was $810, with 50% of Americans getting very little.

Analysis

Today, I’m focusing on treatment of Capital Gains and Dividends. I will use IRS data, as those are unassailable, for the returns filed in 2001 for 2000 and 2009 for 2008.
The following table shows the declared income from capital gains by the bottom 80% of Americans vs the top 6% of Americans.


I don’t want to read too much into these figures. It should be pointed out that 2008 was a terrible year for the stock market, as was 2000.
Note that the burden of losses accrued to the lower incomes. This is consistent for the decade and can be attributable to many factors, none the least of which is access to sophisticated hedging instruments which mitigates losses.
Note that the Top 6% is roughly double in ratio over the bottom 80%what it declared in 2000. This is due to the dramatic decline in share of personal wealth of the bottom 80% over the decade.

Discussion

Capital Gains tax rates have progressively lowered since the Carter Administration. They have been a key component of the US Tax Code for many decades and enjoy broad based support from economists. There is a troubling aspect to the capital gains laws that has produced unexpected and counterproductive behaviors.

When a period of risk aversion exists, as it has for the last 10 years, investors seek short time horizons and liquidity. Under the tax code, there is no difference between a new technology or a share of IBM. However, there is a practical and philosophical difference. New technologies have longer horizons and are far less liquid.

Favorable tax treatment for risk averse behaviors produces a counter punch to policies that would promote growth. To counter recessions, investment in NEW must be made, which means taking risks and expecting longer time horizons. Let me put it another way.

Theoretically, under the current law, one could have placed a $100 bet on Feb 5, 2010 that the Saints will win the Super Bowl again (2DAT!!) this Feb 6. You’d get $10:1 odds. By holding this bet for a year, you would be eligible for capital gains treatment. This is the same kind of bets people place in our stock market. It is simply speculation that does not create economic activity in the form of new jobs or new assets. It simply takes money from one party and gives it to another based on the outcome of a "random" event. This is not the basis for good long run economic policy.

Our economy has systematically reduced incentives for investing in long term real assets by treating gambling the same way for tax purposes. With this kind of treatment, one can reasonably conclude that one would see declines in real wages, declines in real investment and a polarization of the distribution of wealth. Take a look at that table again…

It is not that we want to punish anyone who has disposable wealth, it’s that superior policies reward people for doing what is best for the long run survival of our economy. The Bush Tax treatment punishes the poor and the economy overall. One need only compare 1993-2000 with 2001-2009 to see the marked reduction in real investment and increased focus on non jobs producing speculation.

It should also be noted that a significant majority of the benefits of the Bush Tax Cuts were due to treatment of capital gains and dividends. Just thought I'd throw that in there.

Thanks and I look forward to your comments.

Next Up .... Monetary Policy and China - Why what we're doing may work

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