I didn’t catch President Obama’s state of the Union Address this week as I am sure many of you didn’t either. There more pressing issues to address (like scrubbing the grout on my kitchen floor) than listening to a lame duck president boxed in on policy by an opposition Congress.
I read about Obama’s speech though. His message was predictable—tax more and spend more. But the president did catch my attention with his proposal to raise the capital gains tax rate. He wants to hike the capital gains rate to 28%, as if 24% isn’t high enough already. Raising the capital gains tax rate is precisely the opposite of pro-growth tax reform.
Thankfully, a higher capital gains tax rate has no chance of becoming law in the next two years, but it is worth discussing why higher capital gains rates are such a bad idea in case our next president is as misinformed on tax policy as President Obama.
It may not feel like it with so many new regulations coming down the pike in recent years, but we still live in a capitalist system. In a capitalist system, capital investment drives growth, not government spending. When you raise the tax on anything, you get less of it. So when you raise the tax on capital you get less capital investment and therefore less growth and fewer jobs.
Second, capital gains are not adjusted for inflation. Let’s say you buy a stock for $100 and inflation averages 5% over the ensuing three years. After holding the stock for three years you sell it for $115. According to President Obama you should pay a 28% capital gains tax rate on that gain, but the purchasing power of your investment is the same as it was three years ago. Why should you pay any tax on this phantom “gain” let alone a higher tax than you pay today?
The third and most important and most practical reason that a higher capital gains tax rate is a misguided idea is that it generates less revenue. The capital gains tax is one of the easiest taxes to avoid. The historical record proves that when capital gains tax rates are high the government collects less revenue than when they are low.
If the president wanted to give the economy a shot in the arm we would be talking about a reduction in the capital gains tax rate instead of an increase.
Jeremy Jones, CFA
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