If President Obama and Congress want more tax revenue as part of a deal to avoid the fiscal cliff, they should consider cutting the capital gains tax rate.
Since 1981, every four-year period after the capital gains tax rate was reduced saw an increase in the amount of capital gains revenue the government received.
President Obama not only insists that the Bush tax cuts expire for the top 2% of income earners, he wants a hike in the capital gains rate to 20% from 15%.
With other changes, including a new 3.8% ObamaCare-Medicare tax on investment income, the effective top capital gains tax rate will rise to 25%.
"Raising the capital gains rate will most likely reduce revenue," said Will McBride, chief economist at the conservative Tax Foundation. "That's based on a long history of capital gains changes since World War II.
Cap Gains Tax Hike Backfires
The one time the capital gains tax rate was increased since 1981 was in 1987, from 20% to 28%. From 1987-90, capital gains revenue fell from $33.7 billion to $27.8 billion, with an average annual decline of -12.8%.
Capital gains tax rates were cut from 28% to 20% in 1981, again from 28% to 20% in 1997, and from 20% to 15% in 2003. Capital gains tax revenues grew by an annual average of 15.8% from 1981-84, 17.8% from 1997-2000, and 25.5% from 2003-06.
"One of the worst things you can tax is capital formation," said McBride. "When you increase the capital gains rate, you increase the tax on using equities to finance investing.
When the capital gains rate was reduced from 20% to 15% in 2003, capital gains revenue grew about $2 billion from 2002. In 2004, when the 15% rate was in effect for a full year, capital gains revenue rose to $73 billion, a nearly $22 billion increase from 2003. Capital gains revenue continued to rise, peaking at $137 billion in 2007. From 2003-07, the U.S. government collected about $155 billion more in capital gains revenue than the Congressional Budget Office had predicted.
Going back further than 1981 shows a similar effect. From 1968-76, the capital gains rate rose each year, going from 25% to 39.875%. During that period, the average annual growth rate in cap ital gains taxes was 9.8%. From 1954-67, the capital gains rate stayed at 25% every year. Average annual growth during that span was a more-robust 14.1%.
Raising capital gains rates isn't just a loser for the federal budget.
"It's a bigger loser for the private economy," said McBride. "Our simulations find that by far and away, the biggest danger to the economy in the fiscal cliff is an increase in the capital gains and dividend rate.
Obama would also hike the tax rate on dividends by taxing them as regular income as they were before the Bush tax cuts. That would increase the top rate on dividends from 15% to 39.5%. With the ObamaCare tax and other changes, the payout tax rate would nearly triple to 44.6%.
The Tax Foundation modeled the impact of letting all the Bush tax cuts expire, not just for those in the top 2%. That would reduce GDP by more than 9% over 10 years with nearly two-thirds of that due to the higher investment tax rates. Those hikes would reduce federal revenues by about $158 billion over 10 years.
'Fairness' Vs. Finances
Despite the evidence, neither Obama nor congressional Republicans are proposing to cut the current capital gains tax rate as part of a fiscal cliff deal.
Obama is committed to the rich paying more as a matter of "fairness." In a 2008 debate, he said he'd raise the capital gains rate "for purposes of fairness" even when the moderator noted that such cuts had increased revenue.
Meanwhile, GOP lawmakers being hammered as the party of the rich aren't eager to propose a capital gains tax cut.