NCPA - National Center for Policy Analysis


April 11, 2008

The Federal Reserve's efforts to reflate the financial system with negative real short-term interest rates may have a dire consequence: sharply higher effective tax rates on capital, says economist Michael T. Darda.

The current effective tax rate on capital is around 30 percent, down sharply from the 60 percent rates seen as recently as the early 1990s.  The result has been an extended period of economic growth, strong advances in productivity, falling unemployment and rising real wages and incomes for most Americans.

But this positive trend may not last, says Darda:

  • The statutory capital gains will automatically jump to 20 percent from 15 percent in 2011 unless legislative action is taken to extend the current rate.
  • Democratic presidential front-runner Barack Obama has stated a preference to raise the top rate on capital gains to as high as 28 percent, a near doubling of the current rate.
  • Even more worrisome is that the collision of a 28 percent tax rate on capital gains combined with inflation above 3 percent would raise the effective tax wedge on capital to nearly 60 percent -- the highest in 17 years.

The combination of a 28 percent tax rate on capital with a sustained inflation rate of 3.25 percent would knock trend productivity growth down by 0.5 percent per year, according to Darda.  But it could be even worse: A return to 5 percent inflation would raise the effective tax rate on capital to 70 percent, pulling trend productivity growth down by 0.7 percentage points or more -- a direct threat to U.S. living standards.

Source: Michael T. Darda, "The Inflation Threat to Capital Formation," Wall Street Journal, April 10, 2008.

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