Impact of the Capital Gains Tax

February 25, 2014

There are many problems with the capital gains tax, says Kyle Pomerleau, an economist at the Tax Foundation.

First of all, it is a tax on income that was already taxed when it was earned originally.

  • When an individual earns a wage, that wage is taxed by the state and federal governments. He then takes what is left and purchases stock. When he sells that stock and realizes a gain, that profit (the difference between the value of the stock at time of sale and time of original purchase) is again taxed.
  • Most notably, the difference in stock value is often merely attributable to inflation, not an actual gain. As such, the effective capital gains tax rate is often much higher than what is stated on paper, as the individual may not even have profited from the sale.

Second, the tax encourages an individual to consume rather than to save. An individual who spends his money now on purchases will have to pay a one-time sales tax. However, one who saves his money and invests in stocks or bonds will not only be subject to the capital gains tax, but also to additional sales taxes once he uses the income generated to make purchases.

Because the tax encourages consumption, fewer funds are invested. And people who do invest are hesitant, due to the tax, to move from one investment to another, even if it would be better. All of this slows economic growth.

The United States is further harmed by the tax because it encourages corporations to move to countries that have lower capital gains tax rates, making it easier to raise capital. The opposite is also true.  When the capital gains tax in the United States was lowered in 1978 from 39 percent to 20 percent, American firms were able to raise funds through stock offerings much more easily. In just five years, the daily volume on the New York Stock Exchange increased from 28.6 million shares to 85 million shares.

The capital gains tax in the United States outstrips much of the industrialized world. Lowering the tax would spur economic growth and increase savings and investment.

Source: Kyle Pomerleau, "The High Burden of State and Federal Capital Gains Tax Rates," Tax Foundation, February 11, 2014.

 

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