Politics & Policy

Punishing Investment

The reconciliation bill's capital-gains-tax hike is a prosperity killer.

On Tuesday, the president signed the Democrats’ health-care-reform bill, but the House’s “reconciliation” bill of fixes has yet to become law. The Senate will is debating it now and might vote on it this afternoon.

Among the bad provisions that the reconciliation bill would add to the law — special deals, an increase in the employer tax per uncovered worker from $750 to $2,000, a federal takeover of the student-loan industry — is an assault on the burgeoning investor class: a new 3.8 percent Medicare tax on capital gains and dividends. Between this and the hike that was already slated to come at the end of this year, the tax on investment income (which applies to single filers making $200,000 or more and married filers making $250,000 or more) will jump from 15 percent today to 23.8 percent in 2013 if the reconciliation bill passes.

Such an enormous tax hike is very bad news for financial markets, retirees, investors, and even the U.S. Treasury. The Left likes to call investment returns “unearned income,” an absurd phrase that ignores that capital is formed from already-taxed income and that corporations pay an additional 35 percent income tax before any value flows through to shareholders. The capital-gains tax is an unfair and inefficient double tax. The proper rate is therefore zero, and even relatively small increases can do big economic damage.

Capital formation is critical for starting businesses, buying new equipment, investing in research and development, and encouraging innovation. Every increase in the capital-gains tax punishes investors by lowering their after-tax rate of return, discouraging risk-taking and thus preventing investments from taking place. That means less productivity growth, less job creation, and lower wages throughout the economy. We need more capital gains, not less, to accelerate our economy’s lackluster recovery.

The tax hike scheduled for the end of the year — which was set up in the law that enacted the 2003 tax cuts, and will push the rate from 15 percent to 20 percent — is already a deterrent to capital investment. One of the most effective stimulus policies the federal government could adopt would be to repeal that impending tax hike and give investors the all-clear to make investments based on the existing 15 percent rate.

Meanwhile, the proposed 3.8 percent tax — a Medicare tax in name only, because the revenues will be immediately raided from the Medicare trust fund to pay for the Democrats’ new health-care programs — is more likely to reduce revenues than to increase them. By lowering investors’ after-tax return on capital, the higher rate will depress the stock market and encourage investors to hang onto assets with long-term gains to avoid the tax. When the capital-gains rate was cut in 1978 and 1981, revenues steadily increased. When the rate was hiked in 1987, revenues declined. President Clinton’s 1997 capital-gains rate cut helped propel an incredible bull-market run, more than doubling capital-gains tax revenues from their pre-rate-cut levels in just a few years.

Most recently, in 2003, when the capital-gains and dividend taxes were cut to their current rate, revenues went up. Between 2003 and 2005, capital gains revenues totaled $185 billion, $16 billion more than the Congressional Budget Office had projected before the tax cuts — and a whopping $47 billion more than the CBO expected after the cuts passed.

Advocates of the new tax argue that it affects only “the rich.” But that group includes most of the employers in the country, and deterring them from investing means less job creation. The higher tax rate also will reduce the after-tax return on stocks, depressing the stock market and reducing the value of tens of millions of retirement accounts.

In 2008, candidate Obama had a memorable exchange with FOX News’s Bill O’Reilly in which he made clear that he would not raise capital-gains rates above 20 percent. If the Senate passes and the president signs the reconciliation bill, that broken promise will cost investors and the U.S. economy dearly.

– Phil Kerpen is vice president for policy at Americans for Prosperity. He can be reached through Twitter, Facebook, and www.PhilKerpen.com.

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