The Agenda

Brad Plumer on the Taxation of Capital Income Taxation

Brad Plumer, drawing on the work of Jared Bernstein, seems to suggest that plotting period by period capital gains tax rates against investment levels tells us something meaningful about the causal relationship between the two. More specifically, he says:

Jared Bernstein, on the other hand, brings the graph to suggest that there’s never been a clear relationship between the capital gains tax rate and investment.

Is a clear relationship the same thing as a causal relationship? Or might a clear relationship actually reflect confounding variables, thus creating a misleading impression? One wonders if we can apply this logic across the board, i.e., only “clear relationships” of the kind Bernstein identifies will demonstrate the value of a given spending initiative. This approach would have interesting, and potentially problematic, implications for public policy. 

Plumer quotes a number of scholars, including Tyler Cowen, who suggest that the capital gains tax rate matters very little. Cowen goes so far as to suggest that a belief that capital gains taxes have a significant impact on future investment levels is a “great myth.”

There are, however, other views on this question. Greg Mankiw and Matthew Weinzierl offer a stylized model in which reductions in capital gains taxes are partly self-financing:

The neoclassical model yields particularly simple expressions for steady-statefeedback effects, but it is also important to consider the transition path to the steady state. We therefore consider a log-linearized version of the model for the special case of unitary intertemporal elasticity of substitution. For our canonical parameter values, we find that the immediate revenue feedback effects are quite similar for capital and labor taxes: slightly more than 10 percent of a tax cut immediately pays for itself through higher labor supply and national income. For both types of taxes, the feedbacks grow over time toward their steady-state values, with the feedback for a capital tax cut reaching halfway after about ten years.

That is, “growth pays for 50 percent of a capital income tax cut in the steady state.” 

Mathias Trabandt and Harald Uhlig build on the work of Mankiw and Weinzierl, and they pursue a dynamic scoring exercise to determine how much of a cut in labor income vs. capital income is self-financing:

We find that for the US model 32% of a labor tax cut and 51% of a capital tax cut are self-financing in the steady state. In the EU-14 economy 54% of a labor tax cut and 79% of a capital tax cut are self-financing.

Trabandt and Uhlig offer another way of thinking about taxes on labor income vs. capital income: how close are various market democracies to the point of diminishing returns, i.e., how many are past the point on the Laffer Curve at which higher taxes actually lead to revenue decreases rather than increases?

For the benchmark calibration with a Frisch elasticity of 1 and an intertemporal elasticity of substitution of 0.5, the US can increase tax revenues by 30% by raising labor taxes and 6% by raising capital income taxes, while the same numbers for the EU-14 are 8% and 1%.

To provide this analysis requires values for the tax rates on labor, capital and consumption. Following Mendoza, Razin, and Tesar (1994), we calculate new data for these tax rates in the US and individual EU-14 countries for 1995 to 2007. Denmark and Sweden are on the “wrong” side of the Laffer curve for capital income taxation. By contrast, e.g. Germany could raise 10% more tax revenues by raising labor taxes but only 2% by raising capital taxes. The same numbers for e.g. France are 5% and 0%, for Italy 4% and 0% and for Spain 13% and 2%.

We show that the fiscal effect is indirect: by cutting capital income taxes, the biggest contribution to total tax receipts comes from an increase in labor income taxation. We show that lowering the capital income tax as well as raising the labor income tax results in higher tax revenue in both the US and the EU-14, i.e. in terms of a “Laffer hill”, both the US and the EU-14 are on the wrong side of the peak with respect to their capital tax rates.

If Trabandt and Uhlig are right and Cowen and Bernstein are wrong about capital gains taxes, the consequences for growth could be very significant. Denmark and Sweden are, according to this framework, growing despite their level of capital income taxation, not because capital income taxation has no impact or a negligible impact.

This obviously doesn’t settle the underlying dispute. But if skepticism is warranted in the case of “clear relationships” (i.e., crude period by period correlations) in some domains, it seems profoundly unwise to assign them great significance in others. 

More recently, Tyler Cowen has offered nuanced thoughts and helpful links on the subject of capital income taxation:

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