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.
History has not been kind to such episodes. The combination of a rise in the statutory tax rate on capital and rising inflation nearly doubled the effective tax rate on capital between 1986 and 1991. This period also witnessed a stock market crash and a recession. Bringing inflation and marginal tax rates down created a major pro-growth inflection point in the early 1980s. But this progress could be substantially undone if we allow easy money to once again collide with sharply higher tax rates on capital.
The current effective tax rate on capital is around 30%, down sharply from the 60% rates seen as recently as the early 1990s. This drop has been occasioned by a long period of falling inflation and the reductions in the top tax rate on capital gains in 1997 and 2003. 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. The statutory capital gains will automatically jump to 20% from 15% 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%, a near doubling of the current rate. Even more worrisome is that the collision of a 28% tax rate on capital gains combined with inflation above 3% would raise the effective tax wedge on capital to nearly 60% – the highest in 17 years.
From the late 1960s to the early 1980s, effective tax rates on capital averaged more than 100%. Perhaps it is no coincidence that real equity values collapsed by nearly two-thirds from 1968 to 1982. This period saw sputtering productivity, rising inflation, high unemployment, and an American economy in general decline.
Work by my firm suggests that the combination of a 28% tax rate on capital with a sustained inflation rate of 3.25% would knock trend productivity growth down by 0.5% per year. But it could be even worse. A return to 5% inflation would raise the effective tax rate on capital to 70%, pulling trend productivity growth down by 0.7 percentage points or more – a direct threat to U.S. living standards.
Eliminating the tax on inflated gains, especially at a time when the inflation expectations have been on the rise, would help to boost asset values and whet the appetite for risk. This would complement Fed and Treasury efforts to reflate the financial system and stabilize the housing and credit markets. It may also reduce the potential for an inflationary flare up by putting some of the Fed's excess liquidity to work in the real economy.
One cannot achieve a capital gain unless after-tax income is placed at risk. The higher the real, after-tax reward to successful risk taking, the more willing individuals will be to make bets on long shots. This increases the efficiency of capital and spurs innovation and entrepreneurship. Output and employment are enhanced.
Maximizing noninflationary growth with sound tax policy – while restraining the growth of entitlement spending – is the only way to deal with long-term structural deficits, without a crushing tax burden. Allowing effective tax rates on capital to spike will restrain productivity and make fiscal integrity more difficult to achieve. It is the wrong way to try to raise revenues.
While indexing the capital gains tax for inflation would bring many benefits, the same cannot be said about the popular rebates and credits that currently pollute the U.S. tax code. This includes the bipartisan $168 billion stimulus package that recently sailed through Congress.
Consumer-based rebates in 1975 and 2001 proved largely ineffective. Rebates shift spending from one place to another without altering the incentive structure or adding new money to the financial system. Unless the Fed is running the printing press to finance the rebate checks, the spending by the recipient of the rebates is offset by a bond holder or taxpayer saving to finance it. In the global sink of dollar liquidity, only the Fed controls the faucet and the drain.
To the extent that rebates shift valuable resources away from more productive uses, they probably result in a net reduction in long-term growth. In other words, after a one- or two-quarter fillip, the rebate checks set to arrive in taxpayer mailboxes this summer likely will result in slower growth.
It would be helpful to increase the real, after-tax return to successful risk bearing. This could be done by indexing the capital-gains tax for inflation, as is currently done with the income tax brackets. This would also help head off a potentially destabilizing tax increase, preserve productivity gains, and restore the economy to a sustainable, noninflationary growth track.
Mr. Darda is the chief economist of MKM Partners.
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