The 69% increase in capital-gains taxes

The House plan for ObamaCare that passed on Saturday contained a plethora of new and increased taxes, which the Americans for Tax Reform listed in an effort to make Americans aware of the burdensome cost of the bill.  The Wall Street Journal reports today on one aspect of the new taxes that ATR missed.  The Pelosi Plan, if passed by the Senate, would increase capital-gains taxes 69% from their present level, making them higher than any time since the first Clinton term:

House Democrats are funding their new entitlement with a 5.4% surtax on incomes above $500,000 for individuals and above $1 million for joint filers. The surcharge is intended to snag the greatest number of taxpayers to raise some $460.5 billion, and so the House has written it to apply to modified adjusted gross income. That means it includes both capital gains and dividends.

That surtax takes effect on January 1, 2011, or the day the Bush tax rates of 2001 and 2003 expire. Today’s capital gains tax rate of 15% would bounce back to 20% because of the Bush repeal and then to 25.4% with the surtax. That’s a 69% increase, overnight. The last time investors were hit with anything comparable was 1986, when the capital gains rate jumped to 28% from 20%, a 40% increase, as part of the Reagan tax reform that lowered income tax rates.

How did that increase work out in 1986?  Not so well, as it turns out:

The 1986 experience was not a happy one. Tax revenues from capital gains surged before the increase took effect in 1987, as investors moved to cash in at the lower rate. Revenues then plummeted. Total realized capital gains didn’t again reach their 1985 level of $172 billion until 1996. By 1992, the federal government was barely getting more in revenue ($29 billion) at the 28% rate than it did in 1985 ($26.5 billion) at the 20% rate.

Rate reductions, as in 2003 when Republicans cut the rate to 15% from 20%, have typically had the opposite effect. Treasury receipts from capital gains climbed to an estimated $117.8 billion in 2006 from $49 billion in 2002.

Once again, this is an example of the folly in using static tax analysis for public policy, perhaps especially on capital-gains tax rates.  Democrats in 1986 — and now — assume that hiking the CGT rate by 69% will produce 69% more revenue that what was received at the old rates.  That doesn’t take into account market behavior after tax conditions change.  A capital-gains tax hike will push investors to cash out before it hits, and then shelter their assets rather than putting them to work.  After all, at a CGT rate of 25.4%, they would probably pay less tax by getting interest off of their cash than by assuming the risk of losses and paying higher tax rates on the gains.

During the presidential campaign, Barack Obama stumbled when he first proposed at CGT rate of 28%.  His big-money backers reeled from the idea, and later Obama reduced it to 20%, still a significant increase.  Nancy Pelosi has jacked it back up again, and one has to wonder whether all of those Wall Street wizards who supported Obama in 2008 are having buyer’s remorse yet.

If they don’t, voters certainly will.  Obama needs investors to return to the market in order to start getting new jobs created in significant enough numbers to lower unemployment — and fast.  Hiking the CGT rate will have the opposite effect.  In fact, the rate of escalation may push capital overseas entirely, which would make the economic stagnation a long-term proposition, and double-digit unemployment a fixture of the Obama administration.

The Pelosi Plan would strangle the economy.  If Obama expects to minimize his mid-term losses, he has to get the Senate to strip out the enormous escalation in CGT rates.

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