The following article is an except form pages 168-170 of my book The Conscience of a Young Conservative. If you enjoy, free PDF copies are available through Liberty.me, and print copies are available on Amazon. 

The capital gains tax is much lower than both the income tax and corporate tax rate. The revenue maximizing point of the capital gains rate is also much lower than that of the income tax or corporate tax. The reason the revenue maximizing point is so much lower is due to the fact that while everyone needs to work to survive (and thus pay income tax), not everyone needs to invest in something subject to the capital gains tax (ex. stocks, precious metals, bonds, property).

One example of the Laffer Curve effect on capital gains comes from the Bush era. In addition to the income tax cuts, Bush also cut the capital gains tax in 2003. For those in the bottom 40%, their capital gains tax rate was cut from 15% to 5%, while the higher brackets had their capital gains tax cut in half from 20% to 10%. So were revenues from the bottom 40% cut by 66% and from everyone else in half? Not by a long shot – investors pay close attention to the capital gains tax rate, and the cuts encouraged more investment.

The cuts more than paid for themselves, totaling $110 billion in revenue in 2006[1] – which is 100% higher than they had been in 2002 and nearly double the $63 billion that the CBO predicted would be collected without the cut.[2] It is significant that this was the CBO’s prediction before the cut since they automatically assume that a lower tax rate yields less revenue.

Based off of data from the 1976-2004 period, Ohio State University professor Paul D. Evans has calculated that for each percentage point shaved off of the corporate tax rate, a 10.32% increase in revenues surfaces.[3] The data also estimated the revenue maximizing point to be at 9.69%.[4]

capgains

Source: Adam Smith Institute.[5]

One myth that arises is that if the capital gains tax were to be either lowered or abolished completely, people would simply convert all of their income into capital gains to pay a lower rate. If it were that easy to do, everyone would already be doing it because the capital gains tax (1997 onward) has been lower than the one applied to the top four brackets of income. [6] But this isn’t something that the average worker can do quite easily, and others realize that earning general income has no risk to it, while the stock market contains plenty.

There are countries with no capital gains tax, and it has had no effect on the amount of revenue collected from income tax. Australia’s personal income tax collected just about the same amount of revenue when their capital gains tax was 0% as they did when they had the highest capital gains tax in the world. Income tax was 12.5% of GDP in 1980 with no capital gains tax, and 12% of GDP with the highest capital gains tax.[7] When Hong Kong had no capital gains tax, income tax receipts rose 17.8% annually during the 1984-1996 period while the US averaged a 7.1% annual increase with a capital gains tax ranging between 20% and 28%.[8]

Indexing the capital gains rate for inflation would be another way to lessen its burden. Unlike any other tax, the effective rate of capital gains can be harsher than the marginal rate. In 2007, the value of the dollar was roughly half of what it was in 1984, which leads Richard Rahn to propose the following thought experiment: “Assume you purchased a common stock in a company in 1984 for $100 a share and sold it in 2007 for $200 a share. Have you received any “income” from the sale of the shares of stock?” The purpose of this thought experiment is to demonstrate while the clear answer to the question is “no,” the answer is still “yes” to the IRS.[9]

 

[1] Congressional Budget Office, “The Budget and Economic Outlook: Fiscal Years 2008–2017,”

January 2007, p. 86, Table 4-3, www.cbo.gov/showdoc.cfm?index=7731&sequence=0.

[2] “Sign Up For CBO Emails Sign up for All CBO RSS Feeds An Analysis of the President’s Budgetary Proposals for Fiscal Year 2004.” Congressional Budget Office, 1 Mar. 2003. <http://www.cbo.gov/publication/14347>.

[3] Evans, Paul D. “The Relationship Between Realized Capital Gains and their Marginal Rate of Taxation, 1976-2004. Institute for Research into the Economics of Taxation, October 2009.

[4] Ibid.

[5] Ward-Proud, Liam. “The Effect of Capital Gains Tax Rises on Revenues.” The Adam Smith Institute, 2010. <http://www.adamsmith.org/sites/default/files/resources/capital-gains-tax.pdf>.

[6] In 1997 the Capital Gains tax was reduced to 20%. The tax was previously 28%.

[7] Ward-Proud, “Effect of Capital Gains on Tax Rises.”

[8] Ibid.

[9] Rahn, Richard. “Inflation and the Tax Man.” The Wall Street Journal, 17 Jan. 2008. <http://online.wsj.com/article/SB120053175732296095.html>.