Yesterday, Bloomberg News leaked a story about the Biden Administration’s plan to increase the long-term capital gains tax rate for ‘high income earners’ to 39.6%. Couple this with the 3.8% surtax to help fund Medicare, and the effective rate at the Federal level would 43.4% for this group. This doesn’t take into account capital gains tax rates at the state level, which run as high as 13.3% in California and as low as 0% in a number of states (including Texas and Florida).
Proponents for increasing the marginal tax rate on this group of income earners stress how much extra money it could make for the Federal government. Some estimates put the number at around $1 trillion over the next decade. Of course, these guesses make a lot of assumptions which may or may not come to pass. You know, things like economic growth, investors willing to absorb the gains, stock market appreciation, etc.
$1 trillion, huh? An additional $100 billion per year for the next ten years, on average? That doesn’t seem like too, too much of a stretch, does it? According to the OECD, who breaks down our budget much more coherently than the US Treasury itself, Washington collected, on average, $112.756 billion per year from 2010-2019. That works out to be, duh, $1.127 trillion over the past decade. So, doubling the effective tax rate on high income earners should just about double the tax receipts. Right?
After doing a little legwork on my end, I have concluded the capital gains tax rate isn’t a terribly effective gauge to determine tax receipts. From 1976-1978, the top rate was 39.875%, and ‘realized gains as percentage of GDP’ averaged 2.2%. This resulted in $23.9 billion in taxes paid on capital gains. Just a few years later, from 1982-1984, the maximum rate was 20%, and the government collected $49.9 billion in capital gains taxes, as realized gains as a percent of GDP averaged around 3.5%.
I won’t bore you with all the data points. Let me just say tax rates aren’t as neat as either side of the argument would like for them to be, at least in terms of tax generation. However, perhaps not surprisingly, the numbers suggest ‘realized gains as a percent of GDP’ are greater when the ‘average effective tax rate’ is lower, on average.
This leads me to the follow assertion: the biggest factor in determining capital gains tax receipts is, drum roll please, asset prices. When asset prices go up, the government collects more money. When they go down, it brings in less. How basic is that? There isn’t any guesswork, and you don’t need an academic paper to confuse the issue.
As a result, it would seem the best tax policy to grow asset prices would be that which encourages savings and investment. Intuitively, asset prices will go up if/when there is more money searching for investment opportunities. As economist Shahira ElBogdady Knight so aptly put it in a working paper for the Joint Economic Committee of the US Congress all the way back in June 1997 entitled ‘The Economic Effects of Capital Gains Taxation’:
“Saving and investment are crucial to economic growth and rising living standards. However, high costs of capital, double and triple taxation of saving, and taxation of inflationary gains discourage these activities, thus lowering economic efficiency and long-term growth prospects.”
This makes sense, at least to me. Taxes and regulation, while necessary for the functioning of our society, are a cost of/on capital. The higher they are, the more they discourage savings and investment. Further, they inhibit the free flow of capital throughout the financial system to its highest and best use, thereby depressing returns and wealth generation.
Consider the following example, which is incredibly common, as anyone in the investment industry will tell you.
Investor A in Alabama has an investment which has appreciated significantly over the years. If they sell it and realize the gains, they would potentially pay up to 28.8% of the current market value of the investment in taxes, using current tax laws. Unfortunately, the growth potential for the investment has cooled, as analysts expect to grow at a rate 2% per year less than the market. What should they do? Sell the asset and reinvest in the market, or hold onto it?
Hold onto to your hats. This is going to get super nerdy in a hurry.
The easy answer is: what is their time horizon? If they can wait a little while, they will eventually be able to make up the difference. If the return differential is 2%, the math suggests it will take about 18 years, assuming that 28.8% tax. If the differential is 3%, it shrinks to around 12 years. Finally, for the purposes here, IF their current investment trails the market return by 5% per year over the entire time, they will be back to ‘even’ by year 8, or thereabouts.
Not surprisingly that is a big hurdle for a lot of investors to overcome: “if I sell investment X and reinvest the after-tax proceeds (28.8% less), I need to find an investment which will outperform X by 5% per year for 8 years just to get to ‘even’ with where I would be if I didn’t sell it.” For those of you keeping score at home, the math is 1.05 raised to the 8th power minus 1.
Now, let’s raise the stakes a little bit, and use the proposed new rates. This would max out in Alabama at 48.4% (including state tax). How long will it take now? At a 5% return differential it would take about 15 years to get back to where you would be if you didn’t do anything. At 3%, you will need about 24 years to do it. Finally, at 2%, drum roll please, how does 36 years strike you?
This is the biggest problem with the capital gains tax: it is a form of capital control. Instead of growing their wealth more rapidly, which is ultimately beneficial for society (and government coffers), the investor in the example doesn’t do anything in order to avoid paying the tax. As such, unless their investment is in danger of collapsing, for whatever reason, it is often in their best financial interest to simply stick with the underperforming asset.
By the way, the government doesn’t collect a red cent when they do so.
Now, the kneejerk reaction to this I have used an extreme example, an investment with a cost basis of essentially $0. Fair enough. To be sure, there will be plenty of instances where investors with a modest gain in an asset will be willing to pay the tax, and move onto something else. Some back of the envelope equations suggest investors will probably be relatively ambivalent if/when the unrealized capital gain is 10% of the market value of the investment, or less. Even when the unrealized gain is 25% of the total, many high-income investors might shrug off having to pay the tax. However, when it is 50%, brother, it starts getting hard to pull the string on the sell side…really hard.
I have been doing this line of work for decades, and I have seen this very situation numerous times. In fact, it is common. So, I have seen first-hand how the capital gains tax inhibits the free flow of capital throughout the financial system. Further, I have done the math I have shared in this newsletter on numerous occasions (I should probably save the spreadsheet this time). So, this isn’t theory to me; I am not trying to outthink myself here.
I have been there and done that. Better put, I am here and I do it.
In the end, the Administration’s proposed increase to the capital gains tax rate for high income earners would have ironic consequences, as it effectively freezes significant amounts of capital. Obviously, this would reduce tax receipts. Let’s hope the Congress can quit its constant backbiting long enough to punt this back to the President. Further, God love you if you made it to the end.
Take care, have a great weekend, and be sure to tune into our podcast “Trading Perspectives.”
John Norris
Chief Economist
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.