Ending the reduced tax rates on capital gains and dividends, one of many options being considered as part of major tax reform legislation, could deal a dramatic blow to the U.S. economy and actually end up losing revenue for the Treasury. Raising rates on these types of investment income could cost 1.3 million jobs and shrink the economy by almost $1 trillion, according to a new analysis by the nonpartisan Tax Foundation.
"Taxing capital gains and dividends at the same rate as ordinary income would reduce capital formation, productivity, and wages to such an extent that it would be a major revenue loser for the federal budget," said Tax Foundation Fellow Dr. Michael Schuyler. "Few tax increases would actually cost revenue, but the capital gains (and dividend) tax is one of them."
The conventional "static" assessment of treating capital gains as regular income estimates an increase of $108 billion in federal revenues. This type of estimate is incomplete, however, because the individuals and institutions making investment decisions are highly sensitive to their after-tax rate of return. The Tax Foundation's dynamic model finds that the higher tax rates would cause capital stock to decline by 16.9 percent and employment to decline by 1.25 percent, and would shrink the size of the overall economy by 6.3 percent.
"The name of the game in comprehensive tax reform is growth," said Tax Foundation president Scott Hodge. "We need smart policies that will both simplify the tax code and effectively foster economic growth over the long term. Increasing tax rates on capital gains and dividends, even though it would technically eliminate a major tax expenditure from the code, would have the opposite effect."
Tax Foundation Fiscal Fact No. 381, "Reduced Tax Rates on Capital Gains and Qualified Dividends" by Michael Schuyler, Ph.D. and Stephen Entin, is available online. This study is the third of a series of 11 case studies in the Tax Foundation's Economics of the Blank Slate series.
The Tax Foundation is a nonpartisan research organization that has monitored fiscal policy at the federal, state and local levels since 1937.