What’s "Courageous" When It Comes to Taxing Investment Income?

Thom Lambert —  4 February 2006

Today’s New York Times accuses President Bush of getting things “exactly backwards” by exhorting Congress to demonstrate political courage by resisting the urge to raise taxes. The politically courageous move, the Times says, would be to raise taxes (i.e., to refuse to extend the 2003 cuts beyond their expiration date). In particular, the Times calls for brave lawmakers to eliminate the “special low tax rates for investment income,” which “overwhelmingly enrich the rich and will be even harder to justify in the years to come, when, by all reasonable estimates, the country’s financial outlook will have deteriorated further.” It was, the Times says, “Orwellian” for President Bush to suggest that courage would be required to extend the tax cuts on investment income.

No it wasn’t.

As any politician knows, it takes a good bit of political courage to resist popular — but wrong — ideas. One such idea, held by even the smart folks who write editorials for the Times, is that those “special low tax rates for investment income” cause the country’s financial outlook to deteriorate. Most folks think this simply must be the case. After all, if tax rates are lowered, won’t receipts necessarily fall?

Counterintuitively (to most people), the answer is no. As yesterday’s W$J observed, capital gains tax receipts have gone way up — by 45%, to be exact — since President Bush’s 2003 investment tax cut package lowered the rate from 20% to 15%.

How can this be? Well, the reduction in tax penalty on capital asset sales contributed to a doubling of gain realizations, from $269 billion in 2002 to $539 billion in 2005. Tax receipts on these gains rose from $49 billion in 2002 (at a 20% rate) to $80 billion in 2005 (at a lower 15% rate). In addition, the lowering of tax rates on dividends has been followed by a tripling of dividend payouts.

Most voters, busy with their own lives (i.e., doing the various things that create all this wealth!), are rationally ignorant of the revenue effects of tax cuts on investment income. Repeatedly told by media outlets like the Times that tax cuts inevitably enhance deficits, they rationally form opinions that all tax cuts reduce revenues.

Our elected officials, however, are charged with knowing the real effects of different types of tax cuts. In our republican democracy, we expect them to make the wisest choices — even when those choices contradict populist sentiment. That sometimes takes political courage.

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

6 responses to What’s "Courageous" When It Comes to Taxing Investment Income?


    R. James writes:

    The importance of investment activity to the economy far outstrips the revenue it generates for the government, and arguably any significant decrease in investment activity on account of taxation is simply not worth the revenues generated.

    This is entirely analogous to arguing that leisure is more pleasant than work, so people should stay home.

    The choice facing policymakers is not whether revenues generated by a particular tax are “worth” the disadvantages of imposing the tax. The choice is whether the disadvantages associated with that tax are worse than the disadvantages of (i) raising those revenues via some other tax or (ii) via deficit financing or, alternatively, (iii) of not having the revenue at all and cutting some program. Economics can inform that analysis but the choice is ultimately a political one.


    Sigh. I was looking forward to watching this blog develop, but with that kind of reasoning I must admit I’ll probably never come back.

    The applicability of the “Laffer Curve” thesis to current US tax rates has been debunked dozens of times, most recently by the CBO (availble here: http://www.cbo.gov/ftpdocs/69xx/doc6908/12-01-10PercentTaxCut.pdf ) which found that, even if the so-called “supply side” effects of tax cuts are included, the 2001 & 2003 income tax cuts have a negative impact on the Federal budget.

    Even using the numbers you posted, did you consider that taxpayers rationally delayed realization of goals due to a belief that a tax cut was coming, or, upon the cut coming, realized more than their investment strategy recommended out of a fear that the tax cut would not last? Either explanation would have a significant impact on your analysis, but you addressed neither, and apparently just took two data points, drew a line, and came up with the conclusion you wanted.

    As for “courage,” even under your reasoning retaining a tax cut would not be “courageous,” it just wouldn’t be as irresponsible. Investors want tax cuts. Big donors want tax cuts. There’s no political coalition for responsible budgetary policy. Ergo, even if, as you argue, cutting taxes is the right course, it is still the easiest course and thus doesn’t require any courage.


    Josh is right that it would be fallacious (“post hoc, ergo propter hoc”) to conclude that, because capital gains receipts increased following a cut in tax rates, such a cut was the sole cause of the increase. But there can be no doubt, as R. James says, that lowering the cost of investing leads to more of it. That, of course, fuels the economy (contributing to the bull market that Josh notes) and can ultimately generate tax revenues in excess of those that would be produced at a lower rate. Josh also recognizes that lower capital gains rates can enhance allocative efficiency as they encourage investors to go ahead and sell capital assets (they’ll pay less tax on the gain realization) and re-invest their proceeds in ventures that look to be more profitable. Overall wealth is enhanced, of course, when capital flows to its highest and best uses.

    All this is pretty complicated, and the vast majority of voters don’t follow it. (And for good reason! Their costs of educating themselves regarding the intricacies of tax policy exceed their benefits of possessing the additional education.) Thus, there is a conventional wisdom — reflected in the NYT’s editorial — that “special low tax rates for investment income” inevitably send deficits spiraling.

    My only point was that it sometimes takes political courage to resist acting in accordance with this sort of conventional wisdom.


    R. James —

    This kind of academic attempt to force “investment activity” onto a typical supply/demand curve fails in the real world.

    First, I think the assumption that investors respond to tax rates rather than overall expected returns is misguided. Investors care about overall returns. At the margins these may be affected by tax rates, but are far more influenced by how the S & P 500 and broader market indeces perform.

    More importantly, you suggest that we can calculate receipts by multiplying “investment activity” by capital gains rate. That’s just plain wrong. Only gains are taxed. Losses, at least in part, are deducted. That is why market results will determine cap. gains receipts far more than tinkering with tax rates.

    Don’t get me wrong — I don’t mind the lower cap. gains rates. I think they serve a few purposes. Initially they helped inspire a lifeless market (although that effect has probably passed). More importantly lower tax rates encourage reallocation of capital from less promising investments to more promsing investments. I’m not urging that they be trashed. Let’s just be intellectually honest about them.


    In response to Josh:

    One need be neither a politician nor a professor to understand that if you lower the cost of something, people will consume more of it. Thus, by lowering taxes on investing, people will invest more.

    The only question is whether the amount of increased investment activity, multiplied by the lower tax rate, will yield more (or less) revenue than the former (lessor) amount of investment activity multiplied by the former (higher) tax rate.

    At the extremes, the answer to this question is easy to see: A 100% tax rate will yield less revenue than a 50% tax rate because no one will invest (and 100% of nothing = nothing). A 0% tax rate will yield less revenue than a 50% tax rate because no taxes are being collected at the 0% rate.

    So the President (and Professor Lambert) are right in asserting the basic principle that lower tax rates can generate additional revenue. And history, time and again, has proven this to be so. The trick (for the policy maker seeking to maximize tax revenues) lies in finding the correct rate.

    PS: A whole other question is whether investments should be taxed at all. The importance of investment activity to the economy far outstrips the revenue it generates for the government, and arguably any significant decrease in investment activity on account of taxation is simply not worth the revenues generated.


    Only a politician or a professor could conclude that capital gains receipts increased as the result of a specific tax rate change by George Bush, and not the global bull market that has pushed not only the US but Canada, Britain, Germany, Spain, Brazil, etc. to record highs.

    Is there any proof that lower rates aid receipts over the long haul (ie through both bull and bear markets)? I haven’t seen any. Instead you rely on the Kudlovian hope that the markets will spiral upwards indefinitely. Good luck with that.