On December 31, 2010, the low tax rates on capital gains and
dividends enacted in 2003 will increase to the higher level that
applied prior to that year. Many economists agree that the
expiration of these tax cuts will discourage investment and slow
economic growth. The United States already has one of the world's
highest capital gains tax rates.
This paper examines the economic effects of allowing the tax
rates on long-term capital gains and dividend income to increase in
2011. Because the economy would suffer from these tax increases,
Congress should act now to make permanent the existing tax rates
for capital gains and dividends.
Our analysis indicates that higher tax rates on these forms of
income would do serious economic harm. For example:
- The slower economy causes employment to shrink by 270,000 job
in 2011 and 413,000 in 2018. Similar job losses continue for the
next seven years of our model's forecast horizon of 2008 through
- Economic output as measured by gross domestic product (GDP)
after inflation would fall by $44 billion in 2011 and $50 billion
in 2012 from the levels that the economy would attain without this
- These economic effects would be vividly evident in take-home
pay. Personal income after taxes would decline by $113 billion
after inflation in 2011 and $133 billion after inflation in 2012
when compared, again, to levels that would likely prevail without
tax rates going back up.
Capital Gains and Economic Growth
Capital gains taxes are voluntary, paid only when appreciated
capital assets are sold. President Bush reduced capital gains taxes
on the sale of taxable assets that have been held for longer than
one year (so-called long-term assets). Short-term taxable assets,
held for less than a year, are taxed at a rate that usually is
higher than the 15 percent long-term capital gains tax rate under
the President's tax reduction.
The current long-term rate does not appear to discourage
investors significantly from selling assets. However, high capital
gains taxes do create what is called a "lock-in effect," where
investors avoid onerous taxation by not selling assets. Econometric
analysis shows a strong link between higher capital gains tax rates
and the lock-in effect. Investors are willing to hold onto
investments for a longer period of time in order to pay the lower
taxes on long-term capital gains.
If high taxes make investors unwilling to sell taxable assets,
the lock-in effect can reduce economic growth by preventing the
reallocation of capital in low-performing investments to more
profitable ventures. Economic growth slows as new businesses find
it difficult to acquire start-up or expansion capital.
Though reducing the tax on capital gains is beneficial to the
economy, a better tax policy would reduce the tax rate on all
capital investment. A broad reduction in the taxation of capital
will lead to more investment and more capital stock. As the
Congressional Budget Office notes, "Reductions in capital taxation
increase the return on investment and therefore the formation of
capital. The resulting increase in the capital stock yields greater
output and higher incomes throughout much of the economy."
Lower taxes on dividends
The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of
2003 set the taxes for qualified dividends at the same rate as
taxes for long-term capital gains. This change ensures that income
from different investments are treated the same. The appreciation
of capital gains is thus no more desirable than dividend income
Before JGTRRA, the average dividend marginal tax rate was 28
percent, or almost twice that of the current long-term capital
gains tax rate of 15 percent. This made retained earnings
(capital gains) a more popular investment choice than distributed
earnings (dividends). The focus on stock appreciation contributed
to accounting scandals at companies like Enron and WorldCom. At the
other end of the income spectrum, high taxes on dividends lowered
the income of retirees who depend on dividend income.
Companies responded to the change in the dividend tax rates by
increasing dividend payments, and some, such as Microsoft,
disbursed dividend payments for the first time. Investors now have
more choices when making investment decisions between companies
that pay dividends or rely on capital appreciation to reward
Lowering taxes on dividends also reduced the double taxation of
corporate income, as this dividend income was already taxed at the
corporate level. This makes the tax code fairer and also encourages
economic growth by reducing the tax on capital. Previous research
by the Heritage Center for Data Analysis indicates that even firms
that do not distribute dividends could have lower capital costs and
Historical Treatment of Capital Gains
Throughout most of the 20th century, capital gains either were
taxed at a lower rate than other income or were only partially
exposed to taxation. The encouragement of capital formation and
investment, the offset of double taxation of corporate income, the
offset of inflation's effect on capital gains, and the
encouragement of risk-taking all justified this discrepancy.
The Tax Reform act of 1986 ended the differential treatment of
capital. Capital gains realizations spiked 91 percent during 1986,
the last year of the lower capital gains tax rate. They then
declined 55 percent in 1987 and did not recover to the pre-tax hike
level for almost a decade. In 1990, capital gains tax rates, then at
28 percent, were again lower than the top marginal tax rate after
the latter increased to 31 percent. This differential grew after
the 1997 capital gains tax cut.
This history clearly demonstrates that the tax rate on capital
gains and dividends makes an enormous difference in the way
investors and firms handle income from capital.
High tax rates on dividends also have a distorting effect. Firms
retain earnings instead of paying them to stockholders. This
reduces the influence of stockholders as firms seek funding from
resources independent of the marketplace of investors.
In short, high taxes on these two forms of income from capital
have the same effect they exercise on other capital incomes: The
marketplace for capital operates less efficiently and with less
capital, the pace of economic growth slows, and the quality of
The Economic Costs of Failing to Extend the Low Tax
The scheduled expiration of the President's tax cuts at the end
of 2010 will alter future investment decisions, slow economic
growth, and reduce personal income. The top capital gains tax rate
will increase from 15 percent to 20 percent. This increase will
promote lock-in, expand the double taxation of capital income, and
drive investment abroad.
The capital gains rate in the United States already is higher
than the average long-term tax rate in most industrial countries.
Americans don't save enough as it is, and investment and savings
would both be discouraged by higher capital gains tax rates.
In addition, the special exclusion for dividend income will end,
and dividend income will again be less desirable than capital
appreciation. The highest rate for dividends will climb back up to
36.5 percent if marginal rates remain at current levels, which will
further distort investment decisions and hamper growth.
Effects of Higher Tax Rates
An analysis of how increasing these tax rates would likely
affect the U.S. economy shows a general slowing of economic
activity when compared to the economic situation that would prevail
without tax increases. For example:
- Increasing capital gains and dividend tax rates would reduce
the capital stock by $12 billion (in constant 2000 dollars) by
- Potential employment would drop by 270,000 in 2011 and 413,000
- Personal incomes would decline by $1,675 (in 2000 dollars) for
a family of four in 2012.
- The broadest measure of economic activity, GDP after inflation,
would decline steadily over the forecast period of 2011 through
- In 2011, GDP would be $44 billion below where it would be if
the tax cuts were not made permanent. That figure would rise
to $50 billion in 2012.
- Annual GDP after inflation losses would average $37 billion
below baseline over that seven-year period.
Higher taxes on capital will hinder the growth of investment and
capital stock. The decrease in capital will reduce economic growth,
which will lead to higher unemployment and reduced personal income.
Tax rates should not be a determining factor in allocating
investment dollars, and lower tax rates mitigate the lock-in
Investment is a forward-looking enterprise, and companies are
already making decisions about their future. Making permanent the
lower tax rates on capital gains and dividends will make future
investment more attractive to businesses and investors. This will
ensure more capital stock and economic growth. Congress should
therefore make permanent these reductions on the cost of
William W, Beach
is Director of, Rea S.
Hederman, Jr., is Senior Policy Analyst in and Assistant
Director of, and Guinevere Nell is Research Programmer in the
Center for Data Analysis at The Heritage Foundation.