Why Obama Gets Capital-Gains Taxes Wrong

While the power of tax cuts has been largely marginalized this decade by the Bush administration’s weak-dollar policies, it’s important to remember the impact of taxation on economic activity. Taxes, and capital-gains taxes in particular, distort economic incentives for good or bad depending on their direction.

And in Barack Obama’s case, his plan to raise the capital-gains rate is an economic negative that he’ll hopefully rethink if elected. Raising the capital-gains rate would penalize investment success, push wages down on the margin, and it would help calcify wealth disparities in this country owing to a reluctance of shareholders to spread capital around.

First the obvious. Taxes are nothing more than a price. The higher the tax on any activity, the more expensive it is to engage in same. Looked at from the perspective of capital-gains taxes, they are a price placed on investment success, and a tax on risk capital that drives the intrepid investor away from risky investments on the margin. When we consider that businesses and entrepreneurs are reliant on the willingness of investors to offer up capital in order to grow, the ideal rate when it comes to capital gains is by definition zero.

In many ways a non-existent capital gains rate should appeal to Obama. He clarified to ABC’s Charles Gibson his desire to raise the rate as something rooted in “fairness”, but given the basic truth that there are no wages without capital, the only fair action to take with respect to lower-income workers would be to erase the tax on capital investment. Abolishment of the rate would increase the amount of capital available for wages, plus it would increase the wage competition for what is always a limited supply of workers.

For those who own shares that have risen in value, the capital gains rate is most problematic. As mentioned, taxes are merely a price, and when the price of selling shares is high, the incentive for investors to defer the sale of appreciated shares rises.

At first glance the above is unfortunate given the implosions this decade of Enron, Worldcom, Bear Stearns, and Lehman Brothers to name a few. Politicians regularly talk up the importance of diversification with the aforementioned firms in mind, but with the price of selling potentially set to rise, the reluctance to unload appreciated shares will grow. Capital-gains taxes are a tax on investment diversification, so they work at cross-purposes with a bipartisan Washington consensus in favor of investment diversity.

But probably the greatest, though least spoken of reason for capital gains abolishment is that a vibrant economy is totally reliant on the unfettered flow of capital. When individuals with large share gains are made reluctant to sell due to taxes, the economy is burned twice:

The economy is first harmed by the aforementioned reluctance of individuals to realize gains. This is a problem because it’s through the sale of shares that investors voice their displeasure with the direction taken by company management. If tax distortions make this necessary process less likely, the growth companies of yesteryear will lose out on the all-important price signals telling them they must improve.

Put simply, how many longtime Microsoft, Dell and Cisco shareholders are reluctant to sell solely due to capital-gains taxes? If so, how does this help those firms if tax rules give them a distorted and elevated view of the job they’re doing?

Secondly, this reluctance to sell and redeploy capital to the most productive opportunities means that tomorrow’s Microsofts potentially go wanting for capital. And when you consider what today’s Microsoft has done for ours and the world economy, it’s essential that we foster an environment where the best ideas of the future get funding.

Capital-gains taxes discourage the above process whereby stale companies overseeing capital destruction lose out to tomorrow’s winners. This is unfortunate for the economy on its face, and when we remember that Obama seeks to promote economic fairness, capital-gains levies once again work at cross-purposes with his goals.

Indeed, taxes on investment gains merely reinforce the existing commercial outlook by virtue of the richest firms of today holding onto capital that would more likely depart in a tax-free environment. If the policy is one of “spreading the wealth around”, then it’s essential to remove the tax barriers that make this result less likely.

On a positive front, Barack Obama, if elected, will be positively restrained in what he does by the political economics of his desire to be a two-term president. That being the case, it is hoped that he’ll cross the aisle on the all-important question of capital-gains taxes. A lower or abolished rate would be a big economic boost all else being equal, plus it would help Obama realize what are now simply campaign platitudes about higher wages and greater economic fairness.