The Fascinating Federalism of Capital Gains Taxes

Or, Why California Governor Gavin Newsom Should Hope that the Federal Capital Gains Tax Rate is Not Increased

One thing that economists are fairly sure of is that a cut in the tax rate on capital gains increases the amount of gains subject to the tax and that, conversely, an increase in the tax rate on capital gains decreases the amount of gains subject to the tax. This is especially true in the short run.

This is so because capital gains taxes are levied in the United States only when the capital gains are realized, i.e., when the asset is sold, and the decision about whether to sell the asset is up to the owner.

Here’s how George Washington University economist Joseph J. Cordes put it in, “Capital Gains Taxes,” in the first edition of my Concise Encyclopedia of Economics:

Because capital gains are not taxed unless an asset is sold, investors choose when to pay the tax by deciding when to sell assets. Payment of the tax can be delayed by holding on to an asset with a capital gain, which is financially worthwhile because the amount owed in taxes remains invested in the asset and continues to earn an investment return. Payment of capital gains can be avoided altogether if an asset is held until death. After weighing the advantages of not selling, a rational investor may conclude it is better to keep an asset rather than sell it. When this happens, the capital gain becomes “locked in.” No tax is collected because no capital gain is realized through sale. The gain from staying locked in is greater at higher tax rates, so that the volume of capital gains that are realized falls as the tax rate rises, and vice versa.

Cordes notes that this point is made by proponents of the view that decreasing capital gains tax rates increases capital gains tax revenue, but the point holds whether or not the net effect is to increase tax revenue.

Cordes points out that the net effect on capital gains tax revenues from cutting the capital gains tax rate will depend on how sensitive capital gains realizations are to the capital gains tax rate. If they rise by a higher percent than the percentage drop in the tax rate, that is, if realizations are highly elastic with respect to the tax rate, then capital gains tax revenues will rise. And if they aren’t very sensitive, capital gains taxes will fall. It’s an empirical issue and Cordes deals nicely with the state of knowledge at the time he wrote, namely in the early 1990s.

Stephen Moore makes the same point about capital gains realizations in “Capital Gains Taxes” in the second edition of the Concise Encyclopedia of Economics. He writes:

The capital gains tax is different from almost all other forms of federal taxation in that it is relatively easy to avoid. Because people pay the tax only when they sell an asset, they can legally avoid payment by holding on to their assets—a phenomenon known as the “lock-in effect.”

The effect is symmetric: If the federal government increases the tax rate on capital gains, as Democratic candidate Joe Biden proposes, the effect will be to make capital gains realizations lower than otherwise. Biden proposes to increase the top marginal income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually. The 39.6 percent is the same rate Biden would have on the ordinary income of the highest-income taxpayers. The top federal tax rate on ordinary income is now 37 percent and the top federal tax rate on long-term capital gains is now 20 percent. (Although, as Scott Eastman of the Tax Foundation points out, “Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.)

In short, Biden’s proposed tax rate increase on capital gains is huge, especially for the highest-income taxpayers, who, by the way, have a large percent of overall capital gains.

Here’s what’s not ambiguous: the result of an increase in the federal tax rate on capital gains would be less capital gains tax revenue for California’s state government.

California’s government taxes capital gains at the same rate it taxes ordinary income. With lower capital realizations by California residents, the state government will get less tax revenue from capital gains taxes than otherwise.

And California’s government relies more on capital gains tax revenues than many other states do. In 2019, the latest year for which we have the data, capital gains tax revenues, at $13.8 billion, were 9.5 percent of general fund tax revenues.

Which is why Gavin Newsom, who is facing a large state government budget deficit (although he has substantially overstated it) should hope that whoever is elected in November will not raise the federal tax rate on capital gains.

 

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Anxiety is rising among the American young

Anxiety increased from 5.12% in 2008 to 6.68% in 2018 (p<.0001) among adult Americans. Stratification by age revealed the most notable increase from 7.97% to 14.66% among respondents 18-25 years old (p<.001), which was a more rapid increase than among 26-34 and 35-49 year olds (differential time trend p<.001). Anxiety did not significantly increase among […]

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Five Essential Books on Public Choice

Earlier this pandemic year, I shared a post on five great books to read first if you want to start learning about public choice economics. Looking back at that list, I’m still pleased with those selections, and think they hold up as “must-reads” for anybody with an interest in public choice. Now, I’d like to build on that list by sharing five contenders for most defining, most impactful, most essential books in public choice economics.

My focus here is on works that I’ve personally found most useful in being able to use public choice as a framework for conducting applied research. There is of course much that gets left out here, and no doubt I have colleagues working in the field of public choice who would come up with completely different lists. Those more influenced by the Rochester than the Virginia or Bloomington approaches to public choice would come up with the most different set of selections. While the Virginia and Bloomington approaches are closely linked in that they are both embedded within political economy and heavily invested in questions of constitution-building and rule formation, the Rochester approach tends to place more emphasis on modeling political coalitions and voting behavior. But that’s an over-simplification; for those interested in more detail on the relationship between these three approaches, I highly recommend William C. Mitchell’s article “Virginia, Rochester, and Bloomington: Twenty-five years of public choice and political science.”

So, with caveats in place, here are five essential books in public choice economics that belong in every library:

 

Calculus of Consent: The Logical Foundations of Constitutional Democracy

James M. Buchanan and Gordon Tullock

The theory at the core of this book is about why people form governments and how particular decisions and areas of life are deemed either in or out of the bounds of public influence. Although the dividing lines between public and private can be easily taken for granted at any particular moment in time, the answers to these questions are actually quite varied across societies and can change radically over time. The book’s approach to these fundamental questions is deeply democratic in that it roots collective action in individuals pursuing their plans and interests while remaining keenly aware of the limits of large scale collective action. This balancing act between optimism about the coordinative power of rules and skepticism about the high potential for abuse and misuse of political power, which can be traced back to the constitutional debates at the time of the American founding, is still a defining feature in public choice today. The importance of this book to the development of the field is a big part of why Buchanan won the Nobel Prize in Economics, and why Richard Wagner called Calculus of Consent the “Ur-text” of the Virginia political economy approach to public choice.

 

Bureaucracy

Gordon Tullock

This volume is actually a mash-up of two books by Tullock, The Politics of Bureaucracy and Economic Hierarchies, Organization and the Structure of Production. The vision that brings them together is the desire to understand behavior within political organizations from the perspective of those on the inside. By providing a framework for understanding political behavior as a function of what it takes to advance within a particular system, Tullock offers a way forward for those seeking to better understand the incentives and constraints facing decision makers within bureaucracies.

 

The Logic of Collective Action: Public Goods and the Theory of Groups

Mancur Olson

Olson’s enduring contribution to public choice economics is perhaps best remembered for its presentation of the free rider problem, and the implied difficulties that any group of significant size will face when trying to work together. Seeming to have a shared goal is not always enough—differences in strategy, priorities, and the trade-offs faced by individuals raise the possibility of shirking and conflict. By exploring the internal politics of groups, Olson’s Logic of Collective Action gives us another useful way to look under the surface of collective action in order to really understand the ways that what people want out of their associations—governments, unions, lobbies, corporations, NGOs, clubs—might differ from what they are likely to get.

 

Governing the Commons: The Evolution of Institutions for Collective Action

Elinor Ostrom

This book is the culminating presentation of the first thirty years of theoretical and applied research into local public goods and community problem solving by Elinor Ostrom and her colleagues in the Workshop in Political Theory and Policy Analysis. The big idea here, in a sense, is to turn Olson on his head. Instead of focusing on the ways groups might fail, Ostrom’s emphasis in this book is on the ways groups might succeed. (Though admittedly the contrast is overblown, because both find cooperation among groups to be most successful when power is scaled down to the level of local actors with the most relevant information and incentives.) In additional to providing a theoretical framework, the book catalogs extensive case studies of local populations working together to resolve seemingly insurmountable problems and analyzes them for common threads.

 

The Political Theory of a Compound Republic: Designing the American Experiment

Vincent Ostrom

This may be the least orthodox choice on the list, but in my view, Vincent Ostrom’s work here is an integral part of the big picture of public choice. In this book, Ostrom engages in a careful analysis of Alexander Hamilton’s and James Madison’s contributions to The Federalist in a return to the great question of the American founding: is it possible to design a better government through reflection and choice? Or are we doomed to the vagaries of history and tyranny? All the books above can be seen as addressing versions of this question. And it is a critically important one. Understanding what can and cannot be accomplished in a political setting is critical to avoiding missed opportunities, yes, but also the excesses of power (and the abuse, oppression, and waste that accompany them) that are the greater problem in the modern world.

 

 

These five books are essential reads for anyone wanting to get the full picture of public choice. Taken together, they represent a holistic and adaptable approach to understanding political and economic systems that takes seriously the great power of working together—for better and for worse. There are many more works that deserve a place on this list, too many more to even name here. Share your picks in the comments below and we’ll all get to reading.

 

 

Jayme Lemke is a Senior Research Fellow and Associate Director of Academic and Student Programs at the Mercatus Center at George Mason University and a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics.

 


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Billions of dollars in federal funds earmarked for boosting nationwide Covid-19 testing remain unspent months after Congress made the money available, according to the U.S. Department of Health and Human Services. In April, Congress allocated roughly $25 billion for federal agencies and states to expand testing, develop contact-tracing initiatives and broaden disease surveillance. According to HHS data, […]

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