“Common Sense” Aside, What Do We Really Know About Capital Income Taxes and Growth?

If you’re discussing tax policy with someone who asserts that his or her point is “just common sense,” this could indicate one of two things: Either no deep thought is required—as the person would have you believe. Or no deep thought has been applied.

The “common sense” notion that capital income taxes hinder growth seems to be more a case of the latter.

Long term capital gains are taxed only when the asset is sold and at roughly half the rate on wages and salaries. Dare to suggest that the rate on investment profits could be raised a bit—so that perhaps the rate on labor income could lowered—and you’re liable to be reprimanded for failing to understand something as plain as the nose on your face: To tax capital income is to tax the reward for saving and thus to discourage saving. Less saving means less investment and less investment means slower growth, fewer jobs, and lower wages.

Everyone knows that.

Everyone, that is, except the people who study the issue.

Economic theory teaches that the impact of capital income taxes on savings is robustly ambiguous. Empirical research has yielded mixed results, but overall the data seem to indicate that reducing capital income taxes decreases rather than increases savings. In addition, lowering capital income taxes is likely to go hand in hand with raising labor income taxes or government borrowing, both of which are arguably at least as harmful to growth as capital income taxation.

I step through these points in a recent Wharton policy brief. Here’s a brief of the brief:

Notwithstanding the common sense story that taxing the reward for saving reduces it, the effect of capital income taxes on savings is theoretically indeterminate. There are several sources of indeterminacy. Here is one:

Suppose that you’re putting money away for retirement and Congress increases taxes on what you earn from that savings. There are two countervailing effects on how much you save. First, every future dollar of retirement consumption now requires additional savings—to pay the additional future tax. Second, you’ll probably plan to spend fewer future dollars on retirement consumption—because it’s become in effect more expensive. Whether, in the end, you save more or less depends on whether the first effect is greater or less than the second.

What then do the data say? Econometricians have taken several different approaches, and findings vary. On balance, however, the empirical literature seems to lend greater support to the view that capital income taxes increase rather than decrease savings.

Some of the best empirical research, for example, focuses on estimating a key parameter of individual choice called the “intertemporal elasticity of substitution”. Applied to the retirement savings story told above, the bulk of estimates for this parameter support the conclusion that the first effect dominates, and retirement savings increase in response to greater capital income taxation.

But even if one could support the claim that capital income taxes—considered in isolation—hinder growth, that would not be enough. Capital income taxes aren’t set in a vacuum. Lower capital income taxes mean higher labor income taxes or additional government borrowing. (Yes, capital income tax reductions could be offset with spending cuts. But that just begs the question of why such cuts aren’t instead being used to reduce labor income taxes or borrowing .) Thus, to make the case against capital income taxes, one has to argue not just that such taxes hinder growth, but that they hinder growth more than labor income taxes and government borrowing.

That’s not an easy task.

Government borrowing is generally thought to crowd out private investment. CBO, for example, posits that each dollar of government borrowing reduces domestic investment by anywhere from 10 to 50 cents.

And although existing research is not definitive, there are valid reasons to believe that labor income taxes are at least as likely to reduce savings as capital income taxes. Consider, for example, that in the retirement savings story, labor income taxes have only the second, savings-reducing effect. Like capital income taxes, they reduce planned future consumption by making it more expensive (in this case, in terms of “leisure”). Unlike capital income taxes, however, they do not increase the number of current dollars that must be saved per dollar of future consumption.

In short, trying to spur growth by keeping capital income taxes low seems—at best—like trying to fix one side of the roof with shingles from the other.