New IRET Study: Government Estimators Ignore Macroeconomic Effects of Changes in Cap Gains Tax Rates

In October we discussed two important research papers released by the Institute for Research on the Economics of Taxation (IRET) sponsored by The Searle Freedom Trust. One found that taxpayers are still sensitive to the tax rate on capital gains, and would report fewer gains if the rate were raised, while the other concluded that tax rate increases would not raise anticipated revenues.

Another great study from IRET has been released, authored by the organization's president, Stephen J. Entin. The paper is important because it examines how and how well major government bodies estimate the effects of changing capital gains tax rates.

The Conclusion:

The CBO, Joint Tax Committee, and Treasury revenue estimators ignore the macroeconomic effects of changes in the capital gains tax rate (and other taxes too) when they prepare revenue estimates for the Administration and the Congress. This practice does the government and the country a major disservice.

The estimators do adjust for taxpayers' microeconomic behavior, their short-term timing decisions concerning the realization of gains in the months before and after a change in the capital gains tax rate, but these have little effect on total revenues over time. The estimators acknowledge that there may be a longer term, more permanent realizations reaction to a tax rate change, but have generally underestimated the effect (more so at the CBO than the Treasury). The result is that they over-estimate the capital gains tax revenue increase from a rate hike, and over-estimate the revenue loss from a rate reduction.

The economic effects that are ignored are even larger than the realizations effects. Higher tax rates on capital gains depress capital formation, causing reductions in labor productivity, employment, and income. Revenues from all taxes are reduced as income is held down. The Volcker panel on tax reform would do well to consider the economic consequences of their recommendations, and not rely solely on the official revenue estimates in making their decisions.

The conclusions, sadly, will not come as a surprise to many who have followed the issue for decades and who have, like ACCF, been fighting to keep capital gains tax rates low so that capital formation will be high.