Why Congress Should “Punt and Tackle”

A few thoughts with you on the tax component of the fiscal cliff debate and why lawmakers should “punt and tackle.”

Punt: To reassure business and financial markets, Congress should punt and extend the entire Bush era tax cuts across the board to provide some breathing room.  As you know CBO says if we do go over the cliff and if no action is taken and we let the tax cuts and sequestration happen — we’re going to fall into another recession, with the economy contracting by 2.9% in the first half of next year and real GDP declining by 0.5% in 2013.

An ACCF study by Dr. Allen Sinai of Decision Economics (consulted for the Dem and GOP Administrations and Congress and Fed Reserve) concurs that there will be recessionary impacts if all of the Bush tax cuts to expire and return to previous levels ($855 billion in lost GDP, up to 3 million jobs lost, an average of $1 trillion in lost consumption spending) See http://accf.org/wp-content/uploads/2012/06/ACCF_specialReport_2012_Fiscal_FINAL.pdf.

But Sinai also looks at the impact of a scenario where lawmakers extend the current income tax rates but allows expiration of the current tax rates on capital gains and dividends (reduced real GDP of up to 0.7 percentage points compared to baseline the next several years, more than a half-million fewer persons working by 2015, in addition to negative effects on the stock market). These negative repercussions will impact the type of entrepreneurship, risk taking and job creation needed to jump-start the economy.

For these reasons, Congress and the president must punt now on taxes.

Tackle: The tax code must be fixed in 2013.  Lawmakers should gear up for an extended debate on tax reform similar to what we experienced in 1986.

Beyond restoring our fiscal balance, we need economic growth and we need favorable tax policy conducive to that growth. It is time to have a serious discussion about broad tax reform as we did in 1978 and 1986.  It’s time to look not only at tax rates but what we are taxing in the first place.  A reduction in marginal rates can help stimulate economic growth but those lower rates should not be paid for with higher taxes on savings and investment in exchange. Under our current income tax structure that means on the individual side not increasing on capital gains and dividends and the generational wealth built from estates.

Lawmakers will be looking for ways to pay for any extensions on marginal tax rates.  Instead of trading those reductions with higher taxes on the hard earned income, retirement security and the risk taking that fuel innovation and growth, they should consider a consumption tax.

A wise perspective on capital gains taxes and inflation to measure fairness.

Look at inflation to measure fairness on tax
From Mr Ethan Schwartz

Sir, The argument that capital gains tax rates must be raised because they “are levied at less than half the top rate of income tax” (“Fiscal cliff redux”, Editorial, November 23) omits a key facet of the analysis: the effects of inflation on tax rates levied upon real, inflation-adjusted returns. When inflation is taken into account, capital gains tax rates generally are much closer to top rates of income tax, and indeed, can even surpass them under certain scenarios.

For example, assume a 2.5 per cent annual inflation rate over a five-year period (a rate that is roughly in line with the annualised change in the consumer price index from 2002 to 2011). Assume also an average 7 per cent annual return on an investment in the total US stock market, with roughly half of that return coming in the form of dividends (again, roughly in line with historical averages).

If dividends are taxed at a favourable rate of only 15 per cent, then the investor who placed $100 into the stock market five years ago and reinvested after-tax dividends would have earned about 6.5 per cent annually and have $137 in stock after five years. Were they to sell the stock they would pay a capital gains tax of 15 per cent on $37 or $5.55 in tax. (The actual rate would be somewhat higher on the portion of gains deemed “short-term”.)

Now consider the effects of inflation. On an inflation-adjusted basis, the $100 they invested five years ago must appreciate to $113 today merely to maintain purchasing power. The investor’s real, inflation-adjusted gain before capital gains taxes is only $24. The $5.55 that they pay in capital gains tax is actually a 23 per cent tax rate on real gains once the effects of inflation are stripped out – a tax rate that is almost twice the average rate paid by Americans earning from $50,000 to $100,000, and more than the roughly 20 per cent rate paid by Americans earning up to $250,000 annually.

The inflation-adjusted capital gains tax rate would be harsher still were average stock returns to lag and were dividends to be taxed as normal income. For example, assume a 35 per cent tax rate on dividends but only a 5 per cent annual return on the stock market, before taxes paid on dividends. Now the investor’s stock is worth just north of $122 after five years, and a sale of shares with a 15 per cent capital gains tax will present a capital gains tax bill of roughly $3.36. This investor is paying north of a 30 per cent tax rate on their inflation-adjusted returns, or significantly more than average taxes paid by most Americans. Raising the capital gains tax rate to near 25 per cent would result in a true rate of almost 50 per cent on inflation-adjusted gains.

There may or may not be a good “fairness” argument for adjusting tax rates on capital gains so as to avoid bias in favour of wealthier Americans. What seems clear, however, is that the only fair and accurate way to compare tax rates on capital gains to rates on normal income would be to adjust all capital gains for inflation, then determine the tax to be paid on inflation-adjusted gains in a truly transparent manner.

Ethan Schwartz, New York, NY, US

Tax Reform Flashback

As the tax reform debate heats up, some pro-growth thoughts from 1978…

Congratulations Paul Ryan

Congratulations to Chairman Paul Ryan (R-WI) as the GOP pick for vice president.  He has been a frequent guest at ACCF events and forums over the years and is an effective statesman who understands the importance of pro-growth tax policy to the economy.