Obama's Capital Loss

REVIEW & OUTLOOK - The Wall Street Journal
Obama's Capital Loss
April 5, 2008; Page A8

Barack Obama recently released his tax records, and it was notable how little he and his wife appear to invest in the stock market. That may explain the Senator's odd belief that a significant hike in the capital gains tax rate won't matter to shareholders or harm the economy.

Or so Mr. Obama's replied to CNBC's Maria Bartiromo when she asked how much he'd increase the cap-gains tax, something he's said is necessary to restore "fairness" to the tax code. Thanks to the 2003 tax cuts, the top rate is currently 15%.

"When I talk to people like Warren Buffett or others and I ask them, you know, what's – how much of a difference is it going to be if it's 20 or 25%, they say, look, if it's within that range then it's not going to distort, I think, economic decision making," he said. He concluded that a higher rate would boost federal receipts, which would allow the government to redistribute "relief to middle class and working class families."

With apologies to economists Buffett and Obama, the history of this tax isn't on their side. The capital gains rate is crucial to investment decisions; higher rates make capital more expensive, dampening incentives to invest and reducing economic growth. John F. Kennedy understood this, as he proposed a capital gains tax cut. Bill Clinton joined with Republicans in 1997 to sign legislation lowering the rate to 20% from 28%.

Critics howled this would reduce tax revenues, and they howled when Republicans cut the rate to 15% in 2003. What followed in both cases was an enormous "unlocking" effect, as investors sold more stock and assets to take advantage of the lower rate. Capital gains realizations soared to an estimated $729 billion in 2006 from $269 billion in 2002. This goosed Treasury receipts from capital gains, to an estimated $110 billion in 2006 from $49 billion in 2002.

Mr. Obama doesn't have to guess what sort of "distortion" would come from significantly raising the cap-gains rate. In 1986, the tax rate jumped to 28% from 20%, a 40% increase. Tax revenues spiked briefly in anticipation of the hike (as investors moved to cash in at the lower rate), then dropped precipitously. Four years later, in 1990, the federal government was still taking in 13% less revenue at the 28% rate than it did in 1985 at the 20% rate.

As for Mr. Obama's implication that capital gains remain the privilege of the wealthy well, that's yesterday. In recent decades, the U.S. has become a shareholder society, and average Americans increasingly rely on investment income to save for retirement or even to pay bills.

In 2005, according to the most recent data from the Internal Revenue Service, 8.5 million households paid taxes on capital gains. A hefty 47% of those tax filers reported income of less than $50,000, while 79% had income under $100,000. Keep in mind that capital gains themselves count as income and often are a one-time windfall from the sale of a small business or long-held stock. These working families would suffer a double whammy, both with a higher tax rate and lower stock prices – because financial markets factor higher taxes on stock profits into lower stock valuations.

With the economy weak, this is an especially poor time to be talking up tax hikes. A higher rate, and its devaluing of U.S. assets, would hammer U.S. competitiveness, making it harder to attract global capital. America is increasingly isolated in taxing capital gains. Many industrialized competitors publicize a lower rate, and many (Germany, Switzerland, Austria, New Zealand) have no levy at all.

If Mr. Obama really wants to lift the economy – and those middle-class American shareholders – he'd advocate cutting the rate, or indexing it to inflation so investors aren't taxed on phantom gains. That would violate the Democratic left's faith that tax rates don't matter to growth and that raising taxes on capital and "the rich" is good politics. We doubt members of America's politically astute investor class agree.