Taxing Risk-Taking, Investment and Innovation

Why are so many leading politicians, including President Obama, ready to increase one of the most destructive taxes known to man?

The current top individual capital gains tax rate stands at 15 percent, and is scheduled to increase to 20 percent at the end of next year. For good measure, starting in 2013 under ObamaCare, upper-income earners will face a capital gains tax rate of 23.8 percent.

But one has to factor inflation into the equation as well. With CPI inflation, for example, moving higher, running at 3.6 percent over the past year, the real capital gains tax rate rises as well since gains are not indexed for inflation. For example, in the case of a one-year investment returning 7 percent with a 3.6 percent inflation rate, the real capital gains tax rate turns out to be 31 percent – more than double the nominal 15 percent rate.

But it’s not just the President’s tax proposals that are troubling. The so-called Gang of Six proposal on the debt ceiling has received a great deal of attention, despite its stunning lack of details and the House Budget Committee noting that given the current policy situation, the Gang of Six are serving up a 10-year $2.8 trillion tax increase.

At first glance, the Gang of Six plan is alluring due to talk that it would actually reduce income tax rates, with the top personal and corporate income tax rates being reduced to the 23 percent to 29 percent range. That obviously would be an improvement over current and scheduled future tax rates. But the question is: How do you reduce rates while also jacking up taxes so substantially? Obviously, deductions and credits must be eliminated, and other taxes increased.

As for taxes on investment, Bloomberg News reported the following on July 21: “The bipartisan deficit-reduction plan gaining momentum in the U.S. Senate would likely require lawmakers to curtail or end the preferential tax treatment of capital gains and dividends. The proposal from the so-called Gang of Six doesn’t mention capital gains and dividends. The plan’s goals for income tax rates, federal revenue and progressivity would likely require Congress to raise tax rates on investment income, said tax analysts who favor and oppose preferential tax rates on capital gains and dividends.”

If so, that would mean a substantial capital gains tax hike – even much higher than the President prefers under is budget plan. Throw in inflation, and the real rate would go even higher.

This is economic madness.

The capital gains tax ranks among the most destructive because it is a levy on the returns on risk taking, that is, on the investment and entrepreneurship that drive innovation and growth. The higher the capital gains tax, the greater the disincentive to start up, expand and invest in businesses.

In the current poor economic climate, our elected officials should be focused on reducing, or preferably eliminating, capital gains taxes. At the very least, the current individual 15 percent capital gains tax rate should be made permanent and the corporate capital gains tax (currently 35 percent) reduced to the same level, along with indexing all gains for inflation.

Instead, policymakers are talking about raising the capital gains tax. If the objective is to restrain entrepreneurship, angel and venture capital investment, technological innovation, U.S. competitiveness, and economic and employment growth, then raising the capital gains tax makes perfect sense.

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Raymond J. Keating serves as chief economist for the Small Business & Entrepreneurship Council.