This content is provided by Americans for Tax Reform Foundation.

Capital income is important to the health of the American economy. Many experts recognize that lawmakers should do everything in their power to encourage entrepreneurs to take risks by allowing them to keep more of their money when those risks pay off in the form of capital gains. Harvard economist Jeffrey Miron notes that taxing capital income “punishes labor effort and savings…savings finances capital formation and research and development, which are crucial for economic growth.”

Predictably, President Obama and Congressional Democrats are plotting a massive tax hike on capital income in 2013. Under the current law being defended by Democrats, the lowest rate on short-term capital gains would jump from 10 percent to 15 percent while the top rate would increase from 35 percent to 39.6 percent as short-term capital gains would cease to be distinguished from ordinary income. A new surtax on investment income in Obamacare is set to bring the effective top rate to an unacceptably high 43.4 percent.

Long-term capital gains, a category that includes dividends, would also see large tax hikes. A 10 percent rate would be imposed on taxpayers in the bottom two income tax brackets, the members of which currently pay no taxes on long-term capital gains, and the rate facing all other taxpayers would increase from 15 percent to 20 percent.

Governor Romney understands the need to reduce the tax burden on savings and investment. For this reason, he has proposed maintaining current rates on capital income for taxpayers earning more than $200,000 annually and eliminating the tax on those who earn less than that amount.

An examination of historical data reveals that reducing the tax burden on capital income is likely to strengthen the economy. The graph above shows that the growth of real private investment is significantly correlated with a low average effective tax rate on short-term capital gains. The data show a similar correlation for the rate on long-term capital gains as well, with a correlation coefficient of 0.45.

Investment is hugely consequential because it is the most volatile component of GDP. Consumption, roughly 70 percent of GDP, is fairly constant. Yet investment can jump rapidly and, in doing so, boost output in a major way.

In addition to correlating with higher investment, low taxes on capital income are also correlated with higher saving rates. Over the period from 1954 to 2008, the correlation coefficient for gross private saving relative to a linear model of its growth and the average effective tax rate on short-term capital gains is a remarkable 0.53. When the relative growth of private saving is compared with the long-term capital gains rate, the number is 0.49.

Saving is also good for the economy in the long run because it means capital will be available for future investments. As economist Adolfo Laurenti says, “savings are always good” because they lead to “a better and strong economy.”

The best policy with regard to taxes on capital income would be a rate of zero for all taxpayers, because eliminating the tax entirely would provide a major shot in the arm to the U.S. economy. Governor Romney’s plan would only bring the rate to zero for taxpayers in the three lowest brackets; those whose income places them in the top three brackets would not benefit from marginal incentive effects. Nonetheless, enacting the plan would reduce the average effective rate on capital income and provide the benefit of a zero marginal rate on capital gains for the vast majority of Americans.  

Economics is about incentives, and reducing the tax burden on capital income will clearly incentivize more investment and more saving. Governor Romney’s plan for capital income taxes is a step towards Reagan-style growth.

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