When he signed this tax cut into law, Bush proclaimed, "The top capital gains tax rate will be reduced by 25%, which will encourage more investment and risk-taking, and that will help in job creation." The opposite is true.
Bush´s advisors appear not to have realized this, but corporate managers did. Their bonuses take the form of options whose value depends on capital appreciation. If they had believed what Bush said, they would have invested their retained earnings in order to increase future production and profits. Instead they opted to create capital gains artificially by buying back their corporations´ own stock.
Obviously, society ought to prefer the reinvestment of retained earnings which creates job opportunities, increases efficiency, and leads to technological advance and long-term growth. Buybacks accomplish none of these benefits. They amount to a misallocation of invest able funds to consumption.
The following graph shows that stock buybacks by our nation´s 500 biggest corporations began increasing in response to Bush´s 2003 capital gains tax cut and have been increasing ever since.
In 2007, our 500 largest corporations were actually paying out more than they took in. They earned $587 billion in profits while paying out $589 billion for buybacks and another $246 billion for dividends . The result was a drop in investment by United States corporations, relative to peers in Germany, Japan and elsewhere. As a result of lack of investment, American economic growth slowed to a snail´s pace.
Clueless Presidential Candidates
Republican voters know that something is wrong with the conventional Republican economic prescriptions. Instead of voting for the establishment Republican candidates in the primaries, they gave the most votes to political maverick John McCain and to FairTax advocate Mike Huckabee. But ever since McCain won, he has been moving quickly to adopt the Republican establishment´s economic recommendations. Although he originally voted against Bush´s capital gains tax cut, he quickly became a capital gains tax cut convert and even began advocating the Flat Tax as the ultimate tax reform.
Senator Obama´s answer is simple but wrong. If elected, he plans to raise the maximum capital gains tax rate to 25%. Although this might stop some investors from consuming their capital, it would cause the government to consume a greater proportion of our nation´s capital stock and future income whenever investors sell one stock to buy another. Even if capital stock is not sold, it would be locked into poor quality investments, making it less available to new growing sectors of the economy.
The Effective Solution
There is an effective tax reform alternative that would jumpstart the stagnating American economy. True consumption taxes (e.g. the FairTax, the Value-Added Tax, and the USA Tax) give capital gains an efficient treatment. They tax consumption, not the part of income that is saved. As a result they encourage people to add to their savings and thus build our country´s future income. Consumption taxes encourage a society to accumulate capital whereas capital gains tax cuts encourage a society to consume it.
The treatment that consumption taxes give to capital gains is especially sensible. Any capital that is consumed is taxed. Any capital that is reinvested goes untaxed. Thus capital gains are taxed at the same rate as other income, but only if consumed. Gone would be the incentive for corporations to buy back their shares of stock. Gone would be the incentive for homeowners to consume the value of their homes.
Consumption tax systems are the ideal for maximizing savings and capital accumulation. In the 2008 presidential primaries, Governor Huckabee advocated completely replacing the entire income, payroll, inheritance, and capital gains tax system with a simple 23% sales tax, the FairTax. The result would be a tremendous increase in American savings and investment.
But it is also possible to incrementally improve the current income tax system. In 1951, President Truman improved the income tax for homeowners by giving them a tax deferment when they bought one home with the proceeds from selling another. Truman´s idea could easily be applied to income producing assets (e.g., stocks, bonds, and rental properties).
As recent experience shows, the Flat Tax is wrong on capital gains. Lowering capital gains tax rates tends to cause investors to consume their capital instead of reinvesting it. Simply raising capital gains tax rates is not the answer because doing so locks capital into bad investments and causes the government to consume capital whenever it is rolled over into new investments.
In our just published book, Trading Away Our Future, we advocate replacing our entire current tax system with a consumption tax. But we also advocate incremental ways to improve our current system. As a first step, whoever is elected president should raise capital gains taxes to the same rate as other income is taxed, but defer capital gains taxes whenever one income-producing asset is rolled-over into another.