ARGOP: What They Don’t Know Can Hurt Us

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On Friday, Lieutenant Governor candidate Mark Darr retweeted a message from Representative Ed Garner.

RepEdGarner Elim AR Cap Gains Tax! RT @markdarr: We have to get our tax structure in line to compete w other states & become biz friendly. Where are the jobs our elected officials tout?

For whatever reason — my guess is because no one has really stopped to question whether Garner knows what he’s talking about — Ed Garner has made himself an authority on this issue in Republican circles.  It’s not enough for Republicans like Garner and Darr that Arkansas is one of only nine states (among those that levy income taxes) to offer some sort of substantial tax break for capital gains. No, Garner and Co. are arguing, in effect, that we should remove all taxes from capital gains and allow companies to realize these profits on investments, which are currently only partially taxed as income, without paying any taxes on that money, which (he says) would encourage businesses to invest more in their business, which in turn (he says) would cause them to hire more people as their companies expanded. Sounds simple enough, right?

Too bad it’s completely wrong.

First of all, it might be helpful to review Arkansas’s capital gains tax structure under Arkansas Code Annotated § 26-51-815. For long-term holdings (greater than one year) that result in a capital gain, 30% of the gain is excluded from being taxed as regular income. With short-term holdings, 100% is subject to tax. Recall that, in Arkansas, $32,600 is the bottom of the highest tax bracket (7%)1, and it’s hard to fathom that someone who would have much in the way of capital gains would not already have $32,600 in net income, so it’s safe to assume long-term capital gains are basically 7% of 70% of the amount, 0r 4.9% (i.e. $4.90 per $100 gain).2

Keeping that additional $4.90 per taxable $100 in capital gains is hardly a windfall for a company; the tax savings on $100 wouldn’t even cover one hour’s wages for a minimum wage employee. Even if we were to buy the incredibly specious argument that every dollar saved by eliminating the capital gains tax would be re-invested into labor, it would take $128 in gross capital gains for the tax savings to cover that one additional minimum-wage hour. Assuming we are trying to create full-time jobs, an employer would have to realize $1,024 in capital gains for the tax savings to cover a single day of minimum wage labor, and that’s without even accounting for employee benefits.

Want the tax savings to cover that worker for a whole work week? $5120 will get you there.

A full year of labor? $266,240.

So, basically, Garner’s “plan” is to create four new minimum wage jobs for every MILLION DOLLARS in capital gains that a company makes, assuming they put 100% of their new-found tax savings back into the company in the form of additional labor. I can see the unemployment line shrinking already.

The relatively small amount of tax that Arkansas’s capital gains scheme imposes, however, is not the only reason why Garner’s plan is flawed. No, his mistake is much broader than that. Extensive research shows little to no connection between capital-gains rate changes and economic growth, especially long-term economic growth. The Congressional Budget Office has explained why this is so:

The sensitivity of realizations to gains tax rates raises the possibility that a cut in the rate could so increase realizations that revenue from capital gains taxes might rise as a consequence. Rising gains receipts in response to a rate cut are most likely to occur in the short run.

Postponing or advancing realizations by a year is relatively easy compared with doing so over much longer periods. In addition, a stock of accumulated gains may be realized shortly after the rate is cut, but once that accumulation is “unlocked,” the stock of accrued gains is smaller and realizations cannot continue at as fast a rate as they did initially. Thus, even though the responsiveness of realizations to a tax cut may not be enough to produce additional receipts over a long period, it may do so over a few years. The potentially large difference between the long- and short-term sensitivity of realizations to tax rates can mislead observers into assuming a greater permanent responsiveness than actually exists.

Because of the other influences on realizations, the relationship between them and tax rates can be hard to detect and easy to confuse with other phenomena. For example, a number of observers have attributed the rapid rise in realizations in the late 1990s to the 1997 cut in capital gains tax rates. But the 45 percent increase in realizations in 1996–before the cut–exceeded the 40 percent and 25 percent increases in 1997 and 1998 that followed it. Careful studies have failed to agree on how responsive gains realizations are to changes in tax rates, with estimates of that responsiveness varying widely.

(emphases added)

This is not mere theory: historical evidence bears it out, at least on a federal level. In November 1978, the top rate for capital gains was cut from 39% to 28%. From November 1977 to November 1978, the economy had grown 5.8%; in the next eighteen months, it fell one percentage point.

In August 1981, the rate was again cut from 28% to 20%. From August 1980 to August 1981, the economy had grown by 3.5%; From August 1981 to August 1982, it fell by 2.8%. Now, I am not the type of person who buys monocausation of phenomena on a macro level, so I fully grant the possibility that other factors could have been at play here. That said, Republicans like Garner like to argue that tax cuts/low taxes are overwhelmingly what drive business. If, however, some other factors can undermine this driving force of tax cuts qua business octane, then it seems pretty silly to suggest that tax cuts are the end-all, be-all, and that they should be adopted without looking at the other possible factors.

Besides, there is also evidence that capital gains increases have a positive effect on the economy. The tax was was raised in 1976, and economic growth jumped up from 3.6% in the previous two years to 5.2% in the next two years. Capital gains were also raised in 1986, undoing the August 1981 cuts and restoring the level from 20% to 28%, and economic growth rose from 2.2% in the previous twelve months to 3.8% over the next twenty-four months. Again, even if we reject the monocausal explanation, such movement suggests strongly that cutting the capital gains tax does nothing to improve the economy and, in fact, may hurt it.

Also, since Garner offered this solution in the context of creating more jobs, I note that the effect of capital gains tax changes on unemployment is even more surprising. The unemployment rate rose after both the 1978 and 1981 capital gains tax cuts, yet it fell significantly after the 1976 and 1986 capital gains tax increases were passed.

Why don’t cuts in capital gains taxes lead to longterm growth? For a number of reasons, from the fact that they only go to the wealthiest families who are more likely to save that money in lean economic times rather than reinvest it (the primary observable failure of trickle-down economics), to the idea of tax independence (i.e. that as long as the capital gains tax isn’t 100%, businesses are going to make the same decisions regarding hiring and expanding regardless of the capital gains tax because some percentage is better than $0). Yet, for whatever reason, Republicans continue to ignore data, fact, and economic theory in favor of their own misguided, unfounded belief in the infallibility of the free market.

Heck, they don’t even listen to people whose only job is to advise the government on the cost/benefit of various proposals. For example,

[i]n 2002, the Congressional Budget Office (CBO) evaluated the stimulative effect that several different approaches to cutting taxes might have. It found that “capital gains tax cuts would provide little fiscal stimulus,” since most of the benefits of such cuts would accrue to high-income households[…]. Indeed, the CBO determined that, of the range of approaches it examined, capital gains tax cuts were among the least effective. Similarly, but more recently, Mark Zandi, the Chief Economist of Moody’s economy.com, examined a set of proposals Congress could adopt to stimulate the economy in the wake of the credit crisis and the developing recession. He found that each dollar spent by the federal government in making President Bush’s dividend and capital gains tax cuts permanent would boost Gross Domestic Product (GDP) by just 38 cents. To put that in perspective, Zandi determined that each dollar dedicated to bolstering the food stamp program, extending Unemployment Insurance, or improving public infrastructure would yield over $1.50 in additional GDP.

(emphasis added)

And it gets even worse. There’s a strong argument to be made that even the existing 30% break in capital gains taxation that Arkansas gives to taxpayers is hurting the state longterm. According to the Center for Tax Justice, in 2008 alone, Arkansas lost $45M in income tax revenue due to that 30% break2, and 89% of that lost money stayed in the pockets of the top 5% of Arkansas incomes (73% stayed with the top 1%!). This is the breakdown one would expect in a state where 75% of the tax returns filed have adjusted gross incomes under $50,000 but only 9% of the capital gains reported were from that group. By way of comparison, AGIs over $200,000 accounted for only 2% of the returns filed … and 75% of the capital gains. Looking at the budget problems Arkansas has had over the last two years, can anyone in his right mind really think that an additional $90M wouldn’t have eased that burden a great deal?

Speaking of budget problems, therein lies the last flaw in Garner’s plan. As David Meeks and others like to point out whenever they think it will work as some kind of rhetorical trump card, Arkansas is required to balance its budget. Using the 2008 numbers again as analyzed by CTJ, if there were no tax on capital gains whatsoever, Arkansas would have lost an additional $105M, which would have resulted either in further cutting of programs and services or in higher taxes elsewhere. Yet tax-cut proponents seem to be under the ridiculous impression that cutting taxes and increasing spending don’t have similar effects on the state’s budget. The only reason they ever give is that, with lower taxes, the economy will grow and the money will be made up through higher revenue under existing tax schemes. Except, like with a lot of what politicians on both sides of the aisle say regarding economics, this is false. Capital gains tax cuts do not pay for themselves elsewhere.

In an article in the Journal of Public Economics, N. Gregory Mankiw — former chairman of President Bush’s Council of Economic Advisers — and Matthew Weinzierl asked, “To what extent does a tax cut pay for itself?” Mankiw and Weinzierl concluded, “In almost all cases, tax cuts are partly self-financing.” Mankiw explained:

Matthew Weinzierl and I estimated that a broad-based income tax cut (applying to both capital and labor income) would recoup only about a quarter of the lost revenue through supply-side growth effects. For a cut in capital income taxes, the feedback is larger–about 50 percent–but still well under 100 percent.

50% payback, of course, also means 50% loss of money that will have to be made up elsewhere.

I realize that there is this pervasive myth in Arkansas, especially among Republicans, that cutting taxes and removing the government interference will create some sort of employment utopia, where every Republican willing to work hard can be the next Sam Walton.  The fact of the matter, however, is that this simply isn’t true.  After all, by definition, not everyone can be in that top 5% of earners who account for 89% of the capital gains taxes.  For those of us who are not in that upper echelon of earners, the money received from that 5% benefits us.  On the flip side, it is mathematically impossible for removing that capital gains tax to result in an appreciable number of new jobs, and it is even less plausible to suggest that taking that revenue from the state would not adversely impact the 95%ers.

All of which is to say that Garner’s position must be based on some combination of not understanding the issue, ignoring the math, or trying to get tax breaks for some rich friends.  His excuse about creating jobs, then, is either evidence of ignorance or a lie that he hopes others will believe.  Neither answer would surprise me; a predictable answer, however, does not equal an acceptable answer.

Update: I know that the DFA estimate of Garner’s proposal puts the lost revenue at roughly $100M over two years. I will address the difference between that estimate and the CTJ amounts in a future post.

[Author’s note: If much of this looks familiar, it is because I didn’t want to re-invent the wheel, and I took most of this post from a previous post I did regarding David Meeks and Dave Elswick.]

1 Someone should mention this to Mark Martin, just in case he hasn’t heard yet.

2 Technically, because repeal of the 30% would increase federally taxable income, the loss would be closer to $40M after you make that calculation. However, this offset only occurs after the repeal (obviously) and is conditioned on a number of ways that the tax payer may find to shelter some percentage of the increased income from federal taxation, so we’ll use the raw $45M value here.

3 If a person were to calculate the effective capital gains tax, however, it would be even lower than this number due to factors like, inter alia, the advantages from deferring the capital gains realization until some point in the future.