Reduced tax rates on dividends, capital gains help our economy

One of the best things Congress did to get our economy back on track was provide a reduced tax rate on capital gains and dividends. The low rate has provided significant benefits to the economy — while costing us very little in foregone revenue.

Even so, a number of legislators have announced their intent to repeal this provision as soon as they can in the name of deficit reduction. That would be a mistake.

The goal of taxation should be to collect revenue in a way that does as little harm to the economy as possible. Taxes on dividends and capital gains slow economic growth considerably, more than taxing consumption or wages. These taxes reduce how much people save and invest and make it more difficult for businesses to raise money to expand and modernize.

This hurts everyone; Greg Mankiw has pointed out that even a worker who does not own stock prospers from a lower tax on investment income by seeing his productivity and wages increase when a firm invests to improve productivity.
Nobel Laureates such as Ed Prescott and Bob Lucas have argued that removing the pernicious taxation on capital income is as close as we can get to a “free lunch.” They reason is that lower taxes on dividends and capital gains ultimately increase savings, capital, productivity, and wages of all Americans.

Still, some in Congress are not convinced. That’s because many empirical studies fail to show that taxes on savings reduce how much we save. But these studies are not the best way to determine savings. The myriad factors that also influence savings are difficult to isolate and control, and at high rates of return we should expect a higher return to decrease savings to some degree. Studies that look solely at the amount of total wealth accumulation — perhaps the best measure of savings — show that it is strongly correlated with the tax rate on capital income.

Since we reduced the rates on capital gains and dividends, results have been impressive. Firms are paying more dividends and less capital is “locked up,” meaning that people sell stock more often. As a result, capital flows to better-performing investments and the market becomes more efficient.

This has produced a happy by-product: The government received more tax revenue. Last year, the revenue collected from capital gains and dividend taxes exceeded $100 billion and surpassed what we collected in 2002 — before we lowered the rate.

Still, some tax writers may be tempted to repeal this because they want more tax revenue for a strained budget. But keep in mind: The corporate income tax will generate more than $400 billion this year. So rest assured: Profits are getting taxed. Businesses that do not earn a profit typically have a difficult time paying dividends for an extended period of time, and their stock price certainly does not generate any capital gains. True, corporate profits are to some degree fungible and can be shifted over time to manipulate earnings goals, and it’s not a practice I particularly admire. But at some point, a successful company has to declare profits and pay taxes, and when it does, the government gets its money.

Congress must remember that our policies do affect economic growth. Anyone paying attention to Western Europe can see that excessive regulation, generous social-insurance programs, and sky-high taxes can strangle innovation and economic vitality in any economy.

The first rule of taxation should be to collect revenue in a way that does the least harm to growth. The last three years have demonstrated that previously high taxes on dividends and capital gains were a particularly costly way to collect revenue.

Everyone is better off when we collect our taxes elsewhere.

Hatch is a member of the Senate Finance Committee.

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