Capital Gains Tax: An Impediment to Recovery

“The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital… the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.”

These words were spoken by President John F. Kennedy in 1963.  He understood that an abundant supply of risk capital is the fuel required for a robust economy.  When you tax capital at a higher rate, you get less of it.  His words beg the question for us in 2011; with our economy struggling, are our tax policies having a good or bad effect on our prospects for capital formation and growth?

A capital gain is the financial profit derived from the sale of an investment like a home, an office building, a farm, a family business, shares of stock or a tangible object.  Put another way, it is the appreciation in the value of an asset. 

Current state law allows individuals and certain types of businesses to exclude 30% of net long-term capital gains from income for income tax purposes. Long-term capital gains on the sale of farm assets are eligible for 60% exclusion.

That’s on top of a federal capital gains tax varying between 10% and 39.6% depending upon circumstances.  This combined burden discourages the risk capital investment spoken of by President Kennedy, reduces our global competitiveness and encourages the flight of jobs overseas.

Some have also argued that this is an unfair double tax of investment returns since the government first takes money through corporate income taxes.

The tax on capital gains may be the most misunderstood tax in existence today.  Its supporters say it’s a tax only on the rich, but that shows a fundamental misunderstanding of the issue.  Capital availability is inextricably linked to overall wages. 

Historical evidence proves that reducing the rate of taxation of capital actually provides an upward boost to overall worker wages.  Paul Samuelson, a member of President Kennedy's Council of Economic Advisers, put it this way:

“What happens to the wage rate when each person works with more capital goods? Because each worker has more capital to work with, his or her marginal product [or productivity] rises. Therefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rates.”

Historical rises in the rate of capital taxation have been followed by slower rates of capital formation and business investment – and economic slowdown.  Furthermore, hikes in this tax have, without exception, been met with declining government revenues from it.

Conversely, cuts in capital gains taxes are followed by periods of growth and actually increased government revenues from this tax over time.  That may seem counterintuitive on its face, but it is absolutely logical. 

When you reduce taxation of something, you get more of it, so it should surprise no one that reduced taxes on capital result in more capital being invested throughout the economy.  That investment creates more and expanded businesses and jobs, which in turn causes increased economic activity – resulting in higher tax collections, even at a lower rate.

Much more could be said about the harmful nature of the capital gains tax, and I believe that the verdict of historical evidence is in; Wisconsin’s capital gains tax needs to be reduced – or eliminated altogether. 

That’s why I’ve co-sponsored Assembly Bill 6, a proposal that would phase out this tax by 2014.  At a time when the lack of risk capital is a huge drag on the economy, we need to attack the problem head on.  We know from past experience that such a tax cut would hurt no one and help many.  If we’re serious about creating jobs in Wisconsin, we need to look at this serious solution instead of nibbling around the edges.

To contact me with any questions or comments or to sign up for my regular e-updates, please send an e-mail to Rep.Knodl@legis.wi.gov or call me at (608) 266-3796.