Another Capital Gains Tax Cut Will Likely Fizzle
On several occasions over the last few months we highlighted a different view of many government policies, proposing their purpose is to influence our behavior in ways that keep the economy on a steady track.
The question we should all ask is: does it work?
And I don’t mean, can they influence our behavior? They clearly can. What I am asking is can they, the government, implement policies that keep the economy on a steady track?
This theory was originally postulated by British economist John Meynard Keynes. Keynes advocated for active government intervention in the economy, specifically to end the boom/bust cycles of free market economies.
He proposed the government’s policy, in periods of growth, should be to raise taxes and cut its own spending. “Extra” money raised by the government in these periods should be saved.
He felt if business was expanding and the economy growing, the government could take a less active role and save its revenue.
When the business cycle turned south and the economy began to contract, the government, now flush with cash from the good times, would have the wherewithal to step in. Keynes proposed that in periods of economic contractions the government should lower taxes and increase spending. Doing this would offset the economic contraction and keep the economy stable, until private business picked up.
Franklin Roosevelt is thought to have been the first “Keynesian” President. He instituted massive government intervention into the economy to combat the Depression. Whether it worked or not is a topic for another time. It did make him popular, so by that measure it worked exceptionally well.
Since the 1940’s, the U.S. economy has experienced numerous expansions and contractions. But overall, since World War II, the U.S. economy has experienced tremendous growth.
So, Keynes’ theory worked, right? Well, no.
It was never really applied. Once politicians had a green light to spend on just about anything, they did. Regardless of whether the economy was doing well or poor, government just kept on spending. In fact, not only did they spend all the money they collected from taxes, they borrowed so they could spend more.
Keynes’ theory failed because he ignored another tenant of economics, which is: results are generally predictable if you understand the incentives. As applied to politicians, the incentive is to get reelected.
How do you get reelected?
You can pass laws that prohibit or restrict some activity, but when you do, for every happy constituent in favor of the law, there are others disgruntled with what you did. Politicians do pass such laws but, as you may have noticed, it is not an easy thing to do.
Another path for the politician to get reelected is to spend money. Just give money to this group and that group and everyone is happy.
Those people opposed to spending, are fragmented. Many are not opposed to spending on things they favor, just things they don’t like. If they get their money, they don’t line up against the politicians. Few oppose government spending as a point of principal.
It’s all going to good causes, right?! Who could be against it?
Another topic for another time.
Keynes’ theory failed because he failed to account for the incentives of the politicians who would have to enact his policies. He failed to recognize that they would never save money or cut spending in good times, that they would always spend.
That doesn’t mean Keynesian economics is seen as a failure, quite to the contrary, Keynesian language is still deeply engrained in our discussion on public policy. You just may not recognize it.
The latest proposal, couched in ‘Keynesian speak’, was President Trump declaring his support for reducing the tax on capital gains. Remember a Keynesian, in bad times, would cut taxes and raise government spending to stabilize the economy.
To be fair, we felt the Administration’s income tax cuts in 2017 were a major long-term positive for the U.S. economy. We do not see a capital gains cut, at this time, as having much of an impact.
To contextualize our thoughts on the matter, consider this: in the 1920’s the Treasury Secretary was Andrew Mellon. When he took office during the Harding administration, he put out a plan to reduce the income tax rate. By the time Mellon took his office the highest marginal income tax rate was 73%.
His thinking was if a tax rate is too high, it stifles economic activity and lowers the revenue the government collects from the tax. He felt the 73% was too high.
Mellon proposed that the “right” tax rate, was the rate where people didn’t think twice about paying it when they made financial decisions. For income tax rates (if I remember properly), he floated 25% as the rate where people would engage in business activity and not worry about paying taxes.
I think that rate is too for what Mellon proposed. I believe at 25% income tax rate people do incorporate taxes into their decisions. On the other hand, I’ve found the current 12% Federal income tax bracket seems to be a level where most people accept paying the tax without much concern.
Which brings me back to the Administration’s capital gains rate cut proposal. Would it stimulate increased activity? Likely yes, but with most people paying Federal taxes on capital gains at 15%, the impact is unlikely to be great.
If you would like to discuss the impact of capital gains on your portfolio, give me a call.