Economic developments in recent weeks have generated a great deal of concern. Turmoil in the subprime mortgage market has spilled over into the broader economy, exacerbating the housing downturn and rattling financial markets. The stock market has been volatile; oil prices recently topped $80 per barrel; and economic forecasters are expecting below-trend growth over the near term.
Against this uncertain economic backdrop, businesses appear to have taken a pause in hiring — payrolls declined in August for the first time in four years. While the economy is likely to weather this most recent storm, these anxious times should serve to refocus our attention on fundamental pro-growth economic policies. Foremost among these are the lower tax rates on capital gains and dividends, passed into law in mid-2003 but set to expire after 2010. I would advocate eliminating these taxes altogether, but the second-best solution is to make the lower rates permanent.
The capital gains tax basically lowers the return on risk-taking. Without the prospect of reward, there is less of an incentive to take a chance on a new invention or new business model. And risk-taking, entrepreneurship and innovation are hallmarks of the U.S. economy and sources of its dynamism and resilience. When capital gains are taxed lightly, we see more venture capital funds and seed money flowing to startup enterprises and growing businesses. That is important because these smaller businesses are the engines of job creation in our society. By some estimates, small businesses account for 60 percent to 80 percent of new jobs each year.
In addition, the capital gains and dividend taxes actually represent a second layer of taxation on equity-financed corporate income. Business profits are first taxed at the corporate level and once again at the individual level as a dividend or a capital gain. This double taxation distorts corporate financing decisions by favoring debt, which can be deducted by businesses and is therefore taxed only once, over equity. More importantly, such double taxation raises the cost of business capital, thereby discouraging saving and investment in our economy. Everyone is harmed by this. The added burden on corporate investment lowers capital formation, which ultimately impacts our prosperity. Workers become less productive with less capital, and virtually all economists agree that productivity is the driving force behind real wage gains. In contrast, a lower tax on capital enhances productivity growth, boosts real wage gains and leads to rising living standards.
Failure to extend the lower rates on capital gains and dividends also would harm our international competitiveness. In this age of global markets, countries around the world have been lowering their tax burden on investment — mainly through reductions in their corporate income tax — to attract international capital flows, which support economic growth and job creation. Unfortunately, it appears that the U.S. is behind the curve in this respect. The data shows that if we allowed the lower rates on capital gains and dividends to expire, the combined corporate and personal tax burden on U.S. corporate income payouts would sum to nearly 57 percent. Apart from Japan, that would represent the highest effective dividend tax rate in the G-7 — higher than Germany, Italy and even France, hardly the typical role model for pro-growth tax policy. That would harm our economy by making us a less attractive destination for global investment.
Lower capital gains and dividend taxes also matter a great deal to the average investor. The share of U.S. households owning stock — either directly or through mutual funds — has nearly doubled in the past 15 years to roughly 57 percent. The average equity investor these days is middle-aged with just moderate income ($65,000). These individuals have seen a direct benefit from lower taxes. It is estimated that 28 million taxpayers saw an average tax cut of $990 in 2006 from the lower tax rates on investment. The elderly are particularly dependent on capital gains and dividend income as a source of income during retirement. In fact, about half of all people older than 65 report some dividend income while about 30 percent of retirees earn capital gains. Allowing the investment tax relief to expire would impact these individuals’ financial security.
From a budget perspective, critics of the lower tax rates typically contend that this policy results in a loss of revenues. In fact, we have seen time and time again that lower rates on capital gains and dividends increase investment activity and economic growth, leading to higher revenues. Let’s take a look at recent history. Estimates from the Congressional Budget Office show that three years after investment tax relief was enacted, capital gains tax receipts doubled, jumping from $50 billion in 2003 to more than $100 billion in 2006. That is an average annual increase of more than 25 percent. It is worth pointing out that the CBO, using static revenue forecasting models that fail to account for the growth stimulus from tax cuts, failed to predict this surge in receipts. In fact, CBO’s January 2004 forecast for capital gains receipts in 2006 appears to have underpredicted revenues by a whopping $49 billion.
Markets and investors are forward-looking and are searching for clues on the direction of post-2010 fiscal policy. In this time of uncertainty, Congress should send the right message by extending the lower tax rates on capital gains and dividends.
Rep. Paul Ryan (R-Wis.) is ranking member of the Budget Committee and a member of the Ways and Means Committee.