Wednesday, December 8, 2010

Why Extending Bush Tax Cuts is Far From Enough

A very important Op-Ed in today's WSJ points out the destructive nature of taxes on the capital structure.

Thomas Cooley, who teaches economics at New York University's Stern School of Busines,s and Lee. Ohanian, who teaches economics at UCLA, write:
 The Obama administration has announced its willingness to compromise on a temporary extension of the Bush tax cuts for all income levels. But the Bush tax cuts never went far enough in providing sufficient incentives to promote higher rates of savings and investment. Temporary solutions like this one or the administration's proposed investment tax credit for businesses will not solve our problem of low capital accumulation. What matters is how the income from capital is taxed over its lifetime.

Economists agree that a large capital stock is a key ingredient for prosperity, as it expands our productive capacity and raises worker productivity, which in turn increases wages and consumer purchasing power. Our capital stock is comparatively much smaller today than it was before the Great Depression. The ratio of business-sector capital to output is about 30% smaller today than it was in 1929. This shortfall reflects the fact that recent investment rates have been lower and consumption rates have been higher compared to earlier in our history.

One important reason that our economy has less capital is because tax rates on capital gains, dividends and other forms of capital income have increased substantially. Prof. Douglas Joines of the University of Southern California has estimated that the average marginal tax rate on capital income, which includes all forms of taxable capital, was around 20% in 1929. In contrast, this rate is estimated to have averaged about 37% between 1990 and 2003, the most recent period for which estimates are available.

Higher tax rates on capital income reduce the incentive to save and invest, which in turn reduces investment and ultimately the capital stock....The history of capital income taxation offers important lessons. Specifically, we should pursue the reforms recommended by many bipartisan tax commissions that have focused on increasing the incentives to save and invest. There is no better way to do this than to permanently cut tax rates on savings and
This is one of the few discussions I have seen of the importance of capital and the dangers of taxing it. Most discussions by economists, who are mostly Keynesians, view consumption as the key to a growing economy and most view the taxation of capital, i.e., capital gains taxes and taxes on dividends, as simply "taxing the rich".

But if you have product and markets are free for prices to adjust, product will clear the market. If however, you don't have machines, i.e. capital, that produce automobiles, you aren't going to have any automobiles.

There's nothing wrong with any tax  cuts, but the significance of what Cooley and Ohanian write about the dangers of taxes on capital needs to be understood.

The full Cooley-Ohanian piece is here.

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