Capital Gains Taxes and the Economy
Authored by Allen Sinai Decision Economics, Inc. Prepared for the American Council for Capital Formation: Center for Policy Research by Decision Economics, Inc. (DE), September 2010.
Capital Gains Taxes and the Economy Allen Sinai* Executive Summary In 2011, capital gains tax rates for taxpayers in the top four income brackets are set to move higher.1 At yearend, the current 15% tax rate on capital gains for assets held one-year-or-more will rise to 20% for individuals earning approximately $34,000-or-more and married couples earning $68,000 or higher. This paper assesses the macroeconomic effects of changes in capital gains tax rates for individuals, with estimates from simulations with the Sinai-Boston (SB) large-scale macroeconometric model of the U.S. economy. The Model is used in simulating reductions, and increases, in capital gains taxation starting in 2011 and extending to 2016, relative to the current 15% rate paid by many taxpayers. The capital gains tax rates considered ranged from 0% to 50% with gradations at 5%, 10%, 20% and 28%. Several conclusions are suggested by the results: x
Very high, or very low, individual capital gains tax rates relative to the current level can do significant damage, or provide significant help, to the economy.
x
Raising the capital gains tax rate from 15% to 20%, 28% or 50%, reduces growth in real GDP, lowers employment and productivity and, ex-post, or after feedback, negatively affects the federal budget deficit. For example, at a 20% capital gains rate compared with the current 15%, real economic growth falls by 0.05 % per annum and jobs decline 231,000 a year. At a 28% rate, economic growth declines by 0.10 % and the economy loses 602,000 jobs yearly . When the capital gains tax rate is increased to 50%, real GDP growth declines by 0.3% per year and there are 1,628,000 fewer jobs per annum.
x
Despite an “ex-ante” or “static” increase in tax revenues from a rise in the capital gains tax—after the negative effects on the economy and feedback effects on tax receipts from
*
Chief Global Economist and President, Decision Economics, Inc. (DE); New York, London, Boston, Chicago. Financial support was provided by the American Council for Capital Formation (ACCF). 1
These tax increases will result from the expiration of reductions legislated in the Economic Growth and Tax Reconciliation Act of 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003, where the maximum longterm individual capital gains tax rate was reduced to 15% from 20% across all income levels. Marginal personal income tax rates also were reduced; originally (2001) to be in stages and then in 2003 the previously legislated reductions were accelerated. A 15% tax on qualifying dividends also expires at yearend and all dividends will be taxed at ordinary income tax rates in all tax brackets. The Obama Administration has proposed leaving the existing tax rates on capital gains and dividends for families with joint incomes less than $250,000 and individuals who earn less than $200,000; also a zero capital gains tax rate for small business. None of these proposals have yet been enacted. The proposals of the Obama Administration in the FY2011 budget were not examined in this study, only responses to various changes in capital gains tax rates compared with the current level.
-2a worsened economy and a weaker stock market, the federal budget deficit actually ends up larger, by over $1 billion per year with a 20% capital gains rate and almost $10 billion per year if the tax rate is 28%. And, at 50%, despite the ex-ante, or planned, increase in tax revenues, $191.5 billion per annum, the actual, or ex-post, federal budget deficit actually ends up lower, by $67 billion per year. x
Reducing the capital gains tax rate to 0% increases growth in real GDP by a little over 0.23 percentage points per year.
Jobs increase by 1,322,000 per annum.
The
unemployment rate drops 0.7 percentage points at its lowest point. And, productivity growth improves 0.5 percentage points a year. x
The net impact on the federal budget of a reduction to 0% is a decline in tax receipts of $23 billion per year, ex-post, far less than the ex-ante revenue loss of the tax change. This tax cut produces new jobs at a cost of only $18,000 per worker.
x
When the capital gains tax rate is decreased to 5% from the current 15%, growth in real GDP rises 0.2 percentage points per annum, the unemployment rate falls 0.2 percentage points per year, and nonfarm payroll jobs increases 711,000 a year. At this capital gains rate, productivity growth improves 0.3 percentage points per year.
x
Lower and higher capital gains tax rates also affect the financial positions of households and corporations. When capital gains taxes are reduced, the aftertax return on equity rises, stock prices increase, household wealth is higher, some capital gains are realized, consumption increases, output and production rise, capital spending increases, household financial assets tend to rise, liabilities decline, debt service burdens are reduced, and household financial conditions improve. These financial effects from the lower capital gains taxes are supportive to additional spending out of disposable income and tend to sustain and raise and for a longer time the multiplier effects from the reduction in the capital gains tax. Corporations benefit as equity prices rise and profits improve from the better economy. This provides additional cash flow that can reduce growth in borrowing or add to financial assets, improving measures of financial well-being for the nonfinancial corporate sector. Higher capital gains taxes would have opposite effects.
Enhanced financial positions for households and businesses provide resiliency to the economy in the face of negative shocks reduce the cost of financing and financial risks taken by those who provide funds for new businesses, entrepreneurship, and innovation.
-3While a small increase in capital gains taxes does not have a large negative impact on the economy, much higher capital gains taxes are very punitive. For example, a 20% capital gains tax rate is not much higher than the current 15%. But, any capital gains tax hike is counterproductive because it brings weaker real economic growth, reduces consumption and real consumption per capita, causes losses in jobs, a higher unemployment rate, less productivity growth, and lower potential output. There is little “bangfor-a-buck” for the economy per dollar of tax revenue on any capital gains tax hike; indeed, the revenues gained ex-post are hardly worth the loss in economic growth, in jobs, in productivity and potential output. Similarly, or conversely, significant reductions in the capital gains tax rate, e.g., to 5% or even 0%, bring strong gains in real economic growth, in new jobs, and likely will increase entrepreneurship and new businesses, increase capital formation, raise productivity growth, bring higher potential output, and greater efficiency. The challenge for macroeconomic policymaking and Washington will be how to devise macroeconomic policies that can increase real economic growth and jobs with minimal increases in the federal budget deficit; or, if possible, reductions. Capital gains tax reduction scores well on these grounds. Capital gains tax reductions, not increases, on what activities, and on whom, perhaps in the context of full tax reform and whether to tax consumption, income, or capital, are more general issues to be considered.
-4Capital Gains Taxes and the Economy Allen Sinai* Introduction This study employs a large-scale structural macroeconometric model with considerable detail relating to capital gains taxation and its potential effects on the overall economy. Analysis of allocative efficiency and equity, normal dimensions for assessing any tax, its incidence and effectiveness, is not part of the research. The conclusions are based strictly on an assessment of the macroeconomic impacts of changes in capital gains tax rates. In 2011, individual capital gains tax rates in the top four income brackets are set to move higher. At yearend, the current 15% tax rate on capital gains for assets held one-year-or-more will rise to 20% for individuals earning approximately $34,000-or-more and married couples earning $68,000 or higher. These tax increases will result from the expiration of reductions legislated in the Economic Growth and Tax Reconciliation Act of 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003, where the maximum long-term individual capital gains tax rate was reduced to 15% from 20% across all income levels.2 The main purpose was to stimulate the U.S. economy. Throughout U.S. history, numerous changes in capital gains tax rates have been legislated as risky investments alternatively have been viewed as needing special incentives or not, capital formation has been an objective, growth of the economy a concern, revenues needed, or issues relating to fairness or the distribution of income central. Capital gains taxation is controversial; in part, because those perceived to benefit most, many think unfairly so, are “rich” as opposed to “poor,” and because of questions about whether a tax subsidy to “risky” investments, i.e., a lower capital gains tax relative to the ordinary income tax rate, really adds to real economic performance or just supports and encourages speculative and unproductive activities. What are the pluses and minuses of this controversial tax? Will the coming increase in capital gains taxes hurt the U.S. economy? How do changes in capital gains taxes affect the *
Chief Global Economist and President, Decision Economics, Inc. (DE); New York, London, Boston, Chicago. Financial support was provided by the American Council for Capital Formation (ACCF). Robert “Chip” Curran performed the simulations with the Sinai-Boston (SB) Model as well as collaborating on other aspects of the research. The comments and suggestions of Margo Thorning and Pinar Cebi Wilber are gratefully acknowledged. 2
Marginal personal income tax rates also were reduced; originally (2001) to be in stages and then in 2003 the previously legislated reductions were accelerated. A 15% tax on qualifying dividends also expires at yearend and all dividends will be taxed at ordinary income tax rates in all tax brackets. The Obama Administration has proposed leaving the existing tax rates on capital gains and dividends for families with joint incomes less than $250,000 and individuals less than $200,000; also a zero capital gains tax rate for small business. None of these proposals have yet been enacted. Tax proposals in the proposed FY2011 budget were not examined in this study, only responses to changes in capital gains tax rates compared with the current level.
-5economy, inflation, jobs and unemployment, productivity, potential economic growth, and federal government budget deficits? What are the transmission mechanisms from changes in individual capital gains taxes to the economy? Would a much lower or much higher capital gains tax rate make a significant difference to economic performance and to jobs? These questions, and others, are dealt with in this paper, where the macroeconomic effects from a wide range of changes in capital gains tax rates are assessed. Estimates are obtained in simulations with the Sinai-Boston (SB) large-scale macroeconometric model of the U.S. economy. The Model is used in simulating the effects of reductions, and increases, of individual capital gains tax rates starting in 2011 and extending to 2016, relative to the 15% paid now by many taxpayers. The capital gains tax rates considered ranged from 0% to 50% with gradations at 5%, 10%, 20% and 28%.3 In this study, capital gains tax changes, up-or-down, if small, show relatively little, but still noticeable, effects on economic growth, jobs, capital formation, productivity growth and federal budget deficits.
Much higher capital gains taxes, e.g., 28% or 50%, are associated with
significant damage to the economy, production, capital spending, employment and unemployment. Much lower capital gains tax rates are noticeably stimulative. Changes in the maximum capital gains tax rate from 15% to a higher rate for families and individuals, while raising tax revenues and reducing federal budget deficits initially, do not produce such a result ex-post, or after feedback, taking account of the direct and indirect effects on the economy of the changes in taxes. A higher capital gains tax rate, e.g., 50% or 28%, or even 20%, compared with the current 15%, leads to reductions in real economic growth, losses in household wealth, less business profits and incomes, fewer capital gains realizations, lost jobs, a higher unemployment rate and reductions in tax receipts, ex-post, across-the-board except for capital gains. There is little “efficiency” from this kind of tax increase; indeed, ex-post the net revenues gained are hardly worth the losses in economic growth, wealth, real consumption per capita, jobs, productivity, and potential output.
3
Although not examined in this paper, which looks at “what if” hypothetical changes to the capital gains tax rate, current policies are set to take the maximum capital gains tax rate to 20% from 15% for all taxable gains and for families with high incomes ($250,000-and-more; individuals, $200,000-and-up) to 23.8% because of an additional 3.8% tax on unearned income contained in 2010 health care legislation. The federal tax on ordinary income at the highest income bracket will rise to 39.6% from 35%, so that the differential between the tax rate on ordinary income and long-term capital gains realizations will be 15.8% in 2011 compared with the previous 20%.
-6Conversely, significant reductions in the capital gains tax rate, e.g., to 5% or even 0%, will bring significant gains in real economic growth, new jobs, entrepreneurship and new businesses, an increase in capital formation, increased productivity growth, and higher potential output. Why these results? An essential element has to do with the role of the equity market in a mixed capitalistic free market system such as exists in the United States, where there are multiple and flexible capital markets, robust financial intermediation, and a diverse set of financial intermediaries to transfer the savings and investible funds of households, businesses, and the rest-of-the-world into taxadvantaged uses for saving and investment, new business development, entrepreneurship and capital formation. A lower/higher capital gains tax relative to ordinary income tax rates increases/decreases the aftertax return on equities and raises/lowers the demand for equities relative to the supply. On average, stock prices rise/fall as a result.
Gains/losses in household wealth, higher/lower
incomes, rising/falling consumption, higher/lower business profits, increased/decreased jobs and incomes, and greater/less capital spending take place. With lags, if the tax is lower and permanent, capital gains can be realized, providing an additional source of funds besides earned income to households for spending, saving, and to pay higher taxes, net, in the aggregate from all categories of tax receipts except capital gains. With robust capital markets and a diverse set of financial intermediaries, including investment banking/brokerage, private equity, venture capital and other such firms, the additional funds, aftertax, realized on a reduction in the capital gains tax can be used for consumption, debt reduction, or additions to household financial assets. Because the capital gains realized are not counted in disposable income but can be spent on consumption, there is a decline in the “savings” rate as conventionally measured in the National Income and Product Accounts (NIPA). But, from a household balance sheet and flow-of-funds perspective, savings actually increase and can find an outlet via financial intermediation into investments that promote new businesses, innovations, research and development, mergers and acquisitions, and business expansion. Housing activity and residential real estate prices should rise with a reduction in the capital gains tax, since the long-term aftertax return on real estate, and the demand for it, will increase. In such a situation, modern mortgage finance and mortgage-related financial instruments that tap or draw on equity in residential real estate, e.g., gross cashout financing, can provide additional spendable funds for household consumption or savings. Since these funds are not counted in
-7disposable income the NIPA personal saving rate would decline but savings increase in the flows-of-funds and the stocks of assets and liabilities in the household balance sheet change. The outline of the paper is as follows. Some pluses and minuses of capital gains taxes are indicated. How capital gains tax changes affect the economy is discussed. The channels in the SB Model connecting changes in capital gains taxes to the economy are indicated. Results for the economy from simulating changes in the capital gains tax rate are reported and discussed. A final section offers some perspectives on capital gains taxation in the current difficult macroeconomic and political environment of the United States. Capital Gains Taxation—Pluses and Minuses Table 1 summarizes some history of changes in statutory individual capital gains tax rates since 1942.4 There have been a number of changes, with the statutory rate over the period ranging from 15% to 45%. Changes in the holding period for purposes of calculating the capital gains subject to tax are not indicated but have been numerous. Figure 1 shows the history of capital gains realizations, seen to be significantly up-or-down at times of major equity bull or bear markets and after changes in capital gains tax rates. Strong rises/declines in capital gains realizations often have occurred not long after the tax rate has been changed. Table 2 shows that over time, capital gains tax receipts have been rising as a percent of individual and total tax receipts. In boom periods and times of rising asset prices, for example 2003 to 2007, capital gains tax receipts moved up sharply, providing a significant source of revenues to the federal government. Part of the surprising strength of tax receipts in business expansions comes from capital gains taxes and similarly some of the surprising weakness during economic downturns from declines in capital gains tax receipts. The role of the stock market in the ups-and-downs of the business cycle should be noted, affecting economic activity in a significant way and thus tax receipts across all categories. Particularly in a business cycle upturn, realizations of capital gains can be nonlinear and thus so can capital gains tax receipts. This was particularly so in the last decade when huge capital gains were realized on sales of businesses, from the residential real estate and stock market booms, and because the total compensation of many corporate executives was tied to the performance of the company’s stock price.
4
The average effective capital gains tax rate, i.e., capital gains taxes paid as a percent of income, depends not only on the statutory capital gains tax rate but also the income tax bracket of a family, the holding period for capital gains, possible unlocking of previously unrealized gains, and other itemized deductions that affect adjusted gross income. The average effective rate is exogenous in the SB Model. But, changes in the statutory rate provide a “lever” that changes the average effective rate which initiates the model simulations.
-8Why should there be a capital gains tax? And, why a differential between capital gains and ordinary income tax rates, that is preferential tax treatment for capital gains income? What are some pluses and minuses of the tax? A capital gain, or increase in the price of an asset realized upon its sale, is income to the holder and as a result subject to tax. Otherwise, a preponderance of investments in capital gains Table 1 Capital Gains Tax Rates: Some History (1942 to 2011)
Date
Statutory Capital Gains Tax Rate (Percent)
2011*
20
2003-10
15
1997-02
20
1987-96
28
1981-86
20
1979-80 1978
28 33.8
1972-77 1971 1970
35 32.5 30.2
1969 1968
27.5 26.9
1954-67 1952-53 1942-51
25 26 25
Comments Expiration of 2001/03 capital gains tax reductions to 2001 levels for individuals and couples in the top four income tax brackets. The recently passed health care bill adds a further 3.8 % increase on capital gains for individual taxpayers above $200,000($250,000 married, filing jointly). Lower capital gains tax rates from the 2001/03 programs of tax reductions to stimulate the economy. Tax reductions from 1997-2002 included as part of budget reconciliation legislation to help spur capital formation. Tax reform legislation to reduce income tax rates and broaden the tax base. The exclusion for capital gains was eliminated so that the tax rate on capital gains was increased to be the same as for ordinary income. Part of major Reagan Administration income tax reductions as stimulus to the economy and to provide tax relief. Full impact of 1978 tax law changes. Transitional tax rate as a minimum and alternative tax repealed as part of a 1978 Act late in the year to help keep the expansion on track and to spur capital formation. Alternative and minimum tax effects. Alternative and minimum tax effects. New minimum tax, higher alternative tax rate on capital gains and earned income tax rate—part of the 1969 Tax Reform Act and from the effects of the Vietnam War surtax. The 1969 Act was the culmination of efforts by the Kennedy-Johnson Administrations to reform the tax system. 10% Vietnam War surtax. The Vietnam War surtax increased the rate for part of the year and was designed to help pay for the Vietnam War. Back to 1942 alternative tax rate. Small change from the 1951 Tax Act. 25% alternative tax on capital gains introduced as part of 1942 tax legislation to pay for WWII.
*Under current law.
vehicles might occur and perhaps too heavy an allocation of resources into what might be less productive activities from an economic point-of-view.5 Although varying degrees of risk are 5
This point is arguable. Some would suggest that there should be no taxes on income from capital so as to encourage saving, investment and growth; instead, only a consumption tax with exemptions to mitigate regressivity.
-9associated with investments in assets whose prices may appreciate, the expected gains on such investments, in aftertax terms, could outweigh the perceived risks and lead to a sizeable misallocation of resources compared to a situation where there is capital gains taxation. Figure 1 Capital Gains Realizations (Bils. of $s)
1000 900 800 700 600 500 400 300 200 100 0 1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
Shaded areas denote Equity Bear Markets. Arrows denote direction of capital gains tax rate change. Data for 2008-09 are DE estimates. Sources: Capital gains realizations, U.S. Treasury; Bear Markets, Standard & Poor; and Decision Economics, Inc..
2009
In addition, those individuals, or families, in a position to invest in capital gains vehicles may already be high in the distribution of income and wealth. Successful investing by them might lead to further disparities in wealth and income, justifying some sort of capital gains tax on grounds of fairness. A final reason is that the taxation of realized capital gains is a source of government revenues. A criticism of capital gains taxation, at whatever the rate and conditions for holding, is that capital is taxed more than once—capital available for investment originally savings taxed as income or profits and then again on the realization of capital gains from the investments made with the saving. Taxing income twice, or perhaps more, e.g., also at the state level, or even more times if dividend income is included, can be argued to be a distortion on allocative grounds, discouraging risk-taking, entrepreneurial activity, and innovations that might lead to new businesses and new jobs. How capital gains as a kind of saving in all its forms and channels affect the real economy, For capital formation, increased potential economic growth and economic growth itself, this is a view of the author. Inequality of income or wealth, or “excessive” executive pay, if societal issues, are better dealt with through higher marginal tax rates for the superrich, e.g., on incomes of $1 million-or-more, or perhaps a $5 million threshold, or one-time excess income taxes.
-10along with the role that financial intermediaries play in mediating savings from the private sector to productive investments, has been little analyzed, analytically or empirically. A higher capital gains tax also raises the cost-of-capital and can reduce capital formation. Table 2 Taxes Paid on Capital Gains (Bils. of $s) Years 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008E 2009E
Tax Receipts 5.943 5.275 3.161 4.350 5.708 5.366 4.253 4.534 6.621 8.232 9.104 11.753 12.459 12.852 12.900 18.700 21.453 26.460 52.914 33.714 38.866 35.258 27.829 24.903 28.983 36.112 36.243 44.254 66.396 79.305 89.069 111.821 127.297 65.668 49.122 51.340 73.213 102.174 117.793 137.042 118.866 85.748
Percent of Individual Tax Payments
Percent of Total Tax Receipts
7.7 5.7 3.6 5.0 5.6 4.9 3.3 3.8 4.7 5.1 4.8 5.2 4.9 4.4 4.4 6.4 7.1 7.8 15.0 8.5 9.5 7.8 5.9 5.3 6.0 7.0 6.6 7.4 9.9 10.5 10.6 12.3 12.6 6.6 5.9 6.5 8.9 10.8 11.1 11.6 10.5 9.9
3.5 2.7 1.7 2.2 2.6 2.1 1.5 1.6 2.1 2.3 2.2 2.4 2.3 2.1 2.1 3.1 3.1 3.6 6.8 3.9 4.2 3.5 2.6 2.4 2.6 3.1 2.8 3.2 4.5 4.9 5.1 6.0 6.2 3.3 2.7 2.9 3.8 4.7 4.8 5.3 4.8 4.2
-11Sources:
Dept. of the Treasury, Monthly Treasury Statement; Office of Tax Analysis; Decision Economics, Inc. (DE).
-12Yet another issue, or question, has to do with how capital gains are realized and whether the activities that give rise to capital gains are “productive,” that is increase productivity, potential economic growth, real economic activity, and jobs.
Capital gains realized from the price
appreciation of residential real estate in the housing boom of 2001 to 2006 led to considerable spendable funds for households and higher real consumption per capita, but may not have engendered much capital formation and the kind of investment that raises potential output and sustainable economic growth. Why shouldn’t one kind of capital gains be taxed differently from another, e.g., gains on stock versus gains on the sale of a business where jobs have been created in the process? Isn’t the latter more productive than the former, deserving of a greater incentive through a lower capital gains tax? There is a possible minus, relating to fairness, because of the unequal ability of households, depending upon the levels of income and wealth, to invest in capital gains vehicles and the advantage, or subsidy, that capital gains taxation provides from a capital gains tax rate that is lower than the ordinary income tax rate. This differential can provide a powerful signal for the allocation of effort to work or investments and typically has been responded to more by high income and high wealth families than middle- to lower-income families. Questions of equity, or fairness, arise every time capital gains taxation, higher-or-lower, is being considered. In the research here, the major concern is with the performance of the U.S. economy in response to changes in capital gains taxes compared with current law. Issues relating to the pluses and minuses of the tax, fairness and equity, income inequality, and the distribution of income or wealth, are not a focus—only how capital gains tax rates affect the economy and its performance. Capital Gains Tax Rates and the Economy—The Process How do changes in individual capital gains tax rates affect the economy? Consider a reduction in the capital gains tax rate for individuals. The aftertax return on equity will rise. This suggests an increase in the demand for new equity issues and in secondary equity markets for the stocks of all companies in different risk categories. For companies issuing stock, there is a reduction in the cost of equity which should lead to increased financing or a shift in the mix of financing from debt to equity. But although these are obvious points of direct impact, they are not the only ones since there are complex transmission mechanisms which, directly or indirectly, respond to changes in individual capital gains tax rates and the reactions of financial markets, in asset prices, then affect the activities of financial intermediaries, the consumer, business activity and financing.
-13Increased demand for equities should raise stock prices, increase equity asset values, increase household wealth and consumption, lead to more production, higher real GDP, new jobs, affect the balance sheet and financial activities of financial intermediaries, and other areas of business and economic activity. Capital gains realizations can be expected as some investors take profits, both short-term and long-run. Existing mortgage finance instruments, or because of financial innovation or financial engineering, new ones that permit an increase in equity extraction from rising values of asset collateral, e.g., margin borrowing on stocks, home equity lines of credit, interest-only mortgage refinancing or structured derivative financial products, generate funds for increased spending, financial intermediation, and savings.
An associated improvement in
household financial conditions should increase the borrowing capacity of households and make credit easier. Financial markets, public and private, some of them auction markets, can absorb the increased supply of debt as investors and lenders diversify assets. This is a relatively new channel from the stock market to the economy which has grown immensely in the last decade. In addition, a larger differential between capital gains and personal income tax rates suggests a shift away from ordinary income-generating work effort and an increase in the flows of funds to activities, or investments, in new enterprises, R&D, technology and innovations to take advantage of expected capital gains in estimated returns. A reduction in the cost-of-capital and increase in potential aftertax returns suggest an increased availability of finance through contemporary financial intermediaries such as venture capital or private equity firms. The formation of new businesses and development of innovations with the prospect of long-term capital gains would be favored. These areas of activity—entrepreneurship, innovation, and the funding of startups or new businesses by financial intermediaries—in response to a reduction in capital gains tax rates have not been explored much in economic and financial research.6 Empirical evidence is scant. But there is considerable anecdotal evidence to suggest a significant response by businesspeople, in financial markets, and in the supply of funds from nonbank financial intermediaries to the real economy because of lower capital gains taxes. For the overall macroeconomy, the reductions in the cost-of-capital and increased stock prices lead to an increase in household net worth, or wealth, which, if the capital gains tax reduction is expected to be permanent, will bring increased consumption. Decision Economics, Inc. (DE) estimates that the propensity to consume a permanent increase in household net worth is approximately $0.06 per dollar, the combined total from both stocks and real estate, with lags 6
See Poterba (1988) for an attempt to examine the effect of capital gains on venture capital firms.
-14of one-to-two years. While nowhere near so strong as the short- and long-term effects of changes in real disposable income on aggregate consumption, it nonetheless is quite significant. In addition, a reduction in the aftertax cost-of-capital, essentially tantamount to a reduction in “the interest rate” or “rental price of capital” in standard macroeconomic paradigms, will bring an increase in business capital spending. In the SB Model, there is also a derived effect on capital spending from increases in aggregate demand, if expected to be permanent, through expectations by business of “permanent” increases in sales and earnings. The propensity to save out of increased household wealth is sizeable and leads to more “savings” by the household sector, although not necessarily on the NIPA basis, and improved household sector financial conditions. With lags, an improved household balance sheet should eventually permit more consumption out of real disposable income, which will positively affect the macroeconomy. Propensities-to-consume disposable income are distributed over time, and cumulative. A significant way that a reduction in the capital gains tax rate can affect the economy is the effect on capital gains realizations and the use of those funds in household spending and savings. This transmission channel is virtually unexplored in standard macroeconomic analysis. The improved stock market that results from a reduction in the capital gains tax will lead to some capital gains realizations as investors, businesspeople, and sellers of other assets such as residential real estate, or businesses, realize gains. Figure 1 showed how capital gains realizations have tended to grow over time (1954 to 2009). Table 3 indicated that capital gains realizations, at times, have been quite sizeable relative to disposable income and are tending higher in the overall economy. Some of the largest increases appear to have followed changes in the capital gains tax rate. In the SB Model, capital gains realizations respond to the overall performance of the stock market and to changes in the capital gains tax and its level relative to the tax rate on ordinary income. Significant effects on consumption and saving from the realization of capital gains have been found, with the marginal propensity to consume capital gains realizations approximately $0.25 per dollar within a year. This is in addition to the propensities to spend out of real disposable income and real wealth. Furthermore, since realized capital gains are not directly counted in national income, upon spending some of the realizations the personal savings rate notionally goes down but the actual volume of savings goes up.
-15Table 3 Capital Gains Realizations as a Percentage of Disposable Income and Gross Domestic Product Date 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986* 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008E 2009E
Disposable Income 2.7 3.5 3.2 2.5 2.9 3.8 3.2 4.2 3.3 3.4 3.8 4.3 4.0 4.8 5.7 4.7 2.8 3.5 4.1 3.7 2.8 2.6 3.0 3.2 3.1 4.1 3.7 3.6 3.7 4.7 4.9 5.6 10.1 4.3 4.4 3.9 2.9 2.5 2.7 3.1 2.9 3.3 4.5 6.0 7.0 8.1 8.8 4.6 3.4 3.9 5.6 7.4 8.0 8.9 7.3 5.2
GDP 1.9 2.4 2.2 1.8 2.0 2.6 2.2 2.9 2.3 2.4 2.6 3.0 2.7 3.3 3.9 3.2 2.0 2.5 2.9 2.6 2.0 1.9 2.2 2.2 2.2 2.9 2.7 2.6 2.8 3.5 3.6 4.1 7.3 3.1 3.2 2.8 2.1 1.9 2.0 2.3 2.2 2.4 3.3 4.4 5.2 5.9 6.5 3.4 2.5 2.9 4.2 5.5 6.0 6.6 5.5 4.0
* In 1986, change in law raised the tax rate on capital gains realizations effective in 1987, prompting investors to liquidate holdings and to take gains in 1986. E-Estimate by Decision Economics, Inc. (DE). Sources: U.S. Department of the Treasury, Office of Tax Analysis; U.S. Dept. of Commerce, Bureau of Economic Analysis; Decision Economics, Inc. (DE).
-16In the household sector balance sheet, or household flows-of-funds, the additional funds from realized capital gains result in some investments and reductions in liabilities, along with an increase of expenditures. Left to “spend” or “save” are the gains, aftertax, resulting from the realizations. Taxes are paid to the federal government and states, another effect of the increased stock prices that comes from a reduction in the capital gains tax rate. The additional tax receipts to federal and state governments offset, to some extent, the original cost of the tax reduction. If, in addition, there is “unlocking” of unrealized capital gains, then the tax receipts of the federal and state government sectors will rise further and provide additional payback, ex-post, as an offset to the ex-ante cost of the capital gains tax reduction. Federal budget deficits can do surprisingly well on capital gains tax reductions, depending on the stock market response, economy effects, and whether unlocking occurs. The mechanisms through which changes in capital gains tax rates, capital gains realizations, and an unlocking of unrealized capital gains affect the economy and the federal government budget are little-known and hardly explored. The uses of funds from these sources in both consumption and saving, the effects on the macroeconomy as the funds flow through the household sector into spending and saving, and the investment of those savings through financial intermediation in a financial system with robust capital markets need to be researched. In the SB Model, some of the effects are captured roughly in the regression coefficients of equations and through model simulation, enlarging and elucidating the transmission effects on the economy from changes in capital gains tax rates. Effects of Changes in Capital Gains Tax Rates on the Economy—Results of Model Simulations What effects would changes in the individual capital gains tax rate have on U.S. economic performance? In light of coming changes to the existing capital gains tax rate, a need for policies to stimulate the economy and jobs and the likelihood of a public discussion on comprehensive tax reform, assessing the potential effects on the macroeconomy of changes in the capital gains tax rate seems appropriate. In order to obtain estimates, the SB Large-Scale Quarterly Macroeconometric Model of the U.S. was utilized. Simulations were performed for changes in capital gains tax rates ranging from 0% to as high as 50%, including rates at 20%, 28%, 10% and 5%. The time horizon was 2011 to 2016—enough to observe short-, intermediate-term, and longer-run effects. Existing law for marginal personal income tax rates was assumed, which
-17includes the yearend expiration of the current lower capital gains and dividend tax rates for the top four income tax brackets. The Appendix provides a summary and schematic of the SB Model (2007 Version) used for the simulations. There is also a short section describing the mechanics of the simulations. Table 4 provides a summary of the results. The average of the changes in simulated values across all years compared with the Baseline is presented for each capital gains tax rate. The results may be taken as the overall effects on U.S. economic performance, over six years, for each rate. The variables reported are only a small subset from the hundreds in the SB Model for which results could be shown. More detail can be found in Tables 6 to 10. In Table 4, results are reported for real GDP growth, inflation, unemployment and jobs, productivity growth, and the federal government budget. Table 4 also reports the ex-ante (static) cost of the change in the capital gains tax rate and the ex-post (dynamic) cost after simulation and economic feedback. Table 4 Macroeconomic Effects of Changes in the Capital Gains Tax Rate (Diffs. from Baseline, Avg. Per Year, 2011-16)* Variables Real GDP Growth (Pct.) Inflation (Pctg. Pts.) GDP Chain Price CPI-U PCE Chain Price Unemployment Rate (Pct.) Nonfarm Payrolls (Mils. Jobs) Productivity Growth (Pctg. Pts.) Federal Budget Deficit, Unified Avg. per Year (Bils. $s) Budget Chg., % of Baseline GDP Receipts, Unified (Bils. $s) Ex-Ante Cost (Static) (Bils. $s) (Avg. per Year) % of GDP Ex-Post Cost (Dynamic) (Bils. $s) (Avg. per Year) % of GDP
Raised to 50 Pct.
Raised to 28 Pct.
Raised to 20 Pct.
Lowered to 10 Pct.
Lowered to 5 Pct.
Lowered to 0 Pct.
-0.3
-0.1
-0.05
0.10
0.16
0.23
-0.36 -0.72 -0.33 0.4 -1.628 -0.6 -401.8 -67.0 -2.4 -49.6 1148.9 191.5 1.1 -401.8 -67.0 -2.4
-0.13 -0.26 -0.12 0.2 -0.602 -0.2 -174.5 -9.8 -1.0 -6.2 551.6 91.9 0.5 -37.2 -6.2 -0.2
-0.04 -0.09 -0.04 0.1 -0.231 -0.1 -8.0 -1.3 -0.0 -1.0 272.0 45.3 0.3 -6.2 -1.0 0.0
0.08 0.16 0.07 -0.1 0.381 0.1 -33.5 -5.6 -0.2 -7.7 -268.9 -44.8 -0.3 -46.4 -7.7 0.0
0.15 0.29 0.13 -0.2 0.711 0.3 -118.2 -19.7 -0.7 -21.6 -435.6 -72.6 -0.4 -129.6 -21.6 -0.1
0.30 0.61 0.26 -0.5 1.323 0.5 -143.4 -23.9 -0.8 -32.8 -451.5 -75.2 -0.4 -196.7 -32.8 -0.2
*Simulations using the Sinai-Boston (SB) Model of the U.S. Economy. Monetary policy unchanged.
The important role of the equity market in the U.S. economy should be noted, since it is a center for transmitting the effects from capital gains tax reductions to the macroeconomy. The SB Model has a large amount of structural detail on expectations and asset prices as they affect financial markets, the financial system and the economy. This includes expected federal government budget deficits (impacts current long-term interest rates, the dollar, and the stock
-18market); expected earnings (impacts the stock market currently); the expected weighted average aftertax cost-of-capital (affects the stock market currently), sector balance sheets, flows-of-funds and household wealth; asset prices; household, business and financial sector behavior as affects the economy; and the detail of tax receipts, by category, including individual and business capital gains tax receipts. Several conclusions are suggested. First, that very high, or very low, individual capital gains tax rates relative to the current level can do significant damage, or provide significant stimulus, to the economy. Raising the capital gains tax from 15% to 28% leads to a loss in real economic growth of 0.1 percentage points per annum over 2011-16 and 602,000 fewer jobs annually. When the rate is increased to 50%, real GDP growth is decreased by 0.3% per year and there are 1,628,000 fewer jobs per annum.7 The mechanisms are through declines in the stock market, negative effects on household wealth and consumption, a higher cost-of-capital, and reduced capital spending. Household financial conditions worsen on a rising ratio of debt-to-assets, lost jobs, and reductions in household financial assets. On an increased cost of equity capital, the weighted average cost-ofcapital, debt and equity, used to discount future earnings rises somewhat—a negative for the stock market—and through reduced household wealth, capital gains realizations, and the cost-ofcapital become sources of slower growth in consumption and for capital spending. The inflation rate, no matter how measured, moves lower from the weaker economy, some 0.4 percentage points per year on the GDP Fixed Weight Price Deflator and 0.7 percentage points per annum in the CPI-U. The unemployment rate is higher by 0.4 percentage points per year and lost jobs, on the nonfarm payroll basis, average 1.6 million per annum. Productivity growth slides 0.6 percentage points per year. Potential economic growth falls from a reduction in productivity growth, declines in persons working and in average hours worked. Household financial conditions worsen to reduce consumption further.
The declines in aggregate
consumption, in turn, reverberate through the rest of the economy, internationally, then back to the U.S. economy through reductions in exports.
7
The nonfarm payroll jobs response probably is overstated, given a sample period heavily influenced by the experience of the 1990s. Nonfarm payroll employment is disaggregated by sector and related to components of GDP, not GDP itself which is econometrically less significant. Structural changes in the labor market, in the use of capital in production, and in the organization of production suggest less employment per unit of output than in the past. This is not yet fully captured by the Model’s regression coefficients because the sample period for the newer phenomena is too short.
-19Despite the tax revenues raised by the increase in the capital gains tax—about $1.15 trillion cumulatively or $191.5 billion per annum—after the negative effects on the economy and feedback effects on tax receipts from a worse, by economy and weaker stock market, the budget deficit actually ends up worse, some $67 billion per year. Thus, a large hike in the capital gains tax rate proves counterproductive by weakening economic growth, reducing consumption and real consumption per capita, causing losses in jobs, a higher unemployment rate, less productivity growth, lower potential output, and an increase in the federal budget deficit. The only positive is a lower inflation rate, which may not help much if already low. Conversely, a reduction in the capital gains tax rate to zero from the current 15% increases growth in real GDP by over 0.2 percentage points per annum, lowers the unemployment rate by one-half percentage point, increases nonfarm payroll jobs 1.3 million a year, and ends up, net, ex-post, costing the federal government less than the initial ex-ante, or static, cost of the tax reductions. The economy is considerably improved, household financial conditions improve, and the U.S. standard-of-living rises. The Baseline includes changes in law set for 2011 that take ordinary income tax rates higher for families with incomes of $250,000-or-more and individual taxpayers $200,000-and-up, as well as down the income ladder to households with joint incomes as low as $68,000. The threeto-five percentage point increase in marginal income tax rates for high income families against a five percentage point rise in the capital gains tax rate preserves much of the differential between ordinary income tax rates and the capital gains tax rate for upper income families and individuals and limits the negative impact. The higher capital gains tax rate does reduce the differential of the capital gains tax rate with income tax rates for families and individuals and thus is negative for the stock market. This increases the cost-of-capital, lowers household wealth, reduces capital spending, and takes down incentives for entrepreneurship and new businesses. For small changes in the capital gains tax rate compared with current law, to 20% or 10%, the effects are relatively small but noticeable. Growth in real GDP is down 0.1% per annum on a capital gains tax rate of 20% and up 0.1% per annum on a lower 10% rate. A third result of the simulations underscores the effect of capital gains taxes on productivity and potential output. In the SB Model, there are certain variables that reflect entrepreneurship and innovative activity, e.g., R&D spending, the number of new businesses, and patents. Generally, the lower is the individual capital gains tax rate, the higher is productivity growth and growth in potential output. Some of this arises from an increased labor stock and higher
-20potential output, calculated as the sum of growth in the labor force and manhours worked. The improvement in productivity growth from a zero capital gains tax rate is quite noticeable, 0.5% per annum. Conversely, with a 28% capital gains tax rate, the decline in productivity growth is 0.2 percent per year. At a 50% capital gains tax rate, the decline is 0.6% per year. These results indicate the negative effect of higher capital gains taxes on the capacity of the U.S. economy. A final empirical result worth noting has to do with the federal budget deficit and the ex-ante cost of capital gains tax reductions, or ex-ante increase in revenues on a hike in the capital gains tax, versus the results, ex-post. After feedback—a stronger economy, improved stock market, more jobs and increased income—higher bases for taxes on personal income, profits, social security and excise taxes with given tax rates and the new capital gains rate raise total tax receipts. The stronger economy leads to reductions in some federal government outlays. These effects reduce the federal budget deficit. In the simulations, no special assumptions were made with respect to “unlocking,” i.e., the realizing of unrealized capital gains as a consequence of the change in the capital gains tax rate. At times, unlocking has raised capital gains tax receipts and the total tax receipts of the federal government. In the SB Model, the capital gains realization function will capture some unlocking reflected in the historical data, but not necessarily all. Table 5 shows the effects of changes in capital gains tax rates on capital gains realizations. Realizations can be significant for government tax receipts and funding that the household sector can spend or save; therefore, need to be taken into account in any analysis that involves capital gains taxation. The responses shown undoubtedly reflect some historic “unlocking” and the effects on realizations, since in some of the history unlocking must have occurred.8 No separate estimate of unlocking is identifiable from these quantitative estimates, however. Tables 6 to 10 show some additional results from changes in capital gains tax rates—on macroeconomic activity, financial markets, the financial position of nonfinancial corporations, and the federal government budget. The simulations used 50%, 28%, 20%, 10% and 0% as the various capital gains tax rates.
8
For an example of an attempt to determine the extent of capital gains realizations and its elasticity of response, see Matthew Eichner and Todd Sinai, “Capital Gains Tax Realizations and Tax Rates: New Evidence from Time Series,” National Tax Journal, September 2000, pp. 663-681. Although the 1986 Tax Reform Act is found to have disproportionate effects, the historical elasticities of response for capital gains realizations are sizeable and consistent with the results reported here.
-21Table 5 Capital Gains Realizations in Response to a Change in the Capital Gains Tax Rate* (Bils. $s) Capital Gains Tax Rate 50% 28% 20% 10% 5% 0%
2011 -74.8 -30.2 -12.0 12.5 25.4 39.0
2012 -325.2 -152.9 -64.5 73.0 155.2 248.0
2013 -439.0 -228.0 -100.2 120.9 265.1 437.2
2014 -443.2 -236.0 -105.0 129.9 287.5 477.5
2015 -415.2 -220.7 -98.4 122.0 270.8 446.9
2016 -361.6 -191.7 -86.2 106.2 236.5 382.4
Average -343.2 -176.6 -77.7 94.1 206.8 338.5
*Estimates using capital gains realizations functions in the SB Model of the U.S. Economy.
The responses of inflation-adjusted consumption and business capital spending are presented for each year, 2011-16, and for the averages of those years.
The effects on Research &
Development expenditures also are shown. Changes in the financial position of nonfinancial corporations are indicated for some key parameters such as cash flow, “debt burden,” “leverage,” and the ratio of investment outlays to cash flow as a need for external financing. In almost no other macroeconometric model is there structure to assess nonfinancial corporate responses, real and financial, to changes in taxation. Generally, in simulations of hikes in the capital gains tax rate compared with current law the economy does worse, losing more in growth the higher is the capital gains tax rate and gaining when the rate is reduced to lower levels. Large changes occur in the stock market, mostly on reductions of earnings from a weaker economy and no offsetting reductions in interest rates. In the simulations, Federal Reserve policy was assumed to be unchanged. In actuality, the Federal Reserve might alter policy in response to changes in the economy and inflation. On an increase in the capital gains tax rate to 50%, the unemployment rate rises sharply, at its peak 0.7 percentage points above the Baseline. Nonfarm payroll jobs peak at negative 2 million three years after the tax increase and average approximately 1.6 million less jobs per annum. Quite the opposite can be seen when the capital gains tax rate is reduced to 0%. A significant decline in the unemployment rate occurs, at most falling 0.7 percentage points below the Baseline. Strong increases occur in jobs, 1.854 million at the peak, and 1.323 million per annum. With higher capital gains tax rates, business profits fall and the cash flow of nonfinancial corporations diminishes.
The ratio of capital expenditures to cash flow rises, indicating
increased demand for external financing by nonfinancial corporations. But, as the higher capital gains tax rates negatively impact on the economy, nonfinancial corporations work to improve financial positions by cutting borrowing and reducing leverage (the debt/equity ratio). The federal government budget deficit actually worsens when capital gains tax rates are raised. The only gains come from the capital gains tax rate increase itself. Tax receipts from the
-22-
Item
Table 6 Macroeconomic Effects of Changes in the Capital Gains Tax Rate Capital Gains Tax Rate Increase to 50%* (Changes Relative to Baseline, Unless Otherwise Indicated) Years 2011 2012 2013 2014 2015
Economy Real GDP Growth (Pct. Chg.) Real GDP ($ 00’ Bils.) Consumption ($ 00’ Bils.) Business Capital Spending ($ 00’ Bils.) Net Exports ($ 00’ Bils.) R&D ($ 00’ Bils.) Inflation Consumer Price Index (%) Consumption Deflator Ex-Food & Energy (%) Jobs and Unemployment Nonfarm Payroll (Mils. of Jobs) Unemployment Rate (%) Financial Interest Rates (%) 3 Mo. CP. 3 Mo. Treas. AAA-Equiv. Corp. 10-Yr. U.S. Treas. Stock Market S&P500 EPS ($/Share) S&P500 Index (Pct. Chg. from Baseline) Dollar vs. Yen Euro Financial Position (Nonfin. Corps.) Cash Flow ($ Bils.) Capex/Cash Flow (Ratio, Pctg. Pts.) “Quick” Ratio (Pctg. Pts.) Interest Charges/Cash Flow (Ratio, Pctg. Pts.) Borrowing ($ Bils.) Debt/Equity (Ratio) Fed’l. Govt. Budget Unified Budge Deficit (-)/Surplus (+) Tax Receipts ($ Bils., NIPA) Corporate Personal Cap. Gains Other
2016
Avg. 2011-16
-1.3 -149.5
-1.1 -289.4
-0.1 -305.9
0.4 -267.1
0.3 -236.2
0.1 -229.4
-0.3 -246.2
-156.4 -8.0
-365.5 -41.3
-428.2 -71.3
-420.2 -86.5
-391.4 -91.7
-364.3 -97.6
-354.3 -66.1
46.7 -4.5
177.4 -11.1
248.0 -12.0
272.4 -10.1
255.0 -8.0
222.8 -7.2
203.7 -8.8
-0.1 0.0
-0.7 -0.2
-1.1 -0.4
-1.0 -0.5
-0.8 -0.4
-0.6 -0.3
-0.7 -0.3
-0.845 0.2
-1.815 0.6
-2.042 0.7
-1.860 0.5
-1.634 0.3
-1.572 0.1
-1.628 0.4
-0.08 -0.05
-0.12 -0.04
-0.09 -0.02
-0.02 -0.01
0.05 -0.01
0.12 -0.02
-0.02 -0.03
0.00 0.02
0.10 0.15
0.16 0.15
0.17 0.15
0.15 0.22
0.15 0.23
0.12 0.15
-2.8 -27.5
-5.0 -43.4
-5.4 -48.1
-5.3 -50.2
-5.7 -51.2
-6.0 -51.7
-5.0 -45.3
-1.1 4.7
-2.4 14.8
-1.1 19.8
1.2 17.3
2.9 10.6
3.6 4.4
0.5 11.9
-16.6 1.0 0.0 0.5 -10.1 -11.5
-42.7 1.5 0.0 1.7 -60.5 -68.7
-51.3 0.3 -0.4 2.4 -124.2 -141.1
-51.9 -0.7 -0.8 2.7 -163.9 -186.2
-54.3 -1.8 -1.2 2.4 -175.8 -199.7
-58.9 -1.4 -1.7 3.2 -166.1 -188.6
-45.9 -0.2 -0.7 2.2 -116.8 -132.6
103.6 123.4 -8.3 139.7 146.1 -8.0
-9.7 -15.2 -23.9 29.2 45.2 -20.5
-112.8 -80.1 -24.1 -26.0 -3.0 -29.9
-132.6 -97.5 -21.1 -40.2 -11.8 -36.2
-126.1 -103.2 -18.0 -44.4 -9.8 -40.9
-124.3 -110.2 -15.2 -50.1 -7.2 -44.9
-67.0 -47.1 -18.4 1.4 26.6 -30.1
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline.
-23Table 7 Macroeconomic Effects of Changes in the Capital Gains Tax Rate Capital Gains Tax Rate Increase to 28%* (Changes Relative to Baseline, Unless Otherwise Indicated) Years 2013 2014
2015
2016
Avg. 2011-16
0.2 -96.2
0.1 -84.2
0.0 -82.4
-0.1 -89.8
-158.8 -25.6
-151.8 -30.5
-138.6 -31.5
-128.0 -33.0
-128.9 -23.1
67.4 -4.2
91.5 -4.5
98.5 -3.7
89.7 -2.8
76.6 -2.5
73.6 -3.2
0.0 0.0
-0.3 -0.1
-0.4 -0.1
-0.4 -0.2
-0.3 -0.1
-0.2 -0.1
-0.3 -0.1
-0.313 0.1
-0.684 0.2
-0.764 0.3
-0.682 0.2
-0.594 0.1
-0.576 0.0
-0.602 0.2
-0.03 -0.02
-0.05 -0.02
-0.03 -0.01
-0.01 -0.01
0.01 -0.01
0.03 -0.01
-0.01 -0.01
-0.01 -0.01
0.02 0.03
0.04 0.03
0.05 0.04
0.04 0.07
0.04 0.07
0.03 0.04
-1.03 -11.62
-1.88 -18.90
-2.01 -21.44
-1.94 -22.67
-2.06 -23.23
-2.16 -23.50
-1.85 -20.23
-0.4 1.7
-0.9 5.4
-0.5 7.1
0.4 6.2
1.0 3.8
1.3 1.5
0.1 4.3
-6.0 0.4 0.0 0.2 -4.4 -5.0
-15.9 0.6 0.0 0.6 -25.5 -28.9
-19.1 0.2 -0.1 0.8 -51.3 -58.3
-18.8 -0.2 -0.2 0.9 -67.3 -76.5
-19.3 -0.5 -0.3 0.8 -73.7 -83.7
-20.8 -0.4 -0.5 1.0 -74.7 -84.8
-16.7 0.0 -0.2 0.7 -49.5 -56.2
41.3 51.0 -3.1 57.1 59.6 -3.0
12.4 10.0 -9.7 27.4 34.0 -7.7
-23.4 -14.6 -9.6 6.2 16.2 -11.1
-31.3 -22.8 -8.2 -1.3 11.5 -13.3
-28.7 -26.3 -6.8 -4.6 11.4 -14.9
-29.1 -31.3 -5.6 -9.4 10.5 -16.3
-9.8 -5.6 -7.2 12.5 23.9 -11.0
Item
2011
2012
Economy Real GDP Growth (Pct. Chg.) Real GDP ($ 00’ Bils.)
-0.5 -54.7
-0.4 -108.0
0.0 -113.1
-58.1 -2.8
-138.0 -14.9
17.7 -1.7
Consumption ($ 00’ Bils.) Business Capital Spending ($ 00’ Bils.) Net Exports ($ 00’ Bils.) R&D ($ 00’ Bils.) Inflation Consumer Price Index (%) Consumption Deflator Ex-Food & Energy (%) Jobs and Unemployment Nonfarm Payroll (Mils. of Jobs) Unemployment Rate (%) Financial Interest Rates (%) 3 Mo. CP. 3 Mo. Treas. AAA-Equiv. Corp. 10-Yr. U.S. Treas. Stock Market S&P500 EPS ($/Share) S&P500 Index (Pct. Chg. from Baseline) Dollar vs. Yen Euro Financial Position (Nonfin. Corps.) Cash Flow ($ Bils.) Capex/Cash Flow (Ratio, Pctg. Pts.) “Quick” Ratio (Pctg. Pts.) Interest Charges/Cash Flow (Ratio, Pctg. Pts.) Borrowing ($ Bils.) Debt/Equity (Ratio, Pctg. Pts.) Fed’l. Govt. Budget Unified Budge Deficit (-)/Surplus (+) Tax Receipts ($ Bils., NIPA) Corporate Personal Cap. Gains Other
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline.
-24Table 8 Macroeconomic Effects of Changes in the Capital Gains Tax Rate Capital Gains Tax Rate Increase to 20%* (Changes Relative to Baseline, Unless Otherwise Indicated) Item
2011
2012
Years 2013 2014
2015
2016
Avg. 2011-16
Economy Real GDP Growth (Pct. Chg.) Real GDP ($ 00’ Bils.)
-0.18 -20.9
-0.14 -38.7
0.02 -37.2
0.06 -30.5
0.01 -30.1
-0.05 -37.7
-0.05 -32.5
-22.3 -1.1
-49.0 -5.5
-49.9 -9.1
-42.6 -10.4
-38.1 -10.6
-40.6 -11.9
-40.4 -8.1
6.9 -1.4
24.3 -1.5
28.8 -1.5
26.9 -1.2
20.9 -1.0
16.7 -1.2
20.7 -1.2
0.0 0.0
-0.1 0.0
-0.1 0.0
-0.1 -0.1
-0.1 0.0
-0.1 0.0
-0.1 0.0
-0.120 0.0
-0.250 0.1
-0.263 0.1
-0.233 0.1
-0.233 0.0
-0.287 0.0
-0.231 0.1
-0.01 -0.01
-0.02 -0.01
-0.01 0.00
0.00 0.00
0.00 0.00
0.01 0.00
0.00 0.00
-0.01 -0.01
0.00 0.00
0.01 0.01
0.02 0.01
0.02 0.03
0.02 0.03
0.01 0.01
-0.39 -4.69
-0.66 -7.70
-0.65 -8.80
-0.61 -9.37
-0.70 -9.64
-0.85 -9.78
-0.65 -8.33
-0.2 0.7
-0.3 2.0
-0.1 2.4
0.2 1.9
0.3 1.1
0.3 0.7
0.0 1.5
-2.3 0.2 0.0 0.1 -1.8 -2.0
-5.8 0.2 0.0 0.2 -10.3 -11.7
-6.3 0.0 0.0 0.3 -20.5 -23.3
-5.8 -1.1 -0.1 0.3 -26.6 -30.2
-6.1 -0.2 -0.1 0.2 -28.7 -32.6
-7.3 -0.2 -0.2 0.3 -28.9 -32.9
-5.6 0.0 -0.1 0.2 -19.5 -22.1
16.3 20.4 -1.2 22.8 23.8 -1.1
8.1 7.0 -3.7 13.5 16.6 -2.8
-3.6 -1.9 -3.4 5.5 10.7 -3.9
-6.7 -6.2 -2.7 1.1 8.8 -4.5
-8.3 -10.3 -2.3 -2.7 8.4 -5.3
-13.8 -16.7 -2.2 -8.2 7.4 -6.3
-1.3 -1.3 -2.6 5.3 12.6 -4.0
Consumption ($ 00’ Bils.) Business Capital Spending ($ 00’ Bils.) Net Exports ($ 00’ Bils.) R&D ($ 00’ Bils.) Inflation Consumer Price Index (%) Consumption Deflator Ex-Food & Energy (%) Jobs and Unemployment Nonfarm Payroll (Mils. of Jobs) Unemployment Rate (%) Financial Interest Rates (%) 3 Mo. CP. 3 Mo. Treas. AAA-Equiv. Corp. 10-Yr. U.S. Treas. Stock Market S&P500 EPS ($/Share) S&P500 Index (Pct. Chg. from Baseline) Dollar vs. Yen Euro Financial Position (Nonfin. Corps.) Cash Flow ($ Bils.) Capex/Cash Flow (Ratio, Pctg. Pts.) “Quick” Ratio (Pctg. Pts.) Interest Charges/Cash Flow (Ratio, Pctg. Pts.) Borrowing ($ Bils.) Debt/Equity (Ratio, Pctg. Pts.) Fed’l. Govt. Budget Unified Budge Deficit (-)/Surplus (+) Tax Receipts ($ Bils., NIPA) Corporate Personal Cap. Gains Other
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline.
-25Table 9 Macroeconomic Effects of Changes in the Capital Gains Tax Rate Capital Gains Tax Rate Decrease to 10%* (Changes Relative to Baseline, Unless Otherwise Indicated) 2015
2016
Avg. 2011-16
0.0 69.3
-0.1 59.4
0.1 73.9
0.1 58.9
108.4 12.7
122.3 17.0
123.2 17.9
143.4 19.4
99.1 12.4
-34.7 2.1
-59.9 2.9
-79.2 2.8
-85.6 2.1
-93.9 2.6
-60.1 2.2
0.0 0.0
0.1 0.0
0.2 0.1
0.2 0.1
0.2 0.1
0.2 0.1
0.2 0.1
0.129 0.0
0.344 -0.1
0.472 -0.2
0.459 -0.2
0.380 -0.1
0.504 -0.1
0.381 -0.1
0.01 0.01
0.02 0.01
0.02 0.01
0.02 0.01
0.01 0.01
0.01 0.01
0.01 0.01
0.01 0.01
0.00 0.00
-0.01 0.00
-0.01 0.00
-0.01 0.00
0.00 -0.01
0.00 0.00
Stock Market S&P500 EPS ($/Share) S&P500 Index (Pct. Chg. from Baseline)
0.42 4.99
0.99 8.32
1.34 9.63
1.39 10.30
1.45 10.59
1.85 10.68
1.24 9.09
Dollar vs. Yen Euro
0.2 -0.7
0.5 -2.5
0.4 -4.0
0.0 -4.3
-0.5 -3.4
-0.6 -2.7
0.0 -2.9
2.4 -0.2 0.0 -0.1 1.9 2.2
7.8 -0.3 0.0 -0.3 10.9 12.3
11.8 -0.4 0.0 -0.5 21.9 24.9
13.0 -0.2 0.1 -0.6 30.0 34.1
13.0 0.1 0.1 -0.5 36.0 40.9
14.3 0.0 0.1 -0.6 42.4 48.2
10.4 -0.2 0.1 -0.4 23.9 27.1
-16.7 -21.4 1.3 -23.9 -24.9 1.2
-10.9 -11.7 4.7 -20.1 -22.1 3.8
1.2 -4.6 5.6 -16.6 -18.4 6.4
4.3 -3.2 5.5 -16.8 -16.6 8.2
-2.3 -6.2 4.8 -20.2 -15.7 9.2
-9.0 -7.2 4.9 -23.7 -13.9 11.5
-5.6 -9.1 4.5 -20.2 -18.6 6.7
Item Economy Real GDP Growth (Pct. Chg.) Real GDP ($ 00’ Bils.) Consumption ($ 00’ Bils.) Business Capital Spending ($ 00’ Bils.) Net Exports ($ 00’ Bils.) R&D ($ 00’ Bils.) Inflation Consumer Price Index (%) Consumption Deflator Ex-Food & Energy (%) Jobs and Unemployment Nonfarm Payroll (Mils. of Jobs) Unemployment Rate (%) Financial Interest Rates (%) 3 Mo. CP. 3 Mo. Treas. AAA-Equiv. Corp. 10-Yr. U.S. Treas.
Financial Position (Nonfin. Corps.) Cash Flow ($ Bils.) Capex/Cash Flow (Ratio, Pctg. Pts.) “Quick” Ratio (Pctg. Pts.) Interest Charges/Cash Flow (Ratio, Pctg. Pts.) Borrowing ($ Bils.) Debt/Equity (Ratio, Pctg. Pts.) Fed’l. Govt. Budget Unified Budge Deficit (-)/Surplus (+) Tax Receipts ($ Bils., NIPA) Corporate Personal Cap. Gains Other
Years 2013 2014
2011
2012
0.2 22.3
0.3 55.3
0.1 73.2
24.1 1.1
73.1 6.4
-7.4 0.7
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline.
-26Table 10 Macroeconomic Effects of Changes in the Capital Gains Tax Rate Capital Gains Tax Rate Decrease to 0%* (Changes Relative to Baseline, Unless Otherwise Indicated) Item Economy Real GDP Growth (Pct. Chg.) Real GDP ($ 00’ Bils.) Consumption ($ 00’ Bils.) Business Capital Spending ($ 00’ Bils.) Net Exports ($ 00’ Bils.) R&D ($ 00’ Bils.) Inflation Consumer Price Index (%) Consumption Deflator Ex-Food & Energy (%) Jobs and Unemployment Nonfarm Payroll (Mils. of Jobs) Unemployment Rate (%) Financial Interest Rates (%) 3 Mo. CP. 3 Mo. Treas. AAA-Equiv. Corp. 10-Yr. U.S. Treas. Stock Market S&P500 EPS ($/Share) S&P500 Index (Pct. Chg. from Baseline) Dollar vs. Yen Euro
2011
2012
Years 2013 2014
2015
2016
Avg. 2011-16
0.6 73.7
1.1 210.1
0.5 274.8
0.0 285.3
-0.3 254.0
-0.6 177.5
0.2 212.6
73.3 3.3
214.9 23.1
298.8 47.7
326.9 64.1
302.3 68.3
221.6 64.0
239.6 45.1
-16.8 2.1
-61.7 8.6
-111.2 11.8
-150.8 11.4
-157.8 8.6
-122.0 5.1
-103.3 7.9
0.1 0.0
0.4 0.1
0.8 0.3
0.9 0.4
0.8 0.4
0.7 0.3
0.6 0.2
0.430 -0.1
1.368 -0.4
1.841 -0.6
1.854 -0.7
1.500 -0.5
0.945 -0.3
1.323 -0.4
0.03 0.03
0.08 0.04
0.09 0.04
0.13 0.04
0.18 0.03
0.15 0.02
0.11 0.03
0.04 0.05
0.01 0.02
-0.03 0.02
-0.02 0.02
0.03 -0.01
0.05 -0.02
0.02 0.01
1.40 15.95
3.77 26.99
4.87 31.67
5.53 34.00
5.87 34.74
5.22 34.82
4.44 29.70
0.5 -2.2
1.8 -8.9
1.6 -14.4
0.3 -16.2
-1.4 -13.9
-3.0 -8.1
0.0 -10.6
Financial Position (Nonfin. Corps.) Cash Flow ($ Bils.) 7.7 27.7 42.2 50.6 54.4 53.2 Capex/Cash Flow (Ratio, Pctg. Pts.) -0.5 -1.2 -1.1 -0.9 -0.1 -0.6 “Quick” Ratio (Pctg. Pts.) 0.0 0.0 0.1 0.2 0.2 0.2 Interest Charges/Cash Flow (Ratio, Pctg. Pts.) -0.2 -1.0 -1.7 -2.1 -1.8 -2.0 Borrowing ($ Bils.) 6.1 35.4 74.1 106.3 133.8 161.4 Debt/Equity (Ratio, Pctg. Pts.) 6.9 40.2 84.1 120.7 152.0 183.4 Fed’l. Govt. Budget Unified Budge Deficit (-)/Surplus (+) -51.7 -41.0 -11.4 1.2 -7.2 -33.3 Tax Receipts ($ Bils., NIPA) -66.8 -46.0 -31.6 -19.9 -17.9 -30.0 Corporate 4.2 16.9 20.3 21.4 20.1 16.0 Personal -75.0 -77.5 -76.1 -72.8 -73.5 -81.8 Cap. Gains -78.3 -87.6 -90.9 -88.0 -83.0 -72.8 Other 4.1 14.5 24.2 31.4 35.5 35.7 *Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline.
39.3 -0.7 0.1 -1.5 86.2 97.9 -23.9 -35.4 16.5 -76.1 -83.4 24.2
-27aggregate of personal, corporate and other sources decline, ex-post, so that the taxes gained on the capital gains tax increase, ex-ante, are more than offset by the lost tax receipts induced by a weaker economy. The reverse occurs on reductions in the capital gains tax rate to 10% and 0%, as shown in Tables 9 and 10. These results demonstrate that the cost of a capital gains tax cut, ex-post, is significantly less than the lost tax revenues from the original reduction in federal tax revenues. For an increase in the capital gains tax rate to 28%, for example, ex–post the federal budget deficit worsens by $6.2 billion per year. An increase to a 50% capital gains tax rate worsens federal budget deficits, expost, by $67 billion per year, despite an initial “score” of positive $191.5 billion a year. At a zero percent capital gains tax rate, the ex-post cost of the tax reduction in terms of the net budget deficit is -$32.8 billion per year versus -$75.2 billion per year, ex-ante. This result, which directionally should characterize all complete economy large-scale macroeconometric models, reflects the induced tax receipts across all tax categories as a consequence of a stronger economy. How to “score” tax changes, either reductions or increases, remains controversial. Current scoring of the cost, or the gain, is done on a “static” or “ex-ante” basis. It is arguable as to whether this is the appropriate way to score the costs of macroeconomic policies designed to stimulate the economy.9 Tables 11 and 12 look at the responses of the nonfinancial corporate sector and the federal government budget in more detail, in response to changes in capital gains taxes. Both the nonfinancial corporate sector and federal government financial position improve with lower capital gains tax rates and are worse with higher capital gains tax rates. Tables 13 and 14 show the effects of changes in capital gains tax rates on the financial position of households and on household “savings,” calculated on a flow-of-funds basis. The asset and liability position of the household sector and other effects on household finances of changes in capital gains tax rates to levels other than the current one are shown as averages over the six years of the simulations. Household financial positions are significantly damaged by higher capital gains tax rates and improve on lower capital gains tax rates.
9
The author is on record favoring “dynamic” scoring rather than “static;” one reason being that reality is ex-post not ex-ante. Another is that policy stimulus, ex-ante, could be too little without taking account of the induced tax receipts that arise from the stimulus itself. Yet another reason is that different tax policies have different induced effects on taxes. By not scoring dynamically, judgments on the efficacy of alternative tax policies could be flawed. Capital gains tax reduction is one of those because of its effects on the stock market, capital gains realizations, capital gains tax receipts and a possible unlocking of gains, demonstrated at various times in history to be of real consequence.
-28Table 11 Nonfinancial Corporate Balance Sheet Effects of a Change in the Capital Gains Tax Rate* (Changes Relative to Baseline, Unless Otherwise Indicated) 50% 28% 20% 10% 5% 0% Item Sources of Funds Total Funds Raised ($ Bils.) Domestic Cash Flow ($ Bils.) Physical Assets Plant & Equipment Financial Assets ($ Bils.) Liabilities Debt Total External Funds ($ Bils.) Short-Term Liabilities ($ Bils.) Long-Term Liabilities ($ Bils.) Financial Position of Nonfinancial Corporations Cash Flow % of Funds Raised (Ratio, Pctg. Pts.) Plt. Equip. & Inven./Dom. Cash Flow (Ratio, Pctg. Pts) “Quick” Ratio (Pctg. Pts.) ST Debt/Liabilities (Ratio, Pctg. Pts.) LTD/Liabilities (Ratio, Pctg. Pts.) Interest Charges/Cash Flow (Ratio, Pctg. Pts.) Liabilities/Net Worth (Ratio, Pctg. Pts.)
-152.5
-61.6
-23.2
31.6
61.9
115.8
-45.9
-16.7
-5.6
10.4
19.2
39.3
-106.5 -94.8
-37.7 -27.3
-13.3 -9.0
19.2 10.3
36.3 18.6
71.2 24.4
-106.6
-44.9
-17.7
21.3
42.8
76.5
32.8 -139.4
9.5 -54.4
3.0 -20.7
-3.8 25.1
-7.1 49.8
-9.9 86.4
-0.2 -0.2
-0.1 0.0
0.0 0.0
0.1 -0.2
0.1 -0.3
0.2 -0.7
-0.7 -0.2 -0.1 0.1 0.1 0.1 0.7 0.2 0.1 -0.1 -0.2 -0.4 -0.7 -0.2 -0.1 0.1 0.2 0.4 2.2 0.7 0.2 -04 -0.7 -1.5 -3.2 -0.4 -0.2 -0.7 -1.3 -3.2 *Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged, with the federal funds rate at Baseline levels.
Table 12 Federal Budgetary Effects of Changes in the Capital Gains Tax Rate* (Changes Relative to Baseline, Unless Otherwise Indicated) Item Unified Budget (+) Deficit/(-) Surplus ($ Bils.) Total Receipts-Unified Budget ($ Bils.) NIPA Budget Deficit (-) Surplus ($ Bils.) Tax Receipts ($ Bils., NIPA) Corporate Personal Cap. Gains (Pers. & Corp.) Other (Soc. Sec. & Excise) Government Outlays ($ Bils., NIPA) Federal ($ Bils., NIPA) Govt. Transfer ($ Bils, NIPA) State & Local ($ 00’ Bils.) Ex-Ante Revenue Cost or Gain ($ Bils.) Ex-Post Tax Receipts ($ Bils.)
50%
28%
20%
10%
5%
0%
-18.1
-2.8
-0.5
-1.5
-5.3
-6.7
-12.4
-1.5
-0.3
-1.9
-5.4
-8.2
-2.4
-7.4
-23.0
-29.4
-69.9
-10.6
-18.4 1.4
-7.2 12.5
-2.6 5.3
4.5 -20.2
8.4 -44.4
16.5 -76.1
-30.1
-11.0
-4.0
6.7
12.6
24.2
22.7 16.8 -53.9
4.9 6.4 -20.1
1.1 2.2 -7.6
-1.7 -5.1 10.2
-0.6 -9.3 19.8
-6.0 -19.8 36.1
1148.9
551.6
272.0
-268.9
-435.6
-451.5
-12.4 -1.5 -0.3 -1.9 -5.4 -8.2 *Decision Economics, Inc. (DE) and simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy is unchanged with the federal funds rate at Baseline levels.
In all circumstances, household financial assets decline relative to the Baseline. With higher capital gains tax rates the economy is weaker, job losses greater, income falls and households run down financial assets ex-stocks.
With reductions in capital gains tax rates, the value of
household equity goes up significantly. This generates additional funds that can be used in spending, reducing short-term liabilities, and increasing household financial assets. The flow-of-
-29Table 13 Household Balance Sheet and Household Sector Savings in Response to Changes in Capital Gains Taxation* (Changes Relative to Baseline) Assets/Liabilities/Net Worth Financial Assets Ex-Stocks ($ Bils.) Cash & Equivalent Bonds Household Equity (Stocks) Liability/Debt ($ Bils.) Consumer Credit Mortgage Debt Flow-of-Funds Saving ($ Bils.) Flow-of-Funds Saving Rate (Pctg. Pts.) Household Debt Service ($ Bils.) Other Financial Risk Variables: Financial Assets/Liabilities (Pctg. Pts.) Debt/Income (%) Debt/Wealth (%) DE Household Financial Conditions Index
50%
28%
20%
10%
5%
-223.0 -33.4 -189.6 -3,437.0
-249.2 -94.8 -154.4 -364.4
-322.2 -140.5 -181.7 1,022.5
-455.2 -216.1 -239.1 2,964.9
-538.1 -262.7 -275.4 4,022.8
-632.9 -317.9 -315.1 5,217.5
0%
-421.5 149.7 -169.5 -1.5 -4.8
-158.7 47.5 -8.5 -0.1 -3.9
-56.1 5.8 69.6 0.5 -2.1
91.0 -51.3 184.3 1.5 2.2
173.3 -83.0 248.9 2.0 6.0
253.3 -116.3 331.7 2.6 8.9
-0.2 0.4 2.5 80.3
0.0 0.5 0.4 50.6
0.0 0.6 -0.4 39.6
0.1 0.5 -1.3 26.3
0.2 0.2 -1.8 20.2
0.2 0.0 -2.4 12.2
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy is unchanged; federal funds rate unchanged from the Baseline.
funds savings rate is higher compared with the Baseline when capital gains taxes are reduced and falls on significantly higher capital gains tax rates. Various measures of household financial risk, such as the ratio of financial assets to financial liabilities, debt as a proportion of wealth, and the DE Household Financial Conditions Index improve with capital gains taxes that are lower than currently. The financial risk variables worsen on higher capital gains tax rates. In Table 14 are estimates of “savings” based on household flows-of-funds and the household balance sheet under the various capital gains tax rate scenarios. Savings, defined as the changes in financial assets less liabilities plus physical assets plus net earnings are higher, relative to the Baseline, the lower is the capital gains tax rate and decline sharply if the capital gains tax rate is raised to 50%. The “savings rate” rises the lower is the capital gains tax rate compared with current law and even when the capital gains tax rate is raised to 20%. The savings rate, as defined here, is not the same as the NIPA savings rate nor that calculated in the Federal Reserve’s flow-of-funds. Concluding Perspectives Capital gains taxes for many individuals and families will be going up at the end of this year. The maximum statutory marginal capital gains tax rate will rise to 20% from the current 15%. In addition, the recently passed Patient Protection and Affordable Care Act will raise capital gains taxes by an additional 3.8% for individuals with incomes above $200,000 (married filing jointly $250,000 and up). The current 15% tax rate on capital gains and on qualifying dividends for families with incomes as low as $63,000 also will expire unless the Obama Administration
-30FY2011 budget, which proposes to hold them at current levels, gets enacted. The capital gains tax rates for individuals in the two lowest income brackets will remain the same. Table 14 Household Sector “Savings” in Response to Changes in Capital Gains Taxes* (Changes Relative to Baseline) “Savings” Flows ($ Bils.) Financial Assets Money & Deposits Misc. Assets Bonds Stocks (1) Life Insurance Pensions (Including Annuitized Assets) Financial Liabilities (Debt) Physical Assets (2) Consumer Durables Real Estate Net “Earnings” ($ Bils.) (3) Interest and Dividends Borrowing Costs “Savings—Total” (Finan. Assets less Liabs. plus Phys. Assets plus Net “Earnings”) “Savings” Rate (Pctg. Pts.) (4)
50%
28%
20%
10%
5%
0%
-33.4 -6.5 -189.6 -3,437.0 9.6 -1,555.1 -318.7 -377.5 -36.6 -340.8 41.5 44.9 -3.4
-94.8 -2.5 -154.4 -364.4 4.4 -581.0 -125.4 -143.4 -21.5 -121.9 53.6 57.4 -3.8
-140.5 -0.9 -181.7 1,022.5 1.0 -218.5 -52.0 -50.3 -15.2 -35.1 55.8 58.0 -2.2
-216.1 1.5 -239.1 2,964.9 -4.4 240.5 54.9 87.1 -3.5 90.6 58.4 55.8 2.6
-262.7 2.8 -275.4 4,022.8 -7.6 469.9 114.1 164.3 4.4 160.0 61.4 54.3 7.1
-317.9 5.3 -315.1 5,217.5 -10.4 707.3 170.4 290.8 31.1 259.7 66.0 54.7 11.3
-5229.4 -32.8
-1157.1 -4.9
549.4 6.8
2837.9 21.8
4061.4 29.5
5473.1 37.1
*Simulations with the Sinai-Boston (SB) Large-Scale Macroeconometric Model of the U.S. Economy. Monetary policy unchanged; federal funds rate unchanged from the Baseline. (1) Market value-based. (2) Principally residential real estate and automobiles, light trucks—all at market value. (3) Interest and dividends earned on the additional financial assets and stock plus reductions in borrowing costs. (4) Defined as “Savings—Total” divided by disposable income.
How do changes in capital gains taxes affect the economy? Will the legislated increase in capital gains taxes hurt the economy? What are the mechanisms by which capital gains taxes affect the economy? And, in the context of the current need for faster economic growth and increased jobs creation, what is the role, if any, for capital gains taxation? These are some of the issues raised and examined in this paper, where changes in capital gains tax rates across a wide range were simulated in the SB Quarterly Macroeconometric Model of the United States to determine the effects on real economic growth, inflation, jobs and the unemployment rate, productivity growth, potential output, and the federal budget deficit. Capital gains taxation is controversial. Much of the controversy revolves around issues of fairness or equity, often a “rich” or “poor” debate since the bulk of preferential treatment on capital gains goes to individuals and families at the upper end of the distribution of income or wealth. Fairness often becomes a highly-weighted dimension of the discussion on the pluses and minuses of changes in the capital gains tax. Here, the research was limited to the macroeconomic effects of changes in capital gains tax rates compared with the current level. Even on this dimension, where macroeconomic research has been performed there is considerable disagreement.
However, most research on the
-31macroeconomic effects of capital gains tax rate changes have been based on partial segments of the economy rather than the full economy-wide empirical analysis conducted here. The SB Model of the U.S. economy contains considerable structure relating to capital gains and its potential macroeconomic effects that are not found in most other research. Analysis of allocative efficiency and equity, normal dimensions for assessing any tax and its effectiveness, was not part of the research and the conclusions are based strictly on the macroeconomic impacts of changes in capital gains tax rates. In the context of the current policy challenges facing the United States, on macroeconomic grounds, maintaining the same or reducing capital gains taxes is one implication. Changes in the capital gains tax rate from 15% to a higher rate, while initially raising tax revenues and reducing the federal budget deficit, do not sustain this result in economy-wide full system analysis. Higher capital gains tax rates, e.g., hikes to 50% or 28%, or even 20%, compared with the current 15%, lead to reductions in real economic growth, in aggregate spending, to lost jobs, a higher unemployment rate, and reductions in aggregate tax receipts, except for capital gains, because of the weaker economy. There is little “bang-for-a-buck” for the economy per dollar of tax revenue; indeed, the revenues gained ex-post are hardly worth the loss in economic growth, in jobs, in productivity, and in potential output. Similarly, or conversely, significant reductions in the capital gains tax rate, e.g., to 5% or even 0%, bring gains in real economic growth, new jobs, entrepreneurship and new businesses, an increase in capital formation, increased productivity growth, higher potential output, and greater efficiency. The budgetary cost of the increased growth and gains in jobs is offset to an extent by increased tax receipts, net, ex-post, from the tax cut stimulus to the economy. And, should unlocking of unrealized capital gains occur and get taxed at a new lower capital gains tax rate, the resulting increase in tax receipts can reduce the ex-post cost of the stimulus even further, making the “bang-for-a-buck” of real economic growth per dollar of lost tax revenues relatively high. Central to the impact of capital gains tax reductions on the economy is the stock market and cost-of-capital. Reductions in capital gains taxation lead to an increased aftertax return on equity and demand for equities as an asset class, relative to supply. Stock prices rise, leading to an increase in household wealth, increases in consumer spending, and derived positive effects on the rest of the economy through multiplier-accelerator interactions in the economy.
The
-32reduction in the aftertax weighted cost-of-capital (debt and equity) for business raises capital spending as does the induced effects on capital formation from increases in sales and profits. Capital gains realizations rise as investors and businesspersons cash-in long-term capital gains.
Consumer spending increases as capital gains realizations, aftertax, are “spent” or
“saved.” Rises in asset prices, both in the values of equity and residential real estate, are reflected in a stronger household balance sheet and reductions in debt because of increased income and capital gains realizations. Household financial conditions improve; in turn, reducing the risk of lending to households and increasing the availability of credit. The prospect of longer-term capital gains at a reduced rate relative to the ordinary income tax induces some entrepreneurship, new businesses, innovation, inventions, and startups using riskbased financing from a range of nonbank financial institutions whose objective is to produce high long-term aftertax returns for investors.
This channel of financial intermediation is
supported by the funds released from capital gains realizations as gains develop and the channeling of them by investors into investments through various kinds of financial intermediation. The central nature of asset prices and their effects on economic activity through investments, globalized financial markets, and financial intermediation is partially captured in the empirical results of the simulations with the SB Model, but probably not fully so, given a lack of data, and a full and elaborated structure on the way modern finance and global capital markets interact with the U.S. economy. The SB Model probably captures more of these phenomena than most, particularly in the full-economy context, but still not fully so. Federal government budget effects from changes in capital gains taxes can be significant. Most importantly, the increase in costs, ex-ante, from capital gains tax reductions can be significantly offset after the economic responses, adjustments, and full economy feedback that occurs. On a significantly lower capital gains tax, for example, the economy is stimulated enough to increase the tax bases for ordinary income, social security, corporate, excise and estate taxes so that at given tax rates induced increases in tax receipts offset some, or even all, of the ex-ante costs of the capital gains tax reduction. The reverse is true on significant increases in capital gains taxes. The economy weakens enough so as to bring down the bases subject to tax— reducing tax receipts across-the-board except for the increased capital gains tax receipts. The federal budget deficit can actually worsen as a result. Increased federal government outlays for income and job support also serve to worsen the federal budget in a weaker economy.
-33All things considered, in the context of stimulating increased economic growth, new jobs, capital formation, productivity and potential output at a relatively low cost to the federal budget deficit, reductions in capital gains, on macroeconomic considerations, should be an important part of any program of comprehensive tax reform that is growth and jobs-oriented. Will the coming capital gains tax increase hurt the economy? The evidence presented here is in the affirmative, although not by much, since the rate is set to rise only to 20%. Nevertheless, this may not be the most important question to be answered. The challenge for macroeconomic policymaking and Washington will be how to devise macroeconomic policy combinations that will increase real economic growth and jobs with minimal increases in the federal budget deficit; or, if possible, actual reductions. Capital gains tax reduction scores well on these grounds. Capital gains tax reduction, not increases, on what activities, and on whom in the context of full tax reform, and whether to tax consumption, income, or capital, is the more general set of issues to be considered.
-34References Arena, John J., “Capital Gains and the ‘Life Cycle’ Hypothesis of Saving,” American Economic Review, March 1964, pp. 107-111. Auerbach, Alan J., and Jonathan M. Siegel, “Capital Gains Realizations of the Rich and Sophisticated,” American Economic Review, May 2000, pp. 276-82. Auten, Gerald E., Leonard E. Burman and William C. Randolph, “Estimation and Interpretation of Capital Gains Realization Behavior: Evidence from Panel Data,” National Tax Journal, September 1989, pp. 353-74. Auten, Gerald, and Robert Carroll, “The Effect of Income Taxes on Household Behavior,” Review of Economics and Statistics, November 1999, pp. 681-93. Bailey, Martin J., “Capital Gains and Income Taxation,” Brookings, October 29, 1963. Break, George F., “Income Taxes and Incentives to Work,” American Economic Review, September 1957, pp. 529-49. Brown, S.A., “The Locked-In Problem,” Federal Tax Policy Economic Growth and Stability, Joint Committee on the Economic Report, 84th Cong., 1st Sess., November 1955, p. 367. Burman, Leonard, and William Randolph, “Measuring Permanent Responses to Capital-Gains Taxes in Panel Data, “American Economic Review, September 1994, pp. 794-809. Carroll, Robert, “The 2001 and 2003 Tax Relief: The Benefit of Lower Tax Rates,” Tax Foundation Fiscal Fact No. 141, August 23, 2008. David, Martin, “Economic Effects of the Capital Gains Tax,” American Economic Review, Papers and Proceedings, May 1964, pp. 288-299. Eichner, Matthew, and Todd Sinai, “Capital Gains Tax Realizations and Tax Rates: New Evidence from Time Series,” National Tax Journal, September 2000, pp. 663-82. Feldstein, Martin, “Behavioral Responses to Tax Rates: Evidence from TRA 86,” American Economic Review, May 1995, pp. 170-174. Feldstein, Martin, Joel Slemrod and Shlomo Yitzhaki, “The Effects of Taxation on the Selling of Corporate Stock and the Realization of Capital Gains,” Quarterly Journal of Economics, June 1980, pp. 777-791. Gravelle, Jane G., “Can a Capital Gains Tax Cut Pay for Itself?” CRS Report 90-254, Congressional Research Service, March 1990. Gravelle, Jane G., The Economic Effects of Taxing Capital Income, Chapter 6 “Capital Gains Taxes,” pp. 123-59, MIT Press, Cambridge and London, 1994. Gravelle, Jane G., “Estimating Long-Run Revenue Effects of Tax Law Changes,” Eastern Economic Journal, Fall 1993, pp. 481-494. Holtz, Charles C. and John B. Shelton, “The ‘Locked-In’ Effect of the Capital Gains Tax,” National Tax Journal, Summer, 1962, pp. 337-52. Musgrave, Richard A., John Lintner and E. Cary Brown. “Discussion,” American Economic Review, May 1964, pp. 300-08. Poterba, James, “Venture Capital and Capital Gains Taxation,” Tax Policy and the Economy, Vol. 3 , 1989, pp. 47-67. Slemrod, Joel. “Do Taxes Matter? Lessons from the 1980’s,” American Economic Review, May 1992, pp. 250-56. Sprinkel, Beryl W. and Kenneth B. West, “Effects of the Capital Gains Tax on Investment Decisions,” Journal of Business, April 1962, pp. 122-34.
-35-
Appendix The Sinai-Boston (SB) Model of The U.S. Economy (2007 Version)—A Brief Summary The Sinai-Boston (SB) Model of the United States Economy (2007 Version) is a large-scale quarterly macroeconometric model that includes considerable detail on: x aggregate demands—consumption; residential construction; business fixed investment and inventories; government—federal, state and local; net exports; the balance of payments and aggregate capital account. x financial markets and asset prices - interest rates, stock prices, and currency exchange rates; - sector flows-of-funds for households, nonfinancial corporations, bank and nonbank financial intermediaries, government—federal, state and local, the external sector and the rest-of-the-world; - balance sheet stocks of assets, liabilities and net worth, and the financial risks of various sectors based on the configuration of its balance sheet; - real estate prices of new and existing homes, generally and the market values of this asset class. x transmission channels and interactions of the financial system with the real economy including from monetary policy and financial markets to the economy - interest rates and exchange rates; - household balance sheets; household sources and uses of funds including income, capital gains realizations, and cashout mortgage financing; flows-of-funds; household and nonfinancial corporate business financial risk effects on spending; - stock market prices, residential real estate prices, and household wealth effects on consumption; - housing prices, the value of residential real estate as collateral, cashout mortgage financing, rental price of real estate, affordability of residential real estate, and real estate wealth effects on consumption, home sales, housing starts, and residential construction; - the rental price of capital, weighted average cost of debt and equity, and business capital spending, business sector “financial risk” and business spending on capital goods, inventories and employment; - capital gains realizations on stock and real estate and effects on consumption spending, savings, household and business balance sheets, and the tax receipts of federal government, states and localities; - aftertax real interest rates as returns on saving and costs of borrowing and spending; - aftertax expected real rates of interest and other asset prices; - aftertax weighted average cost-of-capital to business and discount rate for expected earnings and stock valuation. x price and wage inflation modeled in a stages-of-processing approach—producer prices, consumer prices, GDP price deflators, and inflation expectations with the effects of expected inflation feeding back to wages and then into prices, and through unit labor costs to prices. x expectations - “antidotal” evidence; - forward-looking and model-consistent, particularly for financial markets; - extrapolative, backward-looking, particularly for the real economy and inflation, reflecting expectations and adjustment lags; - consumer and business sentiment surveys, directly on consumption and some categories of business fixed investment. x trade, international activity and international financial flows, including the current account; trade and current account endogeneity to economic growth and interest rates; exchange rates, exports and imports. x potential output and its growth based on productivity; labor force participation rates; capital stocks; R&D; real money balances; employment and unemployment; technology.
-36x
global economy interactions and responses—endogenous with major G-7 countries through economic growth and exchange rate effects on U.S. exports, imports, and the current account. The SB Model (2007 Version) has approximately 950 equations containing nearly 1500 variables, 950 endogenous (including identities), and over 500 exogenous variables. The “financial system” and its channels to the real economy are extensively covered, with about onethird of the behavioral equations, including sector sources and uses of funds, sectoral balance sheets, equity market wealth, real estate wealth, mortgage and housing finance, and measures of financial risk comprising the “financial system” (Table A.1). Aggregate Demands The aggregate demands of the model include 31 categories of behavioral equations for real final demands—16 for consumption; 8 for business capital spending and inventories; 11 for exports and imports; and 2 for federal and state and local government purchases. Computer spending is separately identified in all relevant final demands, minimizing distortions caused by rapid declines in computer prices. For simulation purposes, this richness of detail allows the model to yield differentiated impacts among the various demand categories, improving the linkages to downstream systems used in disaggregated industry models. The latter provide a “bottom-up” check on aggregate profits in the model such as the S&P500 Operating EPS, a principal measure of corporate profits. Markets There is a “goods” market, “money” market, “loans” markets, “financial intermediaries” markets, numerous “fixed income” securities markets, the “equity” market, and “currency exchange” market. There is a “labor” market, which helps determine aggregate supply and the potential output of the economy. There is an “international” market where trade, capital flows and the current account are modeled. The “financial intermediaries” sector is comprised of commercial banks, thrift institutions, and nonbank financial intermediaries. There is a government sector—federal, state and local—and its financing. Financial System The “financial system” is an elaborate and detailed portion of the SB Model, consisting of 479 equations, 317 behavioral and 162 exogenous. The richness of detail extends to 59 fixed income markets, where a wide array of nominal and real aftertax interest rates have significant effects on portfolio adjustments, flows-of-funds, balance sheet states, sector financial risks, and as transmission channels from the financial system to the real economy. Flows-of-funds (uses and sources of funds) by sector and sectoral balance sheet stocks of assets and liabilities are represented for households, nonfinancial corporations, the federal government, state and local government, commercial banks, thrift institutions, nonbank financial intermediaries and the rest-of-the-world, another distinguishing feature of the Model. Spending and financing are jointly determined with financial flows, liquidity and financial risk feeding into numerous categories of real sector expenditures. The real spending side of the Model explicitly recognizes “wealth” effects from equities and real estate valuations and the effects of realized capital gains, or losses, in equities and on the physical asset, housing real estate, valued at market prices; also for balance sheets, consumption, and tax receipts. Expectations Expectations of future economic and financial variables are important in the SB Model and a distinguishing feature. Expectations enter the Model in many ways—from surveys of consumer and business sentiment conducted by widely-followed organizations (such as the U. of M. Survey Research Center and the Conference Board) to calculations of expectations for GDP and prices by mathematical formulas. Survey expectations appear in numerous consumer and business spending equations. Expectations constructed by formula can be backward-looking, using past values of economic variables, or forward-looking and model-consistent, using future values of variables based on calculations by the Model. In the latest SB Model Version, greater use is made of surveys for the expectations of households and businesses, including the Gallup Poll Presidential Approval Rating. Several have been found to directly affect some categories of private sector expenditures.
-37Expectations differ across agents in the economy, formed as extrapolative or backward-looking on income and on the inflation expected by consumers. Inflation expectations affect wage inflation and price inflation. Expected future profits and expected interest rates affect equity prices, hence household wealth and consumption. The long-term nominal 10-year U.S. Treasury and AAA-equivalent new corporate bond interest rates are affected by bond market inflation expectations formed in a second order Pascal probability distribution model and by the U. of M. Consumer Survey expected inflation ex-food and energy. The formation of expectations in financial and real markets distinguishes the SB Model from many others, with forward-looking and model-consistent, “permanent,” and extrapolative expectations of different lagged structures empirically estimated and appearing in different real economy, or financial markets. Survey expectations also are used and are determined structurally within the Model. Some market forward expectations variables (futures markets) also enter into some financial market equations. A “quick” effect of future expectations into current financial asset prices and returns characterizes key financial markets through the generation and discounting to the present of model-consistent expectations for some of the fundamental factors that affect long-term interest rates, the U.S. equity market, and exchange rates. In turn, real final demands or aggregate demands are impacted sooner through the financial-real interactions of the Model than might otherwise occur if expectations were not so modeled. Interest Rates Interest rates are modeled through a segmented markets approach, where fixed income markets reflect the demands and supplies for various assets across sectors and the interrelated behavior and arbitrage between markets. Real after-tax interest rates provide a major input into spending and borrowing, rather than nominal interest rates. Tax considerations enter extensively throughout the Model, affecting asset prices and incentives such as in the aftertax weighted average cost-of-capital and rental cost of housing. Monetary policy; credit demands; fiscal policy and federal budget deficits; expected and current; financial intermediaries activity; inflation and expected inflation, model-generated and survey; and foreign holdings of foreign exchange and the exchange rate are key determinants of interest rates. Equity Markets The stock market reflects the demands and supplies for equities through a fundamental valuation approach, principally based on the present value of expected earnings, expected after-tax returns on equity, volatility of earnings, expected growth in the economy, and interest rates. The expectations are forward-looking, reflecting market behavior that incorporates future expectations into current asset prices. Multiple interest rates play a role in determining stock market prices. The S&P500 Common Stock Index is modeled. Exchange Rates The dollar exchange rate is modeled against key bilateral exchange rates such as the yen, euro, and pound-sterling in addition to a trade-weighted average of sixteen countries, the Federal Reserve Major Currency Exchange Rate. The dollar is a function of expected inflation in the United States vis-à-vis several key OECD countries, relative short- and long-term interest rates in the United States and abroad, trade flows and the current account, expectations of relative economic growth across countries, the expected U.S. Government structural budget deficit, and some elements of overseas demand for U.S. assets. Transmission Channels: Financial-Real and Real-Financial Interactions A considerable number of channels for financial-real interactions are modeled, including multiple effects of numerous interest rates on aggregate demands through direct impacts on spending and borrowing and indirectly through sectoral balance sheet positions and various measures of financial risk as defined on the balance sheet. The channels for the effects of the stock market on spending and elsewhere are numerous— household wealth, capital gains realizations, the weighted average cost-of-capital (debt and equity), consumer sentiment and consumption, and also the external financing of business. Tax receipts at the federal and state level also are affected by the stock market through realized capital gains, e.g., capital gains tax receipts and the federal budget. Impacts are on consumption, business fixed investment, residential construction, exports and imports, and on the long-term interest rate on expected federal budget deficits.
-38Exchange rates, set by demands and supplies for the U.S. currency vis-à-vis other major currencies, impact interest rates, inflation, profits, trade flows and the current account, the federal government budget deficit and thus spending aggregates, directly and indirectly. Quick discounting of future expected values that relate to profits, the economy, deficits, and relative economic growth across countries impact current financial asset prices, including interest rates, thus spending through the channels financial and real asset prices to the economy. The real economy and real final demands—consumption, business fixed investment and inventory accumulation, federal and state and local government spending, and export and import financing—drive demands for finance, short- and long-term, with loans and credit responsive to real economic activity, as well to the interest rates and costs of borrowing that go with the demands. The segmented markets approach to interest rates reflects these demands and sector uses of funds in a flow-of-funds framework to help determine various “prices,” e.g., interest rates and equity market costs, as transmission points from the real economy to finance and credit. In turn, various asset prices such as interest rates affect, with lags, real economy spending aggregates. Financial conditions in the various sectors—households, business, financial institutions and government—evolve over time measures of credit and financial risk which also can feed back to the real economy. Other linkages also exist that impact private and public sector spending—federal, state and local. Expected future budget deficits affect current interest rates, particularly longer duration but also short-term interest rates through U.S. Treasury financing, and then through financial-real linkages off interest rates, debt service, the cost-of-capital, and then private sector expenditures. Transmission Channels: Mortgage and Housing Finance Financial conditions and mortgage-housing finance affect housing, residential construction and consumption, with recent versions of the Model adopting an elaborate mortgage finance-housing channel to depict how housing and mortgage finance affect the economy. The housing market affects consumption through a number of channels. There is a real estate wealth effect and effects on consumption and housing from equity in residential real estate liquefied by home-equity borrowing and cashout financing. Interest rates, the cost-of-borrowing, cost-of-capital and a rental price of housing, traditional channels for monetary policy to the real economy, help determine consumption, housing activity, residential construction, and business capital spending in numerous ways. One is directly as a choice for households between saving and spending. A second operates through debt service-toincome and debt service-to-cash flow, or “financial risk” variables, into consumer spending and business capital spending. A third operates through interest rates, the present value of expected future profits, the stock market, cost of capital, equity wealth, and household spending. A fourth occurs through the effects of interest rates and mortgage financing on affordability as it relates to home sales; in turn, affecting home prices, real estate wealth, and consumer spending. The wealth effect induces consumers to spend out of both real estate wealth and non-real estate wealth (consisting of financial assets, including equities, less liabilities). Capital gains realizations from gains (or losses) realized on sales of stocks or realized gains on sales of residential real estate impact on spending and saving, with the funds obtained in this way spent, saved, or used to pay taxes at the federal and state and local levels. Consumers also have a channel of spending out of the liquefied home equity resulting from cashout financing as affected by home prices and interest rates. By refinancing a home mortgage, homeowners can convert the appreciated value of real estate into spending on consumer goods and services. This is a relatively recent channel in the U.S. economy which initially emerged during the late 1990s and has developed further through this decade. Price and Wage Inflation Prices and inflation rates are determined in a stages-of-processing approach that flows from producer prices through consumer prices to chain prices for the GDP deflator components. Prices also reflect the production and supply side of the economy through the “gap” between potential and actual output, and industrial capacity or capacity utilization. Wages and benefits are determined by labor market conditions and are influenced by price inflation and inflation expectations. Unit labor costs and markup pricing by business to maximize profits are an important determinant of prices and inflation. Inflation expectations, formed with lags, affect
-39wage-setting, then product prices through unit labor costs and, in turn, price expectations, then wages, price inflation, etc.. There is no explicit Noninflationary Accelerating Inflation Unemployment Rate, NAIRU, in the SB Model. Instead, there is a highly disaggregated and structural setting-out of inflation at all stages-of-processing. A NAIRU-like result can be produced by the Model and results from underlying factors that raise inflation and lower unemployment until the demand for labor, relative to the supply, along with expected inflation, gets to the point where at a low unemployment rate, inflation begins to accelerate. In the SB Model, this result does not occur from a “natural rate” calculation feeding directly into price and/or wage inflation, but instead from behind-the-scenes structural inflation and wage-setting behavior that generate a relationship between inflation and unemployment which superficially looks like a Phillips Curve in twodimensional space and a “NAIRU.” Crude oil prices are determined in a global demand-supply fundamental framework, with country-by-country demands for oil and supplies of crude oil entering. Crude oil prices estimated in this way are endogenous to the global economy and to the open-economy macroeconomics of the SB Model. The SB Model is open to the global economy and the major economy GDP growth rates, exchange rates, trade flows, and current account flows. Major country macroeconometric models are part of the worldwide linkages of macroeconomies and form the macroeconomic structure of the global economic system, as modeled by DE. Crude oil prices, along with demands and supplies for other energy costs, enter the inflation process in numerous ways—mainly through unit energy costs and markup pricing by goodsproducing and services-producing companies in the U.S. economy. Energy costs and the derivative inflation effects reduce purchasing power for households, businesses, states and localities and companies involved in international trade, thus feed back to various spending aggregates and to U.S. economic growth. Rest-of-the-World and Linkages The Model is “open economy” in its orientation and considers extensively the interactions of money, finance, credit, and sectoral balance sheet states in the real economy. Trade and international capital flows are integral to the dollar exchange rate, which has significant effects on inflation, interest rates, and the economy. The Model uses foreign demand variables, prices, exchange and interest rates to link the rest-ofthe-world to the U.S. economy. Exports are driven by foreign demands, exchange rates, and prices. Price variables from key foreign countries help determine prices in the U.S. through costs-of-production and prices at retail, capturing the increased openness of the U.S. economy and trade that have emerged since the 1990s. Foreign exchange rates play a part in interest rate determination, directly affect trade flows, and indirectly affect the stock market and cost-ofcapital. The components of the current account, goods, services, income receipts and payments and transfers are modeled in detail. Financing of the current account, purchases and sales of financial assets by shareholders also are included in the Model. Policy and Exogenous Variables The Model contains a large number of exogenous variables, 537. This is not unusual in a largescale macroeconometric model, with many of the exogenous variables simply identities, or definitions, that are used or complete the coverage of the model. Main policy levers include tax rates at all levels, personal, business, social security, for capital gains, estate taxes and excise taxes; federal government expenditures, defense and nondefense; population and the demographics of age groups; nonborrowed reserves and Federal Reserve credit; numerous fixed parameters representing institutional or legislated rules or laws; and definitional derivations of capital stocks for equipment, plant, residential housing, sectoral balance sheet assets and liabilities, and other such items. Balance sheet stocks are definitionally determined with some minor components exogenous.
-40Table A.1 The Sinai-Boston (SB) Model of the U.S. Economy (2007 Version) Behavioral GDP and Final Demands GDP Consumption Business Fixed Investment Residential Investment Inventory Investment Exports Imports Government Federal State and Local Final Sales, etc. Supply, Potential Output, and Capacity Capital Stock Prices, Wages and Productivity Producer Prices Consumer Prices Chain GDP Price Deflators Wages Productivity Prices—Other Deflator Inflation Rates Expected Inflation Incomes Wages, Salaries and Supplements Personal Income—Other Corporate Profits Dividends Interest Consumption-Related Investment-related Business Investment Residential Investment Financial System Monetary and Reserve Aggregates Financial Markets Interest Rates Stock Market Exchange Rates Flows-of-Funds or Uses and Sources of Funds Households Nonfinancial Corporations Depository Institutions—Banks Nonbank Financial Intermediaries Government—Federal, State and Local Sectoral Balance Sheets Households Nonfinancial Corporations Depository Institutions—Banks Nonbank Financial Intermediaries Government—Federal, State and Local
Identities
Behavioral
Total Exogenous
Total Variables
45 3 16 6 5 2 5 6 2
122 2 35 23 3 6 11 10 17
167 5 51 29 8 8 16 16 19
147 1 37 37 6 9 12 15 21
314 6 88 66 14 17 28 31 40
0 28 1 112 29 6 47 13 3 14 0 1 22 4 12 6 1 3 11 24 1 23
15 8 23 60 0 1 36 5 12 1 5 0 21 3 12 6 0 2 1 27 7 20
15 36 24 172 29 7 83 18 15 15 5 1 43 7 24 12 1 5 12 51 8 43
9 18 21 91 22 0 50 4 5 9 0 0 18 1 13 4 0 3 3 13 3 10
24 54 45 263 51 7 133 22 20 24 5 1 61 8 37 16 1 13 15 64 11 53
163 10
194 15
357 25
162 13
519 38
59 7 10
19 8 4
78 15 14
54 11 26
132 26 40
73 26 36 3 2 6
94 23 35 0 2 36
167 49 71 3 4 42
95 18 24 0 4 52
262 67 95 3 8 94
4 0 0 2 2 0
4 22 26 1 2 3
8 22 26 3 4 3
0 0 0 0 4 0
8 22 26 3 8 3
-41Table A.1 (continued) The Sinai-Boston (SB) Model of the U.S. Economy (2007 Version) Behavioral Rest-of-the-World
Identities
Behavioral
Total Exogenous
Total Variables
21
22
43
25
68
Demographics
1
2
3
8
11
Miscellaneous Expectations Forward-Looking (Model Consistent) Backward-Looking “Bond Market” Expectational Lags Adjustment Lags Market-Formed Surveys Rates of Return Saving
8 7 0
73 22 8
81 29 8
24 8 2
105 36 20
0 1 0 2 4 0 1
2 1 0 1 0 35 16
2 2 0 3 4 35 17
0 1 0 1 2 9 7
2 3 0 4 6 44 24
416
529
947
537
1491
23 2
0 0
23 2
23 2
11 3 7 6 5
0 0 0 0 0
11 3 7 6 5
0 0 0
Nonresidential Business Fixed Investment Via Interest Rates Via Debt Service Via Rental Price of Capital Via Aftertax Cost-of-Capital
6 1 5 0
0 0 0 2
Residential Investment Via Interest Rates Via Mortgage-Housing Finance Via Rental Cost
6 4 2 0
Inventories Net Exports
Total Addendum: Financial Transmission Channels Consumption Via Interest Rates Via Wealth (Asset Markets, Real Estate, Equity) Via Debt Service Via Mortgage Finance Via Cashout Financing Via Capital Gains
0 0 0 0
11 3 7 6 5
6 1 5 0
0 0 0 0
6 1 5 2
0 0 0 1
6 4 2 0
0 0 0 0
6 4 2 1
1
0
1
0
1
6
2
8
2
10
-42Table A.2 The Sinai-Boston (SB) Model of the U.S. Economy (2007 Version): Sample Historical Performance—Full Model Simulation, 1990:1-2004:4* Variable
RMSE
% RMSE
111.7 98.7 35.6
1.25 1.60 8.78
77.8 27.3 27.6 0.4 49.1 51.0
10.84 10.47 2.67 0.37 5.65 4.43
Unemployment Rate (%)
0.4
7.54
Prices & Wages (Level) GDP Deflator GDP Deflator (% chg.) PPI Nonfarm Bus. Comp.
0.01 0.76 0.04 0.02
1.10 36.86 3.82 1.74
Profits S&P500 EPS ($/share)
1.41
13.36
Interest Rates (%) 3-Mos. T-bill 10-Yr. Treas.
1.04 0.45
26.74 7.72
Exch. Rate (Level) FRB Major Cur. Exch. Rate
0.10
10.56
Real GDP (Bils. 2000 $s) Consumption ( “ ) Resid. Inv. ( “ ) Bus. Fixed Inv. ( “ ) Equip. Plt. S&L Govt. ( “ ) Fed. Govt. ( “ ) Exports ( “ ) Imports ( “ )
*See Table A.1 for Model breakdown and numbers and types of equations.
-43Simulation Description This part of Appendix describes how capital gains tax rate changes were simulated using the Sinai-Boston (SB) Model of the U.S. Economy. The period covered was 2011 to 2016, or six years, long enough to observe in simulation the short-, intermediate-term, and longer-run effects of the tax policy changes. Implementation of the simulation involved changes in parameters and add factors. Parameters that changed for the simulation involved statutory and effective personal tax rates faced by consumers. Personal tax rates appear in a wide range of equations including consumption spending, consumer holdings of financial assets and liabilities, after-tax rates of return and consumer sentiment. Because the capital gains tax rate is a component of the overall personal tax rate, it appears directly or indirectly in a large number of equations describing consumer behavior. Six simulations replaced the current-law 15 percent personal capital gains tax rate with a range of alternatives. These alternatives were a lower capital gains tax, reductions to 10-, 5- and 0-percent, and higher capital gains tax rates, increases to 20-, 28- and 50percent, respectively. The key changes in tax parameters set the economy moving towards a different solution based on the alternative tax rate simulated, instead of what might happen under the current 15 percent rate. The direct effect of capital gains taxes on capital gains realizations is a key part of the simulated effects from the tax changes. The tax on capital gains is only one component of the personal income tax. A decrease in the capital gains tax rate decreases the overall effective personal income tax rate faced by individuals. As the capital gains tax rate moves from the current 15-percent rate to a hypothetical, lower, 10-percent rate, e.g., the reduction in the effective tax rate reduces tax payments by individuals. The lower effective personal tax rate, relative to the Baseline, is implemented in the Model by reducing the effective personal tax rate on capital gains realizations to 10 percent for the simulation of a hypothetical 10-percent tax rate. In the simulation of a 10 percent capital gains tax rate, the effective personal tax rate on capital gains is reduced to 10 percent while the overall capital gains tax rate is reduced to 10 percent. This process of tax rate reduction (or increase) was repeated for each of the six alternative simulations. The effective personal tax rate was changed from 15 percent to 10-, 5- and 0-percent for tax rate reductions and to 20-, 28- and 50-percent, respectively, for tax rate increases. From the reduction in the effective capital gains tax rate to 10 percent from 15 percent, the consumer faces a lower effective tax rate, resulting in more spending because of the tax rate reduction. The impact on the economy flows from lower taxes on sales of capital assets to higher income to increased consumer spending on goods and services and purchases of assets. The key changes that cause the simulations to vary from the Baseline are a result of changes in the personal capital gains tax rate and the effective personal tax rate. No other exogenous variables were changed, except for technical reasons. To present the results in a manner that makes for easy comparison across simulations, the key short-term interest rate in the SB Model, the federal funds rate, is maintained at
-44its Baseline level in the six alternative simulations. This represents an unchanged monetary policy. Nonborrowed bank reserves are increased or decreased in the respective simulations to maintain the federal funds rate at the same level as in the Baseline simulation. This is necessary because a higher, or lower, federal funds interest rate would represent a purposeful change in monetary policy and result so as not to get the isolated effects of changes in the capital gains tax rate. In a simulation, the change in the capital gains tax rate and the change in the effective personal capital gains tax rate (which also affects the overall personal tax rate) are sufficient to generate the bulk of the results in the simulation. But future expectations are an important part of the SB Model. In the course of the simulations, the expected future path of some key variables, such as the federal budget deficit, expected S&P 500 operating earnings per share, expected exchange rate (Federal Reserve Major Currency Index), expected real GDP and the expected consumer price index (CPI) were solved in simulation. This mechanism of using future expectations during the solution of the SB Model captures the impact of expectations on the model solution as it is being generated.
