The Returns On Low Capital Gains Taxes

Chris Edwards insists that “low capital gains tax rates are not some sort of unjustified loophole”:

We’ve had reduced rates virtually the entire time we have had an income tax, and for very good reasons. Low capital gains tax rates are crucially important for spurring entrepreneurship, investment, and growth.

Mike Konczal disagrees. He cites a recent paper by economist Danny Yagan on Bush’s massive capital gains tax cut. Yagan’s research compares S-corporations, which “don’t pay a dividend tax and thus didn’t benefit from the big 2003 dividend tax cut” to C-corporations, which “do pay them and did benefit”:

So that allows Yagan to set up S-corporations as a control group and see what the effect of the massive dividend tax cut on C-corporations has been. Here’s what he finds:


The blue line is the C-corporations, which should diverge from the red-line if the dividend tax cut caused a real change. But there’s no statistical difference between the two paths at all. (Note how their paths are the same before the cut, so it’s a real trend in the business cycle.) There’s no difference in either investment or adjusted net investment. There’s also no difference when it comes to employee compensation. The firms that got a massive capital tax cut did not make any different choices about things that boost the real economy. This is true across a crazy-robust number of controls, measures, and coding of outliers.

The one thing that does increase for C-corporations, of course, is the disgorgement of cash to shareholders. Cutting dividend taxes leads to an increase in dividends and share buybacks. This shows that these corporations are in fact making decisions in response to the tax cut; they just happen to be decisions that benefit, well, probably not you. If right now you are worried that too much cash is leaving firms to benefit a handful of investors while the real economy stagnates, suddenly Clinton-era levels of dividend taxation don’t look so bad.

Yglesias admits that Yagan’s study has its limits:

Any empirical study can be nitpicked in a variety of ways. But the big thing Yagan’s research methodology doesn’t cover is venture capital and startups.

Most business investment is undertaken by established businesses, and established businesses don’t rely on the stock market to fund their investments. But some firms do. Brand-new companies — and especially brand-new companies built around unproven technologies or business models — usually have their early investments financed by venture capitalists. These VCs are hoping to earn a long-term return after the company goes public, and the size of that return depends, in part, on the tax treatment of dividends and capital gains.

Consequently, higher taxes on investment income might depress VCs’ willingness to finance startups.