In his Jobs Creation and Economic Growth Speech (.pdf) at the Brookings Institution on December 8, President Obama announced his proposal to eliminate the capital gains tax paid by small businesses. Here's the relevant passage:
Building on the tax cuts in the Recovery Act, we’re proposing a complete elimination of capital gains taxes on small business investment along with an extension of write-offs to encourage small businesses to expand in the coming year.
Although the final language has yet to be drafted, the likely effects of this tax cut can be predicted.
Small businesses would be encouraged to waste their efforts and resources on tax shelters instead of productive enterprises. They could convert other income into tax-free capital gains by buying assets, such as commercial real estate, taking accelerated depreciation in order get instant tax credits, and then selling those assets to get tax free capital gains.
Even worse, if this provision allows small business owners to sell their current businesses free of capital gains taxation, many would likely sell their businesses altogether, resulting in a loss of jobs in the small business sector.
As bad as these effects would be, Obama's capital gains tax cut would probably not be quite as destructive to the economy as the capital gains tax cuts signed by Obama's most recent predecessors:
- 1. President Clinton's capital gains elimination hurt the housing sector. In 1997, President Clinton eliminated the capital gains tax on most homes, triggering the housing bubble, which turned into a housing bust in 2006.
- 2. President Bush's capital gains tax reduction hurt the corporate sector. In 2003, President Bush lowered the overall capital gains tax rate encouraging businesses to buy back their own stock, leaving corporations vulnerable when the financial crisis hit in October 2008.
American presidents have not always made things worse. In 1951, President Truman initiated the roll-over treatment for capital gains on home sales. From 1951 through 1997, whenever a homeowner sold his or her primary residence to buy another residence, the capital gains tax was deferred (i.e., rolled-over) until the new home was sold. Homeowners would typically build up their equity in one home, sell that home, and then use their savings to make a down payment on a larger home. During that period, there were large changes in interest rates, yet home prices were quite stable. The result was 47 years of accumulating wealth in America's housing sector.
When Clinton, Bush and Obama proposed their foolish capital gains tax cuts, they all thought that they were benefiting the economy. They didn't understand the economics of capital gains taxation.
As we explain in our book, Trading Away Our Future, capital gains taxes don't influence the decision upon whether to make an investment, a decision based upon the expected return from that investment. President Obama is already insuring that small businesses will do less investment. He has been doing so by raising the marginal tax rate on the rich.
Low capital gains tax rates, however, do encourage investment in tax shelters whenever they allow other types of income to be converted into capital gains and they do encourage the founders of a business to sell out, instead of continuing their own leadership of the business. They are a foolish tax gimmick with terrible side-effects.
There is an almost-perfect tax treatment of capital gains -- President Truman's rollover treatment. In order to avoid creating tax shelters, capital gains should be taxed at the same level as other income. In order to encourage the accumulation of wealth, taxation should be deferred when the capital is rolled-over from one investment to another.
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