Econometric analysis does not support the claim that capital gains tax rates have a big influence on business investment. This matters because this is the primary policy justification for this tax break to exist, and because this tax break is the single most important factor in reducing the effective tax rate paid by the wealthy.
One of the problems with the theory that reduced capital gains taxes encourage business investment is that business investment by taxpayers who benefit from reduced capital gains taxes has declined relative to GDP (from 3% of GDP in 1950 to 1% in 2008) despite falling capital gains tax rates, while business and non-profits investment by taxpayers who do not face preferential capital gains tax rates has grown and constitutes the predominant source of business investment: 94% of business investment comes from corporations and non-profits (such as pension funds and university endowments) that do not have preferential capital gain tax rates.
One of the few times when business investment increased when capital gains taxes fell can be more plausibly attributed to changes in depreciation rules that encourage capital investment: "data on the 1960's strongly implies that it was accelerated depreciation for corporate investment that caused capital spending to rise in the 1960's, not lower taxes on individuals."
This makes sense. Most business investment is in property that is expected to depreciate in value and help the firm produce ordinary income, not in property that is expected to appreciate in value over time. Business corporations in the real economy invest primarily in their own operations, not in other corporations or in speculative real estate and commodity investments. Similarly, commercial banks are in the money lending business, not the stock speculation business.
Also, keep in mind that investments in capital stock translate into funds for business investment only when there is an initial public offering of stock. Publicly held companies raise about four times as much money for business investment from bonds, whose returns are primarily taxed as ordinary interest income, as from public offerings of stock. Jenning, Marsh and Coffee, "Securities Regulation" (1992) at 11.
One can make capital gains and losses in bonds, but capital gains tax rates don't do much to encourage investment in them. This is because it is much more common for a bond to trade at significantly less than the price it was issued at, due to an increased likelihood of default, producing a capital loss, than it is for a bond to trade at more than its price at issuance.
A bond whose likelihood of default has not changed can sell for more than its face value when market interest rates fall below the nominal interest rate on the bond. But, generally, the capital gain on a bond due to falling interest rates will never be more than a fraction of a single year's interest rate, on a percentage basis, because the total payments due on a bond will never be more than its remaining principal value plus the nominal interest payments due under the bond. Generally, the portion of the return on a bond that comes from interest payments taxed as ordinary income will be much greater than the portion of the return on a bond that is taxed as a capital gain.
More intuitively, capital gains tax rates aren't very important in the bond market because bonds don't share in upside gains by the corporations that issue them. They are income investments, not growth investments.
Let repeat the key fact, because it is important:
Publicly held corporations are taxed as the same rate on ordinary income and capital gains, and the return bondholders who provide 80% of the capital that those publicly held corporations secure from the public for the purpose of making business investment is not materially affected by capital gain tax rates.
In fact, the estimate that 80% of funds used by publicly held companies for business investment comes from bond sales that indifferent to capital gains tax rates, rather than the stock market which is sensitive to capital gains tax rates, is an underestimate. It excludes loans that corporations secure from banks and other private debt offerings. But, publicly held companies that make up the bulk of our economy can't make private equity offerings.
The 80% estimate is also low because a significant source of investment capital for publicly held companies comes from reinvested profits. The qualified dividend tax rate preference has reduced, rather than increased the availability of funds for business investment from this source, because it favors the distribution rather than the retention of profits relative to the prior tax regime. Capital gains tax rate preferences, in contrast, don't influence the incentives of publicly held companies to retain earning rather than distributing them.
In the United States, external financing from sources such as stock offerings, bond issuance, and private loans account for less than than three-quarters of total financing (i.e. investment capital). Thus, initial stock offerings indirectly account for less than 5% of business investment by publicly held corporations.
In reality, then, capital gain tax rates influence, even indirectly, considerably less than 5% of all business investment by publicly corporations, and individuals who benefit from capital gains tax rates make only about 6% of direct business investment. The other 89% plus of business investment is indifferent to capital gains tax rates.
The tax breaks for capital gains, instead, primarily reward speculative gains by investors in the secondary market.
The impact that capital gains taxes have on business investment is even lower in recessions when initial public offerings are scarce, and no amount of tax rate adjustment can change the fact that falling stock prices don't produce any capital gains. Indeed, since capital losses must be set off only against capital gains (with some limited exceptions), a capital loss provides less of a tax benefit, and hence less of an economic stimulant during recessions than a net operating loss (which is ordinary income) that provides a greater tax benefit at those times because it offsets income taxed at higher ordinary income tax rates for non-corporate businesses.
Capital gains tax rates may provide some stimulative effect on investment, but this impact is greatly exaggerated. Other aspects of the tax code like depreciation rules, tax credits, ordinary income tax rates, and corporate income tax rates are much more important factors in influence amount of capital that will be made available for business investment.
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