Michael Darda, Chief Economist at MKM Partners, makes a powerful argument for indexing the capital gains tax to inflation, High inflation creates a disincentive to invest by raising the effective tax rate on capital. This, in turn, crushes financial markets:
The current effective tax rate on capital is around 30%, down sharply from the 60% rates seen as recently as the early 1990s. This drop has been occasioned by a long period of falling inflation and the reductions in the top tax rate on capital gains in 1997 and 2003. The result has been an extended period of economic growth, strong advances in productivity, falling unemployment and rising real wages and incomes for most Americans.
But this positive trend may not last. The statutory capital gains will automatically jump to 20% from 15% in 2011 unless legislative action is taken to extend the current rate. Democratic presidential front-runner Barack Obama has stated a preference to raise the top rate on capital gains to as high as 28%, a near doubling of the current rate. Even more worrisome is that the collision of a 28% tax rate on capital gains combined with inflation above 3% would raise the effective tax wedge on capital to nearly 60% – the highest in 17 years.
From the late 1960s to the early 1980s, effective tax rates on capital averaged more than 100%. Perhaps it is no coincidence that real equity values collapsed by nearly two-thirds from 1968 to 1982. This period saw sputtering productivity, rising inflation, high unemployment, and an American economy in general decline.
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