The Bailout and Capital Gains Taxes
Whatever its ultimate fate, the $700 billion financial market bailout has me thinking about how events of the past few months have fundamentally changed the nature of economic risk in the U.S. And, that, in turn, raises some interesting questions about capital gains taxes.
For years, we've heard that one big reason for lower tax rates on capital is the need to encourage innovation. We all know the argument: Entrepreneurs and others won't make the chancy investments that drive a vibrant economy without the benefit of lower taxes.
There is plenty of doubt about whether the premise is even correct. But, for the sake of argument, let's assume it is. Let's say that investors will be less likely to risk their money on new businesses and new ideas without government incentives.
Well, the Bush Administration has just promised to put $700 billion in taxpayer money on the table to encourage investment. It has, in fact, put a floor beneath the hazards of investing—at least for a large segment of the financial world—by saying if you bet wrong, government will ride to your rescue. Once we make it through the current mess, this decision to socialize a chunk of financial risk will have some interesting consequences. It should encourage more people to put up their money, which, in turn, should drive down the cost of capital. That, after all, is the whole point of the bailout.
So, if we are now explicitly using Treasury assets to stimulate investment, do we need the tax code to further encourage risk taking? Didn't the mix of cheap money, tax incentives, and lax regulation help enable this mess in the first place?
One lesson we might learn from the recent unpleasantness is that there can be too much risk taking. Remember, innovation is not always productive. Just as pharmaceutical companies have used the research tax credit to develop drugs that save lives, so too have they produced products that ended up killing people. Similarly, while Wall Street has found new ways to make investment more efficient, the flood of money encouraged in part by low taxes has also made it possible for investment firms to peddle the derivatives that are now strangling the financial markets.
To the degree that low capital gains rates encouraged overly leveraged investments in grossly overpriced paper, it may be time to rethink the tax. And if this bailout will cut the cost of capital, do we need a low tax rate too?
I understand there may be other reasons to keep capital gains taxes low, such as ameliorating the impact of inflation on investment returns. But the political argument for low taxes on gains has usually centered on encouraging risk-taking and innovation. And risk just ain't what it used to be. So, is it time to reconsider the preferential tax treatment enjoyed by capital gains, and, if so, how? Let us know what you think.