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I’ve been analyzing the fiscal cliff more closely over the past few days, and the more I examine, the more baffled I become as to what the President is fighting over.  There are $532 billion in scheduled tax increases and at least $401 billion of that falls directly on lower and middle income earners.

This sort of contradicts the “tax cuts for the rich” rhetoric, as it would appear that the brunt of these tax increases would hit the middle class directly.  Even the part that doesn’t hit directly, will likely hit indirectly in the form of job losses and lower income.

Where this becomes even more insane is when you look at the scheduled investment tax increases; that is, increases in the dividend and capital gains taxes.  The projected gains barely raise revenue at all and even that is based on optimistic assumptions.

The capital gains tax is set to increase from 15% to 20% (add an additional 3.8% for Obamacare, as well) and the top dividend tax rate is set to increase from 15% to 39.6% (once again, add 3.8% for Obamacare).  Let’s ignore the Obamacare increases and focus solely on the expiration of the 2003 tax cuts on capital gains and dividends.  Want to take a guess at the net increase in revenue expected from these tax hikes?

$8 billion. 

That’s a very small number when we’re talking about an entire economy.  To put this in perspective, Federal expenditures are over $3.7 trillion (that’s with a “T”) and the budget deficit is $1.1 trillion.   Our overall GDP is around $15 trillion.

What I’m saying is that this “tax on the rich” would lower the annual deficit by a mere 0.007%.  Even these paltry gains are all theoretical, because it assumes that the wealthy don’t invest less as a result; a very huge assumption.  If the wealthy do invest less, it could actually lead to a net contraction in tax revenue.  This is something we’ve observed in the past with tax increases.

After looking at this data, I can come up with absolutely no logical, scientific, mathematical, or economic reason to raise the capital gains and dividend taxes.  The added revenue (even if it holds up after raising the rates) is so miniscule as to be irrelevant.  Whereas, the job losses it’s likely to create are very real and costly.

This is irrational government policy at its worst.  It’s a phony war supposedly being fought against the rich, but which is actually much more likely to harm the middle class.  All in the name of a completely hypothetical 0.007% reduction in the budget deficit.

There’s a reason both Ronald Reagan and Bill Clinton championed lower capital gains taxes.  The evidence is that lower rates actually lead to greater tax revenues and help stimulate economic growth.  While I don’t necessarily believe that cutting the rates below 15% is all that beneficial right now, I also can’t see much of a justification for raising them to 23.8%, given the complete lack of evidence that it will result in any substantial gains in tax revenue.

P.S.  The Fairness Argument

By the way, the main argument in favor of a capital gains tax increase is that it’s more fair for the wealthy to pay a higher tax rate.  However, this argument is based on ignorance of the tax code.  The wealthy already do pay higher rates, once you factor in “total tax burden”.

The main issue is that investors typically pay two levels of taxes.  The first level is corporate taxes, which are sort of an indirect cost to investors.  The second level is the capital gains / dividend taxes.   The Federal corporate tax rate is 35%.   This means that for every $1 of before-tax profit, the investor only claims 65 cents. This is then taxed at the state corporate tax level, before the Federal capital gains tax kicks in.

Ignoring the state taxes, that would mean one would expect to claim 55 cents in after-tax profit for every $1 in pre-tax profit.  In other words, the true capital gains tax rate, once you factor in corporate taxes, is closer to 45%.  Which suddenly doesn’t seem so low.  If you factor in state taxes, this often drifts over 50%.

Of course, it’s true that the corporate tax code is full of holes, so effective corporate tax rates are lower.  But this makes a case for corporate tax reform, more so than an increase in the capital gains tax.