Capital gains tax causes innovation stagnation – bad for the economy

Another argument in favor of continued preferential treatment of capital gains and other capital income taxes relates to the state of the economy since the Great Recession. Ramey (2020) discusses the state of the United States economy since the Great Recession and specifically examines the slow recovery and historically low interest rates. Ramey concludes that by late 2019 (prior to the pandemic3 ) unemployment was relatively low and investment was relatively high – which is inconsistent with the theory of secular stagnation. Thus, increasing aggregate demand to increase long run economic growth is unlikely to be a successful policy response (although this was not the case at the beginning of the pandemic). Instead, Ramey argued that the economy was in a period of “technological lull” and that the policy response should focus on increasing innovation and faster diffusion of new technologies. Increasing taxes on the return to investment (and specifically capital gains) is unlikely to achieve either goal suggested by Ramey, even if tax increases target the very wealthy. While the pandemic justified the use of demand side stimulus in the short run, as the economy continues to recover, we will need to alter our fiscal policy response to focus on increasing innovation and faster diffusion of new technologies. 3 The pandemic led to increased unemployment and a decline in investment and justified increases in aggregate demand to support the economy. However, the economic effects of the pandemic are dissipating as shown by a reduction in the unemployment rate closer to pre-pandemic levels and a significant rebound in investment. Thus, the appropriate policy response is shifting back towards increasing innovation and the diffusion of new technology and away from supporting aggregate demand. 8 Increasing capital gain taxes will do exactly the opposite by reducing investment and shifting investment into owner-occupied housing rather non-housing assets, which would reduce innovation and the diffusion of new technologies. IV. SIMULATION RESULTS We use a computable general equilibrium model of the U.S. economy to simulate the economic effects of these policy changes assuming that additional revenues increase non-social security transfers. This section provides a brief description of the model used in this analysis. 4 The model is a dynamic, overlapping generations, computable general equilibrium model of the U.S. economy that focuses on the macroeconomic and transitional effects of tax reforms. The model is a general equilibrium model in which households act to maximize utility over their lifetimes, and firms act to maximize firm value, with behavioral responses dictated by parameter values taken from the literature; these responses include changes in consumption, labor supply, and changes in the time path of investment by firms that take into account the costs of adjusting their capital stocks. Households and firms are characterized by perfect foresight.