Tuesday, January 10, 2006

Growth in GDP and Tax Receipts: Critics Don't Get It

A report filed last Friday by the Center on Budget and Policy Priorities attempts to show that the improving economy is not causing greater than expected tax revenue growth. The report is found here:
The Center’s report states in part:
“A surge in economic growth is not behind the greater-than-expected increase in 2005 revenues. While economic growth in 2005 has been somewhat more rapid than CBO projected, it has not been nearly strong enough to account for the unexpected revenue growth. GDP growth in fiscal year 2005 was less than 1 percentage point above what CBO predicted in January, 2005, while revenue growth was more than 6 percentage points higher.”

I think the good folks at the Center are missing out on an important point: GDP does not take into account capital gains, but tax revenues do. Since 2003, when lower capital gain and dividend rates were adopted, stock market indexes have been growing. This growth reflects optimism about future profits, and lower tax rates help to increase the after-tax returns to investors. (In previous blogs, I have explained the effects of these taxes on dividends. Check the December Archives on Dividend Tax Policies.) Investors have been cashing in on these gains, increasing tax revenues.

This leads to another misunderstanding: the Center also suggests that these gains are one-time only. Ever hear of a bull market? We can expect future capital gains tax receipts as stocks go up and people move to other profitable opportunities. Lower tax rates reduce the “lock-in effect” that make people want to hold on to assets, and instead allow them to be deployed more freely in a manner that is friendlier to economic growth.

There is a potential damper on growth, however: the prospect that capital gains rates will increase in 2009 and dividend rates will return to those applied to other ordinary income. If you want to incentivize investment, you need a stable playing field. Otherwise, the rational investor will handicap the risk that the situation will change and pay less for the opportunity. This only reinforces the need to make permanent changes in these rates in order to provide a solid platform for future growth. (This has been a common theme on these pages.)

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