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Would Investors Still Take Risks if Capital Gains Taxes Were Higher?

David Callahan

Mitt Romney's release of his 2011 tax rates -- which showed that he paid a 14 percent tax rate -- has again spotlighted the preferential ways that the tax code treats invested wealth. While a multimillion dollar income earned by an employee -- say, a baseball player or a news anchor -- would be taxed at 35 percent (not including payroll taxes), the rate for capital gains income is 15 percent.

Of course, there is a logic behind this big differential: Which is that low taxes on investment income is said to increase risk-taking -- which is a good thing. We want people with wealth to put that money to work by investing in companies, so as to grow the economy, and it is argued that they are more likely to do that -- and take the inevitable accompanying risks -- if their winnings are taxed at a lower rate. (And, also, if they can write off their losses, which the tax code allows.) 

Congressman Paul Ryan is so enamored of this logic that he has proposed eliminating all taxes on capitals gains and dividends. President Obama, meanwhile, has proposed raising the capital gains tax to 20 percent -- a rate still below historic levels -- and tax dividends as ordinary income, with a top rate of 39.5 percent.

But are low taxes on wealth really needed to spur investment and job growth?

It's hard to see why that would be the case. Letting cash pile up in your savings account, or sticking your money in government bonds, is almost never a good idea if you're looking to grow that money. If investing offers a reasonably good chance of a higher return, this will always be an attractive option. Indeed, to not exercise that option -- say, by keeping your 401(k) in bonds, not stocks for years on end -- means that you're effectively losing money. In other words, playing it safe is itself risky to one's financial future. If the stock market seem like a good bet, Americans will always invest regardless of fluctuations in the tax rate on dividends. 

As for capital gains, most Americans don't have cash sitting around to invest in business start-ups or real estate. These investors tend to be more affluent folks with extra cash on hand or institutions (like pension funds and universities). And while they face the same choice as 401(k) holders -- let the money just sit there or try to grow it bigger with some risks -- the difference is that they can better withstand losses if their risks don't pay off. 

It is hard to see why a hike in tax rates on captial gains would lead people with extra cash to just sit on their money. After all, doing that would mean effectively losing more money than investing and paying the higher rates.

Example: If I invest $100 in a start-up and turn it into $200 in three years, that's still a great return regardless of whether I pay $15 in taxes or $39. Especially, if the alternative is making $3 on my $100 by investing in government bonds. 

People with money always want to turn it into more money. Higher tax rates doesn't change the fact that investing in the right stocks or companies will remain a much smarter thing to do with your money than nothing.