Partly Explaining Why Supply-Side Econ Works

The article subtitle to “Deferral Games” in Forbes’ February 26 issue reads as follows (requires subscription; KeepMedia version here):

Take your choice when you sell an appreciated asset. Pay a 15% tax, or buy a convoluted tax shelter that will bleed you with fees and expose you to big trouble with the IRS.

The article points out that some tax-avoidance obsessives are falling prey to such shelters, and how silly it is to do so given the relatively low current level of cap-gains taxes (though some states’ taxes, like California’s, as noted in this previous post, push the rate up to 25%).

In other words, most people who have their wits about them are paying the tax, and moving on. Money flows into the US Treasury. The money that remains gets reinvested, more likely that not in something that has a better chance of achieving a high return than what the person just sold (otherwise, the people involved wouldn’t have sold).

BUT…. imagine if the tax in question was 35% (45% when including certain states’ taxes) instead of 15%. The calculus changes considerably:

• Many, if not most, won’t sell, or will put it off to a future year. Tax immediately collected: Zero. Amount of money put into probably more deserving investments: Zero.
• Some will sell, but will attempt to shelter it by playing “Deferral Games.” Tax collected in those instances (at least immediately): Zero. Amount of money put in those instances into probably more deserving investments: Almost always zero (investments sold by tax-shelter purveyors are rarely the cream of the crop). Expenses involved in enforcing laws against abusive tax shelters: Steep.
• Those who do sell will have a much larger percentage of the proceeds siphoned off by Uncle Sam and whatever state is involved. Tax collected: Substantial from those sellers, but there are so many fewer of them that the total tax collected from all sellers is less than in the current 15% situation. Amount of money put into probably more deserving investments: Much less, because much less remains after the Greedy Hand of the federal and state governments have pulled out theirs.

The above explains why capital gains tax collections have skyrocketed since the Bush tax cuts of 2003 — and why they will drop like a rock after 2010 if those tax cuts are allowed to expire, as they unfortunately will under current law. Also, expect the tax-shelter business to begin booming yet again.