Capital Gains Roller-Coaster and the Size of Government

New 2009 data from the IRS shows how foolish it is for government to tax capital gains income.  As shown in the chart below, capital gains income for 2009 is now back to 2002 levels ($224 billion).  Of course, thanks to the housing bubble, this is after a massive run-up in capital gains income to $819 billion in 2007.  This led to a whopping 73 percent drop in capital gains income from 2007 to 2009!

The capital gains roller-coaster also has a disproportionate effect on government budgets, especially Uncle Sam’s.  The IRS data shows that, in 2009, 87 percent of all capital gains income was claimed by those folks with income (as measured by Adjusted Gross Income) over $200,000.  That means these folks are paying at the highest marginal tax rates which can lead to rapid increases/decreases in government revenue.

This revenue volatility should also concern good/small government folks.  According to Dr. W. Mark Crain in his book Volatile States: Institutions, Policy, and the Performance of American State Economies:

 . . . uncertainty is the enemy of efficiency in public as well as private enterprise.  Budget volatility precludes efficient planning and adds significantly to the cost of government-provided services.  Put differently, a reduction in spending volatility would be equivalent to a funding increase.  The empirical evidence indicates that a 10 percent reduction in budget volatitlity generates efficiency gains comparable to a 3.5 percent increase in the level of funding . . .

The analsysis suggests that the reliability of tax revenues influences the size of government.  Greater instability in tax revenues contributes to spending instability that impedes the efficiency of long-run state government operations.  With less efficient planning, the level of government spending increases, which of course requires additional revenues. [emphasis added]

So in the long run, the volatility in the capital gains tax is helping to increase the size of government at all levels . . . with the exception of those states without an income/capital gains tax.  Um, like New Hampshire 🙂

There is, however, a silver lining in the capital gains volatility.  With capital gains income at such a low level, now is the time to ax the capital gains tax at the federal and state levels.  Not only is the cost of doing so minimized to government coffers, but it would also boost the incentive to invest in new capital which is exactly what the economy needs in this so-called “recovery.”

Chart Showing Capital Gains Income from 1997 to 2009