In this article, I am going to attempt a praxeological (science of human action) explanation of the economic effects of the tax increases on high earners. I am doing this as an exercise to apply what I have been learning in my self-directed studies of the Austrian school of economics. I hope, as a baby Austrian, I do not embarrass myself too badly in this amateur attempt.
Obama is demanding that Bush era tax cuts end for high earners. This will raise the top tax rate from 35% to 39.6%. Dividend tax rates will go from 15% to 39.6%; actually to 43.4% to include the Medicare contribution tax added by Obamacare. Capital gains taxes go from 15% to 20% (actually 23.8% including Medicare contribution tax) or from 15% to 18% (actually 21.8%) if held for 5 years or more.
The immediate effect will be massive stock sales during the remainder of 2012 to take advantage of the significantly lower capital gains rate. Expect investors to favor holding their stocks and avoid profit-taking over the next 4 years in anticipation of a future reversal in tax policy.
Low (15%) capital gains tax rates and bad memories from the bursting of the dot com bubble resulted in corporate mergers and acquisitions being conducted in cash instead of stock. With high capital gains tax rates, expect that trend to reverse, as a conversion of stock does not incur any tax immediately. All of these responses mean that tax revenues from capital gains will fall significantly, as investors apply these tax avoidance strategies.
Low (15%) dividend tax rates resulted in corporations distributing profits to shareholders increasingly through dividends. Many corporations that never distributed dividends before began doing so to satisfy investor preferences due to this favorable tax treatment. With a return to high dividend tax rates, expect a return to much lower or zero dividend yields, as corporations respond to investor preferences to favor keeping retained earnings (already taxed at the corporate tax rate of 35% which is among the highest in the world) in the corporations’ coffers to hold those earnings as capital gains, which do not incur any taxes until shares are sold. Those who rely on high yielding stocks for income will shift to bonds or other forms of fixed income. In addition to Fed Quantitative Easing, which lowers interest rates while raising inflation rates, higher dividend tax rates will further hammer those who rely on fixed incomes like retirees. These responses mean that tax revenues from dividends will significantly decrease, returning to the historical trend prior to the 15% era.
Finally, there is the increase in tax rates on ordinary income in the upper bracket(s). Those who earn at these levels include business owners, corporate executives, and professionals like doctors and lawyers. Many of these high earners have some degree of control to adjust their compensation packages. Expect a greater proportion of compensation to be in the form of incentive stock options, so that tax on that income is deferred until the stock is sold. The modest marginal tax rate increase will have little effect. Those who have less control over their compensation will pay more, while those with greater control will pay less. This may end up being a wash or even a net reduction in tax revenues, if small business owners and professions work less and forego expansion due to reduced incentive. Reduction in the growth of businesses will result in a long period of economic stagnation and lack of new employment opportunities for workers.
Taking all of these effects together, it is pretty obvious that tax revenues from higher tax rates will significantly decrease. Investors avoid taxes by deferring stock sales. Investors avoid dividend taxes by influencing corporations to reduce dividends. High earners adjust compensation to defer taxes until they choose to sell stocks. Business owners and professionals forego growing due to reduced incentives. The economy will surely experience a 4 year period of slow or stagnant growth and persistently high unemployment.
Furthermore, continuing Fed QE and trillion dollar annual federal deficits funded >60% by Fed bond buying will stoke higher inflation. This adds insult to injury as real rates of return will be reduced, but capital gains taxes will be paid on fake gains from inflation. Inflated gains are fake because of the loss in purchasing power due to generally higher prices throughout the economy.
Fun times ahead.