Mind on My Money

How to invest wisely

John Nofsinger is an associate professor of finance at Washington State University and a speaker, writer, and scholar on behavioral finance. See full bio

March 5, 2009, Behavioral Economics

Psychology and Taxes on Capital

New capital taxes won't raise revenue but will discourage investment

President Obama's proposed budget includes an increase in taxes on capital. That won't be very useful in generating tax revenue in the short-run. But it will also make fixing the broken economy even harder.

Taxes on capital include taxes on interest income, dividend income, and capital gains. First, let's get real, people aren't receiving much interest and dividends these days. Interest rates are at historic lows and companies have slashed their dividend by half, 90%, even 100%. And with stocks and real estate falling so much, who has capital gains these days? You are not going to raise much revenue here for quite awhile.

Increasing taxes on capital now will discourage capital from coming into our markets at this critical time. As an illustration of this, consider the proposed energy cap and trade program. This program seeks to tax carbon emissions above a certain level (the cap). A business under the cap can sell those credits to other businesses (the trade) that are over the cap. The purpose of this program is to tax pollution in order to discourage it. They seek to encourage companies to invest in low emission technologies. Note that taxing the carbon emissions discourages producing carbon emissions.

The same principle applies to capital. We need capital to come into the marketplace. We need it for buying homes. We need it going into the stock market (so my 401k can recover!). We need it in our banks so that the government can stop providing it. We need new capital, so why are we discouraging it by increasing taxes on it?

Increasing taxes on capital right now has no benefits because it won't raise significant revenue. However, it has severe disadvantages because it signals those with capital to go somewhere else (for example, China has no taxes on capital gains). I encourage politicians to avoid their ideological stances and think clearly about what new policies actually achieve and what incentives they create.