Raising Taxes to Stimulate the Economy?

I wanted to point out a fascinating Op-Ed piece in the NYT by Len Burman (thankfully not the once-kinky NBA basketball announcer but rather the Director of the Urban-Brookings Tax Policy Center).

He makes what seems to me to be the novel case that sunsetting the Bush tax-cuts two years early would actually do at least as much to stimulate spending than any other proposal currently on the table because it would motivate investors to take their capital gains now, when the long-term capital gains rate is still low, rather than waiting to sell, when the capital gains rate would be higher. He then suggests that if only 20% of his estimate of the $500 billion in gains were consumed by investors (rather than reinvested, which I think is a huge assumption), we would easily generate as much if not more economic stimulus as is being proposed by the Administration and Congressional leaders.

As someone who invests for a living, I think that at least part of this story is likely correct. I can say that were Congress to announce a impending increase in long term capital gains rates, we would immediately go through our portfolio, asset by asset, and make our best assessment as to whether the future expected appreciation in the value of that asset would be greater, on a present value basis, than the value we would realize, post-tax, were we to liquidate under the low-tax regime. I'll spare you the math, but if you use your best guess about interest rates and future asset price appreciation, and apply the appropriate tax rates at the appropriate times, you can estimate this. So in that sense, I agree that an acceleration of the sunset would lead to some tax selling.

Where I think the story might break down is in what happens next. First off, one of the factors which is currently driving the losses in the stock market over the last few months is the loss of leverage on the part of hedge funds and other institutional investors. Put simply, these actors had been buying stocks on borrowed money - money which was being supplied largely by the massive international banks which are currently neck-deep in mortgage-backed securities / sub-prime losses. If you've been following the financial press, you've probably noticed that large banks like Citigroup and Merrill Lynch have recently taken in meaningful capital injections from sovereign wealth funds at pretty absurd terms (11.5% preferred dividend per year in the case of Citigroup).

The long and the short of this is, banks like Citi and Merrill are pulling back on their lending lines to these hedge funds, because a) they want to reduce their credit risk to these funds and b) because their own cost of funds has risen substantially. This pull back in credit has forced hedge funds and other institutional investors to sell assets as the lent money which was used to buy these assets is being "recalled" by the big banks.

So now back to basic economics, if there's a large pool of sellers and very few buyers, that drives prices down. What do you think would happen if a change in the tax law created a whole new set of incentives for investors to sell even more assets? Answer: this induced tax selling might very well push asset prices even lower, thereby a) exasperating the credit crunch (because lending lines collateralized with assets that are falling in price would be curtailed even further through the inevitable margin calls) and b) changing the above expected returns analysis, thereby making it less economically advantageous to take your ever-shrinking gains today rather than tomorrow, even if the tax rate will be higher.

Furthermore, investors like me might very well take the gains, pay the relatively lower taxes, and then plow the post tax money back into the same assets we just liquidated, rather than consuming the proceeds. Such a scenario would do nothing to stimulate the economy and would only increase asset price volatility and potentially deprive the government of future capital gains tax revenue....

Its a complicated question to be sure, and an argument can certainly be made that this would be a very progressive way to stimulate the economy, as the stimulus would be borne on the backs of wealthy individuals who had reaped prior gains from the arguable asset price bubble which helped get us into this mess, but to me, its entirely unclear as to whether the benefits would outweigh the unintended consequences.