With at least $600 billion in tax and spending decisions set to be made, either explicitly, or implicitly, by policymakers come January 1st, this is the first of 15 articles addressing the fiscal cliff.  Taxes on capital gains are the focus.

Absent policy actrion, on January 1, 2013, short term capital gains tax rates will increase from anywhere between 9 percent if you’re in the current 33 percent tax bracket, to 50 percent if you’re in the lowest tax bracket.  If you fall into the top tax bracket, the rate is set to increase by 13 percent.

In addition to short-term capital gains, tax rates on long-term capital gains are set to increase by much more, with the tax rate set to increase by as much as 100 percent for lower income individuals, and 33 percent for higher income individuals.

In addition to the two main capital gains tax rates, the 5 year capital gains tax rate is set to land at 8 percent for individuals in the 10 percent and 15 percent tax brackets, to 18 percent for individuals in the higher income level tax brackets.

Why kind of damage would an increase in the long term and short term capital gains tax rates do to affected individuals and to the economy as a whole?

Net capital gains and Marginal tax rate

On the whole, likely a lot.  The chart above contains the top marginal tax rate, the change in net realized capital gains, and the correlation between these two through time.  It’s a real correlation; when the tax rate goes up, businesses and individuals forgo realizing gains on their real and financial assets.

In looking at a simple linear correlation of the above chart between net capital gains, and the top marginal tax rate, the linear connection would indicate that for each 1% increase in the marginal tax rate, capital gains realization decreases by $850 million.  The effect is almost assuredly larger than the simple linear regression line would indicate.  In doing some further correlations, while controlling for other variables, the best guess is that for each 1% increase in the top marginal tax rate, there is about a $15 billion decrease in net capital gains (the effect is only applicable to capital gains changes less than 5%).

How much are we talking about?  Net capital gains maxed out at about $820 billion in 2007, after which, gains dropped to a recent low of $224 billion in 2009.  In 2010, the most recent year for which full data is available, gives a net capital gains figure of $345 billion. So, if capital gains rates are increased to the current statutory level, this equates to a drop in net capital gains realization of between $50 and $60 billion.

Although the economy and financial markets can expect $50 to $60 billion in decreased asset selling, the decrease is not enough, at least initially, to make it not worth the federal government’s time.  Why?  Because, although the tax base (i.e. the amount of net taxable capital gains) is down, the overall tax rate is up by a bunch.

How much?  Best estimate: a tax increase of $12 billion in the initial year.

With this in mind, wouldn’t it be better to reduce federal expenditures on such things as auditors, statisticians, collectors, transfers, and so forth, rather than penalize individuals and businesses doing the right thing?