Research Papers

The Role of Taxes in the Economy and Society Research Paper

The paper focuses on the effect that capital gains taxes produce on the economy. At first the basic information about the problem is given and the role and impact of taxes on the economy and society is discussed. Furthermore, the paper also traces the effects of capital gains taxation and analyzes in details its effects though the emphasis is basically made on the positive effects because as the analysis shows, low rates of capital gains taxes traditionally lead to quite positive results, naturally if the taxes are properly implemented. Also, the paper raises a very important question concerning those who really benefits from a reasonable capital gains taxation policy. And finally, the paper is concluded by the idea that low capital gains taxes may be positive for the economy at large and each individual in particular.

Traditionally, economy is characterized by the high development of numerous processes, which are closely interlinked to each other. At the same time finance questions are probably the most important in the contemporary economy since they produce a significant impact on the economy at large and the well being of a particular company. It should be also said that such questions as taxation produce a profound impact on the whole society since nowadays the distribution of wealth within a state. As a result such actions from the part of the state as legislative economic acts, introduction of a new tax, or reduction of taxes naturally affects economy at large.

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Obviously there are other more and less significant factors that influence economy but taxes seem to be probably the most important. This is why it is important to research such impact of taxes on economy. In terms of this paper, capital gains taxes will be discussed, particularly their impact on the economy. The analysis will be based on the investigation of American capital gains tax system.

Naturally, the views on the problem may vary significantly but, nonetheless, evaluating the general effect of capital gain taxes on the economy, it is still possible to estimate that it is rather positive than negative. An attempt to prove it will be done further in the paper. Despite existing capital gains tax system is widely criticized but it still works and may serve as a stimulus for economic development. At the same time, it cannot be said that the system is ideal, as in any other system there may be found some demerits but it is quite effective in contemporary conditions.

The entity of the problem and the role of taxes for the society
In order to better understand the role of taxes in the economy and their effects, primarily it is necessary to provide clear definitions of the basic notions, notably capital gains taxes, and clarify the current situations. This will help to understand how the taxations system actually works in order to have some basis for the further analysis. It should be pointed that the further analysis will be done on the basis of the American taxation system. It would permit to understand the entity of the system that, in its turn, would make easier to interpret its influence on the economy at large.
Speaking about the notion of the capital gain, it may be defined as “the increase in the value of a capital asset realized over its cost basis.” (Gillingham and Greenlees 1992:159). For instance, an asset purchased for 10,000 dollars and then sold for 15,000 dollars has a capital gain of 5,000 dollars. The latter sum, i.e. 5,000 dollars, is the subject for the capital gain tax. At this respect it is necessary to underline that for capital gains are not adjusted for the inflation then the majority of capital gain tax is paid on inflation-generated gains that to a certain extent prevent the growth of inflation in the economy. In such a way capital gain taxes may be viewed as a possible regulator of inflation though its effect may be not direct. Naturally, it is not the only effect capital gain taxes produce on economy but it will be discussed further in terms of this work.

Obviously taxes are very important for the economy of any country but at the same time it is necessary to underline that in such a way they affect not only economy as some abstract notion but the society as a whole. What is meant here is the fact that taxes, including capital gain taxes, is a very effective tool, which aim is to regulate the relations in the society and it is only at the first glance it seems that such a regulation is purely economic or financial. However, such a view on the role of taxes is extremely superficial.

In fact, it is necessary to view on taxes in a larger sense. To put it more precisely, the role of tax system is much more significant than the role of just a simple financial tool which is used to diversify the money flow from one individual to another. Obviously, taxation system is very important and it constitutes the basis of the well being of any state and it is practically impossible to imagine normal existence of any economic system, of any state without proper taxation system.

Often any problems in taxation system result in numerous problems in economic sphere often leading to a serious financial crisis. For instance, as it has been just mentioned above, capital gain tax system may affect the level of inflation in the economy but it is only a one-sided interpretation of its role effects. In larger terms, higher or lower inflation may have a direct impact on the financial state in a country and, consequently, it affects the society at large because the higher level of inflation is an issue that the population of a country suffer from the most in the case of a profound financial crisis.

Furthermore, taxation also regulates the distribution of wealth within a state. Ideally, from egalitarian positions, taxes should aim at such a distribution of wealth when there is a kind of social equilibrium and there are no extremes either rich or poor. In other words, form such a view, taxation, as a financial tool, implies redistribution of wealth from richer to poorer layers of the society. In such a way, such a taxations system could contribute to the development of the middle-class and well balanced society characterized by the financial and material well being of each member of this society.

Naturally such a view on taxes is rather ideal but still it does not make their roles less significant and it is obvious that they are still aimed at the redistribution of national wealth controlled by state taxation system between the members of the society. This is why taxes should be viewed at not only in financial context but as a social phenomenon as well.

Macroeconomic effects of capital gain taxes on the economy
However, the main goal of this paper is to discuss taxes in basically financial terms. This is why, on realizing the entity of the taxation system, notably capital gain taxation system, it is necessary to dwell upon the effects of capital gain taxes and their influence on the economy, (in terms of this paper the American economy would be drawn in terms of example and it would be the basis for the further analysis) and system of capital gain taxation would be analyzed.

First of all, it should be said that American incomes and living standards have been growing relatively slowly since American economy expanded practically permanently. However, it is noteworthy that there was only a slight recession in 1990-1991 but it seems to be not typical for the US. In the last decade, capital gains tax tends to reduction that is supposed to stimulate save and investment though such changes are relatively slow this is why their effects may be not very clear without a deep analysis of the situation in American economy in the context of the system of capital gain taxation.

It is a well-known fact that investments in capital are crucial for any economy that is why for the US it was also extremely important to stimulate these investments and a reasonable capital gain tax could be such a stimulus. It is particularly important if the fact that American investments in its own economy have been permanently lowered during last years. To put it more precisely, if analyze the situation in American economy within last couple of decades, it should be said that the late 1980s and early 1990s were characterized by significant economic and financial problem. As a result, American economy, and the government as well, faced a dilemma whether to keep capital gains taxes high (by the way, American capital gains taxes are the highest among the most developed and industrialized countries along with the UK and Australia) or reduce the current system and reduce taxes. To better realize the consequences of positive or negative response to the dilemma, it is necessary to precise some points as for the effects of changing the level of capital gain taxes. It is obvious that high rates of capital gains tax would result in lower level of the return on investments and consequently would depress investments in the economy at large, while reduction of capital gains taxes would lead to cost of capital and, consequently, to increasing investments in American economy. In such a way, the changes of the level of capital gains taxes suggested above could have quite different results and this is why it was necessary to be very careful in order to make the right choice which would produce a positive impact on financial situation in the US and American economy at large. This fact underlines the role which taxes, or to put it more precisely, changes in taxes, may play in economy of a country and it is important to emphasize that the situation in the US was not unique and that the same processes could be observed in any other open market country where the situation resembles that of the US.

Furthermore, a lot of specialists supported the idea of reduction of capital gains taxes, for instance, Dr. Sinai estimates that “a capital gains tax reduction increases savings, capital spending and capital formation, economic growth, jobs, productivity and potential output” and then he continues “the increases relative to what might have happened otherwise are definitely significant, but small to modest in magnitude.” (Gillingham and Greenlees 1992:165). His ideas are supported by his research which reveal that the reduction of capital gains tax would lower the cost of capital an increase business spending capital by 17,6 million dollars per year. As a result, higher levels of investments and capital formation would lead to increasing economic activity and higher level of GPD that could be about 51 billion dollars per year, while national saving rate would increase 44,1 billion dollars per year. So, such statistic, even applied to the US economy is quite impressing.

Moreover, capital gain taxation produces a positive effect on the economy due to its influence on an entrepreneurial activity that results in the growth of employment. The development of entrepreneurship is especially important for the growth of productivity, creation of new jobs, innovations, etc. At this respect the study of Cooper and Lybrand are very interesting as, according to it, “creating new jobs – especially in young technology companies – requires risk capital… The risk capital invested in technology companies is provided primarily by investors subject to capital gains taxation. Furthermore, risk capital investors seek capital gains, not dividends.” (Coopers and Lybrand 2002:134). Thus, it is possible to say that capital gains taxation, especially if its rate is not high, can stimulate investments and creation of new jobs while its effect on venture capital remains insignificant.

Also it should be pointed out that the general impact of the capital gain taxation and its effects are rather positive and stimulate economy. In fact it may be used as an effective tool when the economy of a country suffers from recession as it occurred in the US in early 1990s. It means that they may be used in order to ‘heat’ the economy up but it is necessary to remember that such a tool has to be used quite carefully in order to avoid ‘overheating’ of the economy. This is why the level of taxes has to be regulated carefully as well as the taxes used in the fiscal system of a state.

Tax revenue and capital gains taxes
It is obvious that the effect capital gains taxes produce on the economy significantly depends on the rate of the taxes. Traditionally, it is highly recommended to keep the capital gains taxation rate lower than it used to be for instance in the US, otherwise, its effect may be not as positive as it is supposed. In contrast the consequences may be quite dangerous and ever ruinous for the financial stability within a country.

In such a situation, the question of tax revenue arises. Basically, it would be logical to presuppose that lower rate of capital gains taxes may lead to the reduction of tax revenue. However, there are some factors that help to increase tax revenue, even despite the reduction of capital gains taxes. One of such factors is an unlocking effect that “expands the tax base because realization increase in response to the lower tax rate,”(Graetz 1995:49). Another reason is the dynamic effect that “measures the increase in tax revenue generated from the impact of lower tax rates on economic growth.”(Graetz 1995:64). Finally, there is one more important factor that may contribute to increasing tax revenue and it “measures the increased tax revenue resulting from the increase in the value of existing assets.” (Graetz 1995:67). It means that the reduction of capital gains taxes could lead to increase of the value of existing assets since the tax revenue would be higher if stockowners “pay taxes on the higher value of their assets when realized.” (Graetz 1995:71). Thus, it may be said that lower capital gains taxes rate would not necessarily be followed by reduction of tax revenue and along with the stimulation of investments and creation of jobs its effect is rather positive.

Beneficiaries from capital gains taxes
Taking into consideration what have been discussed in the previous parts of the paper it becomes obvious that capital gains taxes may produce a positive effect but only on the condition that it would be properly used and, as it is recommended, if they are low enough. Several arguments may found in favor of this statement but probably it would more evident if those who benefit from low capital gains taxation are found.

First of all, as it has been said capital gains taxes and their reduction stimulate investment, consequently it would not be a mistake to estimate that the affluent investors could win in first turn. At the same time, the reduction of capital gains taxes would also increase individuals’ income as well. Furthermore, through the stimulation of creation of new jobs it would naturally lead to the reduction of the level of unemployment and improvement of position of ex-unemployed. In such the situation in the economy improves and the conditions for a potential economic growth may be created.

Moreover, McPherson estimates that the whole economy at large and practically every individual will win from the reduction of capital gains taxes. So he believes that “the middle class will benefit from greater appreciation in their pensions… Small businessmen will gain from more generous tax treatment of the gains of their enterprise. And all employees will see wage gains tied to investment-driven higher productivity.” (McPherson 1995:211). So, practically all members of the society benefit in a way from capital gains taxes reduction. Naturally such a benefit may be not equal but still this fact underlines the positive role of the reduction of capital gains taxes.
It is also necessary to underline that not only stockholders benefit from capital gains taxes reduction but other people as well though their benefit would not probably be so significant. But still economy strengthened by the positive effects of reduction of capital gains taxes would generate benefits even for those who do not take an active part in stock market. In all probability they would benefit indirectly but still they would.

Thus, taking into account all above mentioned, it is possible to conclude that the role of taxes in economy as well as in the society is very important. This paper was basically focused on capital gains taxes but it should be treated as an example revealing possible effects of taxes, their introduction, elimination or changes. Speaking about capital gains taxes in such a context it is possible to conclude that, taken at large, they produce a positive effect on the economy. On the other hand, as any other taxes capital gains taxation requires a wise financial policy in order not to make these taxes harmful for the economy. That is why the policy should be reasonable and economically motivated and highly professional because, as the analysis made in the paper shows for the modern economy, like American one, it is more preferable to establish lower rates of capital gains taxes rather than higher ones. Though, it should be pointed out that the level of taxes should be regulated depending on a particular situation in the country’s economy and it is quite difficult to work out some universal recommendations that could be applied in different countries and in different economic situations in the same way and remain successful or effective enough.

Also, it should be said that capital gains taxes, being properly implemented, may produce a positive effect on the economy at large and on each individual in particular either directly or indirectly. Among the positive effects of capital gains taxes, particularly on the low level, may be named the stimulation of investments, as well as capital growth and formation. For individuals it may result in new jobs and higher living standards. Lower capital gains taxes also may positively affect economic growth at large through the increase of savings and stimulation of investments that has just been mentioned.

Thus, it is possible to conclude that capital gains taxes, been low enough, can play a significant role for the economy of any country, particularly of a well developed, industrialized country like the US. On the other hand, it would be a mistake to think that capital gains taxes are a panacea for the economy that is in a deep crisis. Capital gains taxation alone is not enough it should be supported by a reasonable tax system and financial policy as well as the current situation in the economy.

Coopers, G. and Lybrand, M. Generating Economic Growth through Young Technology Companies.” New York: New Publishers, 1997.
Gillingham, R and Greenlees, J. “The Effect of Marginal Tax Rates on Capital Gains Revenue.” National Tax Journal, No 45, June 1992.
Gordon, M. “Stock Market Looks More Like Face of America, Survey Says.” The Associated Press Business News, Feb. 21, 1997.
Graetz, M. Distributional Analysis of Tax Policy. Washington DC: The AEI Press, 1995.
McPherson, D. “Trends in Investment and Tax Policy. Time for a Change?” Business Economics, No 30, Jan. 1995.
Meyer, Lawrence H. A Term at the Fed: An Insider’s View. New York: Harper Business, 2004.
Toporowski, J. 1998. Theories of Financial Disturbance. LA: McGraw Hill.
Wicksell, K. 1967. Interests and Prices. New York: Routledge.
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