# Relationship between taxation, national debt, and pool of private investment money

We've all heard the argument that an increase in taxation of the wealthy, or of investment earnings in particular (capital gains + dividends) will discourage investment and hurt the overall economy. But the following counter-argument has occurred to me. Assuming government spending is held constant, each additional dollar in revenue gained through such taxation will lower the national debt by one dollar. In turn, one dollar less will be sold and bought in treasury bonds. So in all, it will decrease the amount invested in treasury bonds, but without affecting the amount available for investment elsewhere. Of course, this doesn't mean nothing has changed; the proportion of investments in treasury bonds vs private stocks and bonds shifts, and the wealthy have slightly less money in total because instead of giving the government a dollar they can get, say, 3% interest in, they hand it over and get no interest. And those who invested in private firms will keep slightly less of their income, and in turn the government debt will increase less quickly because there is less interest paid on this total debt. The amount of money in private vs. public hands shifts. But the total amount which could be invested in corporations, real estate, etc. would remain about the same.

That is, unless some investors, seeing they are taxed just a little bit more, decide to spend their money on consumables instead of investing it. But then consumer demand increases, and presumably that means profits from firms supplying such products increases, incentivizing more investment. I'm not so certain that this calculation balances out 1-to-1. But it seems far from obvious that taxing investment income decreases the total amount of private investment very drastically as the initial anti-tax argument might suggest. What do you professionals think of this? I realize there are several questions here which may have complex answers, and am happy to be referred to links discussing the issue; still, any rough summary of how much of what I've said may be right, or wrong, would be welcome.

That idea does not work empirically or theoretically. This is not to say that one cannot make some arguments for non-zero capital taxes but not via this channel.

Empirically:

1. Capital taxation is actually associated with higher government debt. This is not to say they cause each other rather they are both driven by discount factor of the government (e.g. see evidence provided in Rieth 2017). Higher discount factor means government is less patient. Capital taxation in essence taxes saving (which is also equal to investment from macro perspective - see discussion of that in Blanchard et al Macroeconomics pp 52), and this means more consumption in the present and debt functions in the same way.

2. Empirically capital taxes have significant and non-trivial negative effect on investment and saving. For example, de Mooij & Ederveen (2003) in their highly cited meta-study show that on average 1% decrease in tax rate increases foreign direct investment (which is an important subset of total investment in any open economy) by 3% and vice versa, so if you increase capital taxes by 1% you would overall see 3% fall in this category of investment, and this is a highly cited meta-study, and I do not think that there are any serious studies showing positive effect. When it comes to investment in general there is a lot of evidence and research showing that investment/saving (again those two equal each other) are very elastic in response to change in tax rates (e.g. see Summers 1981 and sources cited therein). Even going with lowest reasonable estimates there is no reason to believe investment would not change.

Theoretically:

1. The marginal cost of government funds should be in most cases greater than 1, meaning in order for government to take \$1 from private sphere into public sphere it will cost the economy more than \$1. This is because generally speaking non-lump sum taxes (e.g. taxes like capital gains tax) reduce welfare and depress and distort economic activity (and this even holds in cases where the money is eventually spend by government back in the economy). Of course, this does not mean taxes should not be used because government needs to fund public goods and there are distributional concerns, but thinking they are some sort of free lunch is completely unfounded. For example, Goolsbee (1998) founds that corporate taxes (which are economically taxes primarily on capital incomes) in the US between years 1900–1939 caused distortions that resulted in deadweight loss of 5–10% of their revenue.

2. Theoretically, people should save more when government runs deficit than when it runs surpluses (this is a result you will find in many macro models see Romer's Advanced Macroeconomics for some examples in chapters that deal with overlapping generation models or government fiscal policy).

This is because when government runs deficit:

A) People will expect higher taxes in the future so they will start saving (and thus investing) today to be able to afford to keep the same standard of living in the future.

B) government debt is tantamount to government demand for saving, ceteris paribus the higher demand for saving will cause interest rate (price for savings) to increase. That should stimulate people to save more.

Government surpluses will have exactly the opposite effect.

However, you should note this does not mean that capital taxes should not be used. Even though there are some important economic results suggesting that zero capital taxes are most optimal (e.g. see Chamley, 1986; Judd, 1985) there are some good economic arguments for non-zero capital tax rates in recent literature, you can have look at the famous Mirrless review which is the go to source for any current literature on optimal taxation of almost any kind, but to my best knowledge there is no mechanism that makes these taxes more desirable that would work via government debt channel.

• Thanks, this is very helpful and I will look at the Mirrless review for more. I am puzzled by your statement that CG taxes "distort" the economy; don't all taxes do that? And wouldn't taxing income at a higher rate than CG's (as we do in the USA) do so in particular? I'm most thinking of simply making these equal again, not raising CG taxes above income taxes. Also note that I was not considering a government surplus per se, but simply reducing the deficit and hence the debt below what it otherwise would be; I know there are good reasons to keeping a moderate national deficit and debt. Sep 8 '21 at 1:40
• @scottef 1. Yes most taxes do that with some rare exceptions, I even mentioned that in the answer. However, not all taxes distort economy equally badly, some taxes have higher distortions than other. 2. No, in fact many economists would even still say capital taxes should be close to or even zero, because they have very high distortions and they in the end fall mostly on labor anyway. Government can only choose who sends the tax to it not who bears the burden/cost of the tax. Even economists who believe there should be capital taxes do not believe it should be equal to most other income taxes
– 1muflon1
Sep 8 '21 at 4:58
• For example optimal top labor income (eg incomes of CEOs etc) marginal tax could in some most redistributive scenarios be as high as 80% whereas I don’t think I ever seen paper advocating for higher marginal capital tax than 40% even in the most radical redistributive scenarios. Although in less radical scenarios they could be closer but not equal. 3. It does not matter whether you considered government surplus or not, reducing debt will still move economy in that direction and encourage less saving and investment. Not as much as eliminating debt altogether but it will still discourage them.
– 1muflon1
Sep 8 '21 at 5:03
• @scottef 1. You might not have suggested that explicitly but your answer implied it also no need to get defensive about it, I am not trying to bring you down here maybe you did not realized it but you suggested the tax would have no effect net on investment and that would imply it would not distort it. 2. CG taxes are more distortionary because the amount of distortions that tax creates is proportional to elasticity of supply or demand of thing you tax. Tax consumption of insulin and you get very little distortions. However try to tax oranges and you will get massive amounts of them
– 1muflon1
Sep 8 '21 at 14:37
• @scottef supply of capital in a long run is very elastic, in past people thought it is infinitely elastic (hence the zero capital tax result) but there is some evidence that although it’s very elastic not infinitely so, and hence you can have nonzero capital taxes, but not as high labor taxes since labor is much less elastic and thus you can levy much higher labor taxes for less distortions
– 1muflon1
Sep 8 '21 at 14:39

You are right that these questions have complicated answers, so i will put foward some simpler points that may help understand the situation: Your argument that the capital gains tax is a reallocation of wealth from private to public sector is not wrong, but your conclusion that "the amount of investment in the economy will not change because the quantity of dollars avaible is the same", on the other hand, is. The problem is that in economies with healthy financial sectors, it isn't importat at all how much money at hand there is or there is'nt to be invested. As a matter of fact, the financial sector exists exactly to make the "amount of dollars" as irrelevant as possible (since it helps capital flow from places where it is abundant to places where it's not). Far more relevant for the realization of an economic investment are its expected rates of return. A capital gains tax is an increase in the cost of realization of an investment, and therefore it can be understood as a general reduction of return rates across every sector it is enacted. This means that investments that would otherwise be realized will simply be abandoned or scaled down (by both governments and public) as they have become uncompetitive in this new situation. Remember that these investments were desirable before the tax, so we have things that are actually demanded by the market simply being ignored. If there are other places in the economy where this capital can still be used productively, then it will be allocated there. More likely though, the capital will simply flow to foreign markets, as it is often easier for an investor to change countries than to change sectors.

The main problem with capital gain taxes are that they directly affect the price system in the economy. The government is also subject to these prices, so, it also wont be able to invest in places where the change has been significant. In the end we have an reallocation of wealth, yes, but we also have severe disruption of potential productive activities that will affect the economy as a whole. If the intention of a capital gains taxes is to reallocate wealth from some people to others, there are far more healthy ways to achieve that.

• Thank you Br.M, this is all very helpful. I'm most struck by your reminder that investment can flow to other countries with lower taxes. My main remaining question, though, is what you think are the "healthier" ways to reallocate wealth. My thoughts are partly inspired by last year's talk of a "wealth tax," which I am not opposed to on principle, but concluded is messy and easy to game after considering some issues, whereas it seems to me that taxing capital gains is far easier and might in effect generate largely the same result. So I'm curious what alternative you'd recommend instead. Sep 8 '21 at 0:19
• Actually I just thought of another question about your comments. You said investment could flow to other countries with lower tax rates. But this depends upon a favorable exchange rate; if you lose in the transfer say from dollars to yen, this can cancel the benefit of a lower tax in the yen-economy. And wouldn't the exchange rate remain stable only if economic actors getting dollars for your yen plan to either reinvest them in, or buy goods from, your dollar-based economy, the latter again indirectly increasing profits and the gain from investment therein? Sep 8 '21 at 1:45

Michael Kalecki, Political Aspects of Full Employment, Political Quarterly, 1943