Raising The Capital Gains Tax Rate Will Contribute To The Biden Stagflation

Written by Michael Busler on February 19, 2021

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Recently economists have begun to worry about stagflation. That is a condition where the
economy is not growing (stagnant) while prices are rising rapidly (inflation). The US hasn’t seen this problem since the late 1970’s. Recent proposals supported by President Biden will, however, lead the US to stagflation.

Stagflation is a result of having increases in demand in the economy at a time when business cannot increase output to meet the new demand. That means business raises prices. Since they can’t expand output and they are forced to raise prices, the result is stagflation.

Some economists disagree. They argue that conditions are much different today than they were forty or fifty years ago, so that Biden can carry out his agenda without this fear. They note that there was a huge increases in demand just after the 2008-2009 recession. This was brought about by the massive increase in the money supply, the reduction of interest rates to near-zero and massive increases in government spending.

Those Monetary and Fiscal Policy actions pumped up total demand in the economy. Yet prices did not significantly increase. Output also didn’t increase. We had a slow growth economy with little inflation. The point is that government policy did not cause stagflation then and similar policies won’t cause stagflation now.

Logically this position doesn’t seem to be well supported today. The reason is that we are
currently close to facing a capital shortage. Ten years ago, that wasn’t a problem.

In 2010, the public debt, which is the total of all deficits, was $13.5 trillion. Annual GDP was $15 trillion. Assuming another stimulus package is passed by the Biden administration this year, the public debt will be $29 trillion, while GDP will be $21 trillion. Economists generally say that if the debt is less than one year’s GDP, it will not cause problems.

The real problem is the federal government has no plan to ever repay this debt. When the bonds sold to finance the deficit mature, the government simply rolls over the debt by selling new bonds to repay the maturing bonds. Hence the public debt just keeps growing.

The economy is becoming more capital intensive. As that trend continues business will need more new capital to expand. Since the Federal Reserve is continuing to rapidly expand the money supply and since the Biden administration will deficit spend in the range of $3 trillion this year, much new demand is being created.

If business can’t raise capital, they can’t expand to meet the new demand. The only other option is to raise prices. That will mean higher prices and little growth or stagflation.

Instead of taking action to alleviate a capital shortage, Democrats are trying to make it worse.

For instance, a bill has just been introduced in Washington State that will likely have Biden’s support on a national basis. Biden has said all along that he wants the highest income earners to pay their “fair share,” although he has yet to define exactly what that means.

The latest proposal calls for a 7% tax on the sale of stocks and bonds on profits that exceed $250,000. That, the sponsors claim, impacts only the top 2% of income earners. However every dollar paid for this tax reduces capital formation.

Biden wants to raise the federal capital gains tax rate to 40%, from the current maximum of 23.8%, but only for Americans earning more than $1 million per year. In other words, he wants to treat capital gains the same as ordinary income for high-income earners. This will further reduce capital formation.

Biden has also said that he wants to raise the corporate tax rate from the current 21% to 28%. That means corporations will be paying one third more in taxes. This reduces their retained earning and reduces capital formation.

To avoid future stagflation, government policy should be geared to creating more capital.
Instead some state lawmakers and the Biden Administration want to set policy that will take capital producing income away from people that earned it and give it to people who, for whatever reason, did not earn it.

By overtaxing the highest income earners, raising the capital gains tax rate and raising the
corporate tax rate, hundreds of billions of dollars of new capital will not be created. Couple that with the government pulling trillions from capital markets and the resulting capital shortage will stagnate the economy and cause prices to rise rapidly.

Taking actions exactly opposite to what Biden wants, will be the only way to avoid a devasting stagflation.