Bush Capital Gains Tax Plan Periled by Political Reality

To President Bush, his proposal to cut the maximum tax on capital gains from 33% to 15% would provide nothing more than a much-needed shot in the arm for the economy.

“History is clear,” Bush contended in his speech before Congress earlier this month. Reducing the tax on profits from longer-term investments, he said, “will increase revenues, help savings and create new jobs.”

Whatever the proposal’s economic merits might be, however, the political reality is quite different. For lawmakers, the essential calculation about Bush’s plan is that at least half of all the benefits would go to fewer than 1% of all taxpayers--those with incomes above $200,000.

As far as House Ways and Means Committee Chairman Dan Rostenkowski (D-Ill.) is concerned, that alone should be enough to consign the proposal to the ash heap. “I’m not about to tell the wage earners in Chicago that they should pay a higher tax than stockbrokers,” says Rostenkowski, the top tax writer on Capitol Hill.

Political Equation Complex

But for all Rostenkowski’s clout in Congress, his opposition does not entirely close the door to a lower capital gains tax rate. As always in Washington, the hidden political equation is rarely as simple as it seems.

Most Republicans support a change. Moreover, such Democrats as Rep. Beryl Anthony Jr. of Arkansas, head of the Democratic Congressional Campaign Committee and a member of the Ways and Means Committee, point out that many heavy Democratic campaign contributors also stand to gain from a lower capital gains tax rate.

“Why should we do anything to (anger) the rich?” Anthony has asked colleagues.

At the same time, many of the special-interest groups that favor a lower capital gains tax rate, having failed to protect it from the major tax overhaul of 1986, are working overtime to recover. Foremost among the lobbyists is former Treasury Department official Charls E. Walker, who represents some of the nation’s largest industrial corporations and heads the American Council for Capital Formation.

“Any time you’ve got a President talking about this and Charlie Walker pushing it,” says Joseph Minarik, staff director of the Joint Economic Committee, “I don’t think you can count on its disappearing.”

Mark Bloomfield, executive director of Walker’s council, considers Bush’s decision to introduce the plan in Congress now, over the advice of political aides to wait at least a year, “an indication of how strongly Bush feels about this. I’m very encouraged that some sort of compromise will ultimately emerge.”

Many economists believe that the current taxation of capital gains is deeply flawed. The large majority would adjust investment profits for inflation so that taxpayers are not forced to pay taxes on artificial profits that simply reflect general price increases. They also oppose the feature of the existing system that allows taxpayers to escape capital gains taxes at death and permits heirs to avoid any taxes on profits earned before their ownership.

But politicians have never shown much interest in the economists’ favorite reforms. They are worried about the complexity of inflation adjustments and a backlash from individual entrepreneurs and farmers if accumulated profits from their family businesses are taxed at death.

The battle on Capitol Hill over capital gains promises to be a particularly long and nasty one.

Any move to restore a lower tax rate for capital gains would drive a stake through the heart of the delicate 1986 compromise, in which lawmakers agreed to cut income tax rates across the board in return for eliminating many of the business and individual loopholes that previously undermined the fairness of the tax code and distorted investment decisions.

Compare Savings

Nearly all taxpayers with incomes over $200,000 would receive a tax cut from a lower capital gains rate. The average savings would be roughly $25,000 each from Bush’s proposal, according to an estimate by Citizens for Tax Justice, a public lobbying group. That compares with minor or nonexistent savings for the vast majority of taxpayers with incomes under $50,000.

Even Senate Finance Committee Chairman Lloyd Bentsen (D-Tex.), who has supported a capital gains preference in the past, says that any effort to restore it would require balancing the cut with higher top-bracket rates on other income.

But given Bush’s objections to any changes that would raise taxes, many lawmakers are reluctant to start down that path at all.

“Right now, tampering with capital gains is playing with dynamite,” says Rep. Robert T. Matsui (D-Sacramento), a senior member of the Ways and Means Committee. “Anything we might do would open up the whole Pandora’s Box just when we thought it was closed for a while. I’m hoping we don’t have any tax bill this year so we don’t have to worry about all the lobbyists descending on us.”

Bush’s proposal was cleverly designed to overcome several of the frequent objections to capital gains tax cuts.

Since the 1986 overhaul of the tax code, capital gains have been taxed at the same rate as ordinary income. Bush proposed to change that as of July 1.

For persons in the top 28% and 33% tax brackets, their capital gains would be subject to an effective tax rate of 15%. Most of those whose ordinary income is taxed at 15% would face an effective capital gains tax rate of 8.25%. And for those with adjusted gross incomes less than $20,000--including their taxable capital gains--capital gains would be tax free.

The Administration had earlier floated the possibility of a flat 15% capital gains tax, but critics said that would provide no relief to low-income taxpayers.

As of July 1, the Bush proposal would define capital gains as profits from investments held for at least a year. But the required holding period would gradually rise to three years, to blunt criticism that the lower capital gains tax rate encourages the frequent churning of investments.

The Administration also narrowed the scope of capital gains that would be eligible for favorable treatment.

Previous law allowed taxpayers to invest in tax shelters that both provided lower-taxed capital gains and allowed large tax write-offs through depreciation of assets. The Bush plan would exclude corporations from the tax break for capital gains and profits from collectibles and depreciable assets such as investment real estate would not qualify as capital gains.

That would serve to restrict the lower capital gains rate generally to stocks and bonds, although the sale of personal homes, when taxable, would also receive favorable tax treatment.

The Administration went on the offensive against critics who charge that a capital gains tax break would drain money from the Treasury.

The Treasury Department assumes that Bush’s proposal would encourage investors to sell more of their stocks and bonds than they otherwise would. That would more than compensate for the effect of the lower capital gains tax rate, Treasury says, and the Bush plan would actually generate an additional $4.8 billion in revenues next year and $4.9 billion the following year.

That estimate is highly controversial and is likely to be challenged by Congress’ own tax experts. Nonetheless, economists generally concede that a capital gains tax cut would initially boost government revenues from profit-taking.

Over the longer run, however, there is little evidence that a cut in taxes on capital gains in itself generates higher revenues. Even the Treasury estimates show a substantial revenue loss several years down the road, forecasting revenue losses of $6.8 billion in 1994, when the capital gains holding period would go up to two years, and $11.3 billion in 1996, when the holding period would jump to three years.

Over a 10-year period, according to the Treasury estimate, there would be no significant gain or loss in revenues.

Ironically, for all its efforts to overcome such well-known objections to providing a capital gains tax break, the Bush Administration has split apart the political alliance that rallied behind earlier efforts.

“We’re having a hard time generating much interest in the plan on Wall Street,” concedes Bloomfield, the capital gains lobbyist.

Could Cut Profits

The reason is that investment firms reap most of their income from rapid turnover of stocks and bonds. Although they receive most of their business from pension funds and other institutional investors that generally are not subject to taxes, any Administration proposal that encourages individuals to hold their investments for at least three years might cut into Wall Street’s profits.

At the same time, by excluding investments in depreciable property, the White House plan has also excluded, at least for now, politically powerful real estate developers from the coalition of supporters of a capital gains tax cut.

“There are a lot of Democrats who have sold their soul to nouveau-riche real estate developers,” contends Michael Barker, the former chief economist of the Democratic Leadership Council, a group of moderate and conservative Democrats. “This plan doesn’t provide their paymasters with much incentive to wheel and deal in tax shelters again.”

Despite all its problems, though, a capital gains tax cut remains high on Bush’s agenda. And the lobbying support from such important groups as venture capitalists will provide additional momentum on the grounds that reducing capital gains taxes will spur more investment in riskier businesses that need help in competing against foreign firms.

“Because we’ve got a lot of people in Congress who are worried about the competitiveness of the U.S., I’m still expecting some sort of restructuring of capital gains tax rates in time,” says New York economic consultant A. Gary Shilling, a frequent Bush adviser in the past. “But I wouldn’t hold my breath waiting for it to happen.”