Don’t Tamper With Capital Gains

Lured by the seductive idea of raising revenue by cutting tax rates, legislators have made capital gains taxation a major issue on their agenda this summer. Since the tax reform of 1986 became fully effective, gains have been taxed the same as ordinary income, with a top rate of 33%. Then in the presidential campaign, candidate George Bush promised a cut in the maximum tax rate on capital gains to 15%. The issue receded once Bush took office but popped back up as a purported way to raise revenue to meet the Gramm-Rudman deficit target for fiscal 1990.

Capital gains taxes are especially difficult to analyze, so they give rise to many controversial claims. Two of these are front and center in the present debate. One is that cutting the tax rate on capital gains would actually increase government revenue. The other is that business investment would be importantly stimulated by a more favorable tax treatment of capital gains.

Tax Revenue May Not Rise

Because individuals are free to choose when they realize capital gains, there is, in principle, scope for policy to influence the amount of realizations and therefore tax collections in any year. Careful statistical studies show that when capital gains tax rates are expected to change, people speed up or postpone realizing capital gains so as to take advantage of the lower rate. Apart from this effect that is felt when rates are expected to change, the rate level has little effect on the total amount of gains realized by individuals.

Even when more gains are realized, tax revenue may not rise. If the tax rate is cut in half, for example, people must realize twice as much in capital gains as they otherwise would have just to keep revenue from falling. Thus, whether revenue would be increased even in the initial year is uncertain. In subsequent years, there is no way that greater realizations could be expected to offset the lower tax rate, so revenue from capital gains taxation would decline by nearly the same percentage that the tax rate is cut.

To avoid confronting these harsh facts, a gimmicky tax change has been proposed under which the capital gains rate would be cut for two years, after which time the old rate would be restored but gains would be indexed against inflation. This change might raise current revenue, but only at the expense of future revenue and by giving a windfall to wealthy taxpayers. This proposal is one more way in which budget targets are met through accounting tricks and temporary measures when the real problem in the budget is its long-run tendency to run excessive deficits.

Investors Not Influenced

What of the claim that cutting the capital gains tax would stimulate investment by businesses--a claim used to support a permanent rather than temporary cut in the tax rate? Looking at the capital gains tax in isolation, it is hard to see much connection between the tax rate and business investment. Most capital gains that will be subject to taxation are in the stocks of existing companies.

Whether I will pay a larger or smaller tax on a gain in my General Motors stock has almost no bearing on what investments General Motors will make as a company. A new business represents a slightly different situation, and the ability of a venture capital firm to attract money will, in principle, be influenced by the after-tax return that investors hope to earn. But in practice, no venture capitalist entrepreneur will decide not to build a business because he will keep only 70% rather than 80% or 85% of his eventual gain. Nor will most investors who hope to find the next Xerox or the next Apple Computer be much influenced by that range of tax treatment. In any case, most of the funds that go to venture capital firms come from pension funds and corporations that are unaffected by the capital gains tax rates.

The bigger problem with the argument that a lower capital gains tax is needed to encourage investment comes from considering the tax in the context of the overall tax system. The problem then is not just that the good effects are likely to be very small but that the bad effects are likely to be large.

The reason is that putting the capital gains tax rate well below the rate on regular income will reopen the flood gates for tax-shelter schemes that divert funds away from the most productive investments. Tax-avoidance schemes were largely eliminated in the Tax Reform Act of 1986 precisely because that reform brought the tax rate on regular income and capital gains together. Politically, tax reform traded a large reduction in the top rate of the income tax for base broadening and the virtual end of the abuse of shelters. If the preferential treatment of capital gains is restored, it will bring on a new round of clever tax-avoidance schemes that will not only serve the nation’s investment priorities poorly but will also abuse the understanding under which the top tax rates were reduced three years ago.

Indexing More Efficient

Indexing capital gains for inflation is one change in the capital gains tax that would correct a significant distortion that exists. But before getting carried away with the idea that indexing is unambiguously desirable, Congress should realize that capital gains already get favorable treatment relative to income because the tax is postponed until the taxpayer wants to realize the gain. That postponement is valuable, and it cannot be done with other forms of income.

At moderate rates of inflation, such as those being experienced, the advantage of postponement roughly offsets the disadvantage of being taxed on the inflationary component of gains. An additional point is that individuals can now deduct the interest cost used in carrying assets on which they eventually may earn a capital gain, up to the amount of their investment income. To maintain symmetry and fairness, if the inflationary component of the capital gain should not be included as taxable income, the inflationary component of the interest payment should not be deductible from income for tax purposes.

Despite these qualifications, indexing capital gains would be a more efficient and equitable change in the capital gains tax than simply cutting the tax rate well below the rate on regular income. The problem is that indexing capital gains would cost revenue at a time when the government cannot afford it.