The Capital Gains Tax Muddle

Washington’s growing frenzy for some sort of cut in the capital gains tax is being driven by politics and not by economic common sense. Democrats and Republicans in Congress should take a deep breath and back away from their race to reap political capital by offering the most appealing package of capital gains rate reductions. Then President Bush should realize that his reelection prospects in 1992 will not turn on the outcome of his 1988 campaign pledge to cut the capital gains tax rate from the present maximum 28% (33% in some income categories) to 15%.

Until Bush ran for President, there was no passion for further tinkering with the tax system. The reforms of 1986 have only now gone fully into effect. Congressional tax writers urged that no major changes be considered until they could see how the reforms were working. But during the 1988 campaign, Candidate Bush pledged to seek a reduction in the capital gains tax rate. Now President Bush is pursuing his promise, in part to generate some quick revenue that would be gleaned from the turnover of stocks, property and other assets that would be triggered by the lower rate. The revenue bonus, however, would turn into a deficit of an estimated $11 billion by the sixth year of the program, according to Treasury Department estimates.

Democratic leaders in Congress originally opposed any capital gains reduction on the argument that it primarily would benefit the rich. Under the pre-reform system, taxpayers with incomes of $200,000 or more got three-fourths of the benefits. But fearful of being outmaneuvered by the President, Democrats have countered with a package that would include a more modest capital gains reduction, a tax increase in top income brackets and reinstatement of the $2,000 deduction for investments in Individual Retirement Accounts.

There is some argument for changing the 1986 law. Doing away with the IRA deduction was a mistake. And the new tax rates contain a quirk by which a couple’s taxable income of between $77,850 and $177,720 a year is assessed at 33% while all other income above that enjoys a maximum rate of 28%. That should be fixed. Democrats would raise the maximum tax rate for all the higher brackets to 33% and use the revenue raised to pay for restoration of the IRA deduction and to reduce the budget deficit.

But Bush has pledged to veto any tax increase, and the heart of the argument remains the wisdom of cutting the capital gains rate. Before tax reform, the increased value of assets held for more than six months were taxed at only 20% compared with rates of up to 50% on other income. In exchange for greatly reduced rates, Congress decided to tax gains the same as regular income.

If that is to be changed, there should be some rationale other than politics--to provide more equity in the system, obtain some desired economic effect or provide significant new revenue. But the Bush plan would not provide more equity and ultimately would lose revenue.

A number of economists and businessmen agree with Bush that lowering the gains rate will encourage new investment and savings. But this opinion is by no means unanimous. Herbert Stein, who was chief economic adviser to Richard M. Nixon, argues that evidence of economic benefit is murky. Further, to have the desired effect of increasing savings and the quality of investment, the lower rate should apply only to future investments, and not to assets held today.

Those investment decisions already have been made on the basis of existing tax law. But allowing the lower tax on assets acquired after the law goes into effect probably would eliminate the chance of picking up any new revenue, Stein added, along with any real political interest in such a plan.

There may be ways to fashion capital gains legislation that would channel new investment into specific areas such as research and development, but that runs the risk of creating a whole new generation of tax shelters. There are other ways for government to encourage such investment.

Both the President and Congress should reassess just what it is they are trying to achieve by slapping together an isolated tax plan this year. Together perhaps they can fashion a program that will do the job that really needs to be done.