Tax Cut Would Foster a Sounder Economy : Capital Gains: A reduced rate is a bet worth taking, even if some of the benefits will go to those who already are wealthy.

For the second year in a row, a major political battle is shaping up over the capital gains tax.

President Bush has made a 30% reduction the centerpiece of his budget plan. The Democratic congressional leadership opposes any cut. In the end, however, the issue will boil down to whether Congress is willing to make some wealthy people better off in order to improve the long-term prospects for the economy as a whole.

Few doubt that a lower capital gains tax would contribute to long-term economic growth. By raising the after-tax return on personal investments, the lower capital gains rate would encourage increased saving. New and expanding businesses would find it easier to obtain equity capital. And the high debt-equity ratios that could undermine economic stability would decline. All of these changes would contribute to stronger and sounder economic growth. Perhaps that’s why most other countries already tax capital gains at lower rates than ordinary income.

The lower rates would also help correct the distorting effects of inflation on capital gains taxation. Taxes are assessed against gains measured in current dollars--with no adjustment for the rise in consumer prices since the investment was made. As a result, it is not at all uncommon for investors to be paying taxes on what are actually losses, once inflation is taken into account.

But opponents of the tax cut tend to ignore the long-run benefits. They focus instead on two issues: that higher-income groups will have a greater tax reduction than lower-income groups, and that there would be a substantial loss of net tax revenue.

The question of how much of the benefits go to the wealthy depends on how income is defined. When a family sells a house or a family business, should the entire gain count as income in the year of the sale? We don’t think so. But that’s how the tax brackets are currently calculated. If such asset gains are not included as regular income, the relative benefit of the tax reduction is more equally distributed among income groups.

But even if benefits are distributed unevenly across the population, this in itself should not be a reason to reject a policy change if it is good for the economy as a whole. So the critical question is whether there would be a revenue loss that adds so much to the budget deficit as to outweigh the favorable effects of the tax cut.

Even the opponents of the tax cut agree that in its first year, the lower capital gains tax rate would actually be a revenue raiser by encouraging people to “unlock,” or sell, assets that they would otherwise continue to hold. As a result, some people would pay more in taxes even though at a lower rate.

The longer-term revenue effect is uncertain. The Treasury’s staff estimates a revenue gain of $1 billion a year in 1993, when the phase-in period is over. For the same year, the congressional Joint Committee on Taxation has estimated a $4-billion revenue loss. We think that the Treasury’s assumptions about the responsiveness of taxpayers to the lower rates are more likely to be correct. But the technical difficulties of estimating these effects on tax revenue are so great and the resulting estimates so uncertain that competent economists can disagree about which number is correct.

The real reason not to worry about such estimates of a possible fall in capital gains revenue is because cutting the tax will raise future national income. And that means higher overall tax revenue. Neither the Treasury nor the joint committee staff includes increased economic growth and its favorable effect on tax revenue in their analyses of the lower capital gains rates.

What would it take in increased growth to offset a $4-billion revenue loss of the type estimated by the congressional staff? Even a tiny increase in the rate of economic growth--for example from 2.50% a year to 2.56% a year--would add $4 billion of extra revenue by 1993 and more than $12 billion a year in extra revenue before the end of the decade.

Although we can’t say for sure that the long-run net revenue effect is positive, we strongly believe that it is. The potential economic advantages of reducing the capital gains rate are substantial and the potential revenue loss is doubtful at best. Although there are no sure things in economic policy, cutting the capital gains tax is certainly a bet worth taking.