Economists Debate Effect of Capital Gains Tax Cut : Economy: Many believe that it would spur investment but aren’t sure how strong the overall impact would be.

Underlying the current debate in Washington over a capital gains tax is a fundamental question: How much would a cut in the levies on stocks, real estate and other investments really stimulate investment and help the economy?

Many economists believe such a cut would spur spending on business expansion, new plants and equipment, just as advocates maintain. But many aren’t sure how powerful that stimulus would be, how much would go to the most desirable investments and whether the cut would be worth the distortions of the tax system that it would also cause.

And few experts now dispute that a cut in the rate would disproportionately benefit the wealthiest Americans at the expense of others.

“I think there would be added risk taking and more entrepreneurial activity,” said Edward Guay, chief economist at Cigna Corp., the big insurance, health care and investment firm in Hartford, Conn. “The question is, ‘Is this the best way to reach that goal?’ ”

The issue is a highly charged one, as has been apparent all week in Washington in the continuing debates over the unfinished budget plan.

The capital gains tax is levied when individuals sell stocks, real estate, timberland and certain other investments for a profit. Until 1986, the effective capital gains tax rate was 20%. But when the maximum individual tax rate was dropped in the 1986 tax reform bill, the special treatment for capital gains was eliminated, raising the effective maximum rate to 33%.

To President Bush, long the chief proponent of a cut, a preferential rate would bring enough growth to offset the loss in tax revenue. Individuals would suddenly have a far greater incentive to buy stock, and as they did so, businesses would find their cost of capital reduced, and could make the productive investments that would enable them to remain competitive.

Capital gains taxes aren’t now imposed until the assets are sold. If the law were changed, many individuals might choose to sell their stocks and reinvest in new companies, providing a further economic spur, advocates say.

A cut would mean “more productive business investment and, over time, more jobs, growth and international competitiveness,” argues Charls Walker, chairman of the American Council for Capital Formation, a principal advocate for a capital gains cut.

But only a fraction of the capital raised by a tax cut would go to the kind of productive investments that advocates hail.

Economists note that institutional owners of stock--insurance companies, for example, or pension funds and other non-taxable institutions, or foreigners--receive no benefit from the cut and therefore don’t make any added investment. More than half of the stocks on U.S. exchanges are owned by such institutions.

One intended beneficiary of the tax break is small and new businesses, which represent a particularly vibrant part of the U.S. economy. But less than 1% of stock is issued by small businesses, notes Alan Auerbach, a professor of economics at the University of Pennsylvania.

“The amount of money is trivial, so it’s really crazy to have an across-the-board tax cut if helping small business is your goal,” he said.

Another goal of the tax cut advocates is to increase the pool of venture capital that nourishes promising new companies. But again, more than half of venture capital doesn’t come from individuals but from institutional sources--pension funds and foreigners, for example--that are unaffected by the break.

Individual investors tend to be less sophisticated, and more likely to put their money in the tiny, riskier “penny stock” companies that they believe will quickly increase their capital, some analysts assert.

“This tax break has a tendency to lead greedy or inexperienced investors into risky, small-capitalization companies,” said Guay. “The capital gains tax is a great marketing tool for the penny stock brokers.”

Also, the economy benefits from the tax only when individuals purchase newly issued shares of stock, rather than those that have already been traded. Newly issued shares represent only about 2% of transactions, said Bob S. McIntyre, of Citizens for Tax Justice, a labor-backed group that opposes a capital gains cut.

The U.S. Treasury Department has argued that a cut in the effective rate to 23% would stimulate the economy enough to increase tax revenue by $12 billion over next five years.

But other studies have found that while a cut would initially raise revenues--as investors sold off assets to take profits--tax revenues would eventually flatten out or decline. A staff study by the nonpartisan Joint Tax Committee of Congress found that lowering the effective rate to 23% would raise revenue in the first two years, but by the fifth would bring losses of $11 billion.

Some economists also worry about the distortions of the tax system that such a cut would cause.

It would prompt many Americans to look for ways to lower their taxes by converting earned income to investment income. The cut would also complicate the tax code, reversing the simplifications that Congress took in 1986 and probably making it necessary to write hundreds of pages of new tax rules, analysts noted.

“It creates a lot of work for tax lawyers, accountants and investment advisers that doesn’t necessarily help the economy at all,” Auerbach said. “There’s a compliance cost.”

Guay worries, too, about a cut’s tendency to increase indebtedness. The tax benefit would prompt many individuals to borrow money to speculate in investments, “and more debt is something this economy doesn’t need at the moment,” he said.

Few now dispute that most of the benefits of a cut would go to the wealthiest Americans. According to Administration figures, $27 billion of the $49 billion in capital gains in 1990 will go to families whose incomes have averaged $200,000 or more for the past five years.

Families with incomes of $50,000 or less will claim an estimated $4.8 billion in capital gains, or less than 10% of the total.

However, advocates of a capital gains tax sometimes argue that even if the preferential treatment initially benefits the wealthy, by expanding the economy it indirectly benefits--”trickles down”--to others.

Barry Bosworth, senior fellow at Brookings Institution, said the experience of other countries doesn’t offer much guidance on how the United States should handle the issue of capital gains.

Germany, for example, has a low capital gains tax. But the country has much higher corporate profit taxes, which raises its cost of capital and makes it difficult to compare the systems, he said.

Economist Guay says he believes that a capital gains tax cut can be beneficial.

“It’s easy for people to sit at home and not take any risk,” he said. “I think the country needs something to encourage people to invest their money for a possible higher return,” he said.

But he added that any evaluation of the benefits of the tax needs to consider its secondary effects on the economy.