A Reduction in the Capital Gains Tax Would Benefit Relatively Few

Growth is becoming the word of the day, and well it should. Even 1 percentage point more of growth a year over 10 years would increase our GDP by about $800 billion. That’s enough to meet all our needs to provide jobs and training for those on welfare, college educations for all who want them, more for Social Security and health care--and possibly even a tax cut. Budget deficits, for better or worse, could be a thing of the past.

But how to get that growth? Everyone trying to get some new concession from Uncle Sam will tell you it isn’t for selfish reasons, God forbid, but rather to promote economic growth. At the top of the list in some quarters is reduction in taxes on capital gains.

To be sure, there is a lot of money at stake. Capital gains taxes on individuals came to about $36 billion on $152 billion of net gains in 1993. With the huge stock market rise last year, the amount is certainly greater now. We can add corporate capital gains of $45 billion in 1993, again probably greater in 1996. Thus, cutting capital gains tax rates is likely to offer great tax savings.

But the question is: Who would it help?

According to U.S. Treasury estimates, excluding 50% of individual capital gains from taxation and taxing gains only above those associated with inflation, as the GOP proposes, would have cost $19 billion in tax revenue based on current realized gains. Of that, almost half--close to $9 billion--would have gone to the top 1% income earners. More than $14 billion--almost three-quarters--would have gone to those in the top 10%. Fully 60% of individuals would receive only 8.4% of the benefits.

Should anybody get more of a tax break on capital gains? In fact, capital gains are very lightly taxed now. For those at the median income of $47,720 for a four-person family last year, the marginal tax rate on capital gains was 15%. For those with incomes of $95,440, twice the median, the tax rate was 28%. Even for those in the top income class, the rate was only 29.2%.

But that is only part of the story. Capital gains are taxed on realization. That means we can keep accumulating our gains indefinitely unless we sell the assets that are gaining in value. If we keep them until we die, there are no gains taxes at all, as our heirs can declare a new, current “basis”--that is, a new beginning value from which gains are calculated. What’s more, since capital gains are taxed only when assets are sold, it is possible to cash in and spend capital gains with little or nothing in the way of taxes. One technique is simply to borrow against the assets and spend the proceeds of the borrowing.

Another technique that can make the tax on capital gains far less than the tax on other forms of income is to sell only an amount of the assets equivalent to the gains. For example, take an owner of 20,000 shares of stock selling for $45 each that has earnings per share of $5. If the earnings are paid out, the shareholder is taxed at a rate of up to 39.6% on his $100,000 in dividends. Suppose, by contrast, that no dividends are paid and the earnings are retained. Other things being equal, the stock may be expected to be valued at $50, the original $45 plus the $5 of retained earnings. The stockholder can collect these earnings in cash, if he wishes, by selling 2,000 shares. But on these shares, he has a taxable gain of only 2,000 times $5, or $10,000. Hence, even at a rate of 28%, he pays only $2,800.

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But suppose we concede all this. Might a new reduction in capital gains taxes somehow stimulate investment and thus increase economic growth? Some of the rich would get richer, but it is hardly clear that the benefits of this increased growth will trickle down to the rest of us.

First, to the extent this might be true, it can hardly apply to reduction in taxes on gains we have already seen. This would offer a windfall to current owners, possibly raising the value of their assets, but have no effect on new investing. Bygones are bygones. Investors must be and are forward-looking. The argument that the tax reduction might increase investment can apply only to new gains.

The reduction in tax rates on new gains might make investors, anticipating capital gains, ready to accept lower returns. This would lower the cost of capital to those trying to raise it to finance the actual real investment, in plants, machinery, research projects--or buying out other companies.

The reduction in the cost of capital, however, would hardly be great, and there is some question as to how responsive business investment is to at least moderate changes in the cost of capital. It is the expected return on investment heavily influenced by business conditions and sales prospects that is of overwhelming importance. If it were desirable to interfere with the market by tax measures to lower the cost of capital, which I doubt, far more effective devices are investment tax credits and subsidies. To promote growth in the long run, we must look to all kinds of investment and, most important, to investment in human capital. Reductions in capital gains taxes deprive the Treasury of revenue that might much better be used in providing more and better education for our young, training and retraining for our adults and moving the idle or ill-equipped, whether on welfare rolls or not, into productive labor.

A good principle in taxation is to tax all true income alike, regardless of its source. This does suggest restricting capital gains taxation to gains over and above inflation and allowing for full offset of losses. But it also suggests eliminating the current 28% cap on capital gains tax rates. It suggests, further, eliminating the huge loophole on assets passed on in estates. And it suggests taxation of real capital gains as they accrue rather than offering the major benefit of delaying taxes for many years, until “realization.”

Without these measures to eliminate the current preferred treatment for income from capital gains, there is little excuse for the great boon to relatively few that would be affected by capital gains tax reductions. It would be for those receiving much of their income in capital gains, as opposed to most of us, reasonably rich or poor, who get almost all of our income in interest, dividends, noncorporate profits, pensions or just working for our wages and salaries.