The battle over whether to cut the U.S. capital gains tax is raging again, spurred in part by provisions in the House Republicans' "Contract with America" which would reduce the tax rate on capital gains and index gains for inflation.

The issue of capital gains taxation is a divisive one. On the one side are those who argue that taxing income from capital reduces savings and investment incentives and, thus, greatly dampens the nation's long-term prospects for increased productivity and economic growth.

On the other side, however, are critics who argue that these productivity gains are exaggerated and that it is fundamentally unfair to give preferential tax treatment to people earning capital income, while those who earn primarily wage income are forced to carry a full burden. Proponents counter, however, that capital gains from the stock market are the result of retained earnings that have already been taxed once through the corporate profit tax, so the unfairness lies in the current "double taxation" of capital gains. The resolution of this struggle may have significant effects on individual taxpayers, the budget deficit and the economy's long-term growth prospects.

Theory vs. Experience

Capital gains income can arise from a variety of sources. If you sell your stocks, bonds, home or other property for more than you paid for them, you must claim the appreciation in those assets as capital income on your tax return. The capital gain from the sale of your home can usually, with certain restrictions, be rolled over into the purchase of a new home to protect the gain from taxation. Although many individuals are affected by capital gains taxation in all these areas, economists and policymakers usually focus on stocks and bonds because of the implications they have on the long-term growth prospects for the economy.

Economic theory tells us that when the cost of funds goes down, firms will use the opportunity to borrow more funds so that they can increase their investment in new property and equipment. Taxing capital gains effectively increases the cost of funds to firms because it reduces the after-tax return to stockholders. In other words, if potential stockholders knew that they would not have to pay taxes on the appreciation of their assets, they would be willing to pay a higher price for new issues of stock. If firms could raise larger amounts of funds selling their own shares, they would not have to resort to other, possibly more costly, methods of raising funds, such as selling bonds or taking out bank loans. It follows that if there is a cut in the capital gains tax rate, the resulting decrease in the cost of capital should spur investment and increase the long-term growth rate of the economy.

Although this behavioral effect does not, in theory, raise much controversy, many researchers have called into question its real-world relevance for two reasons. First, it could be that changes in the capital gains tax rate have only small effects on potential stockholders' incentive to buy stock and, consequently, on the overall cost of capital. If this is true, then policymakers wishing to reduce firms' capital costs might do so more directly through an investment tax credit.1

Second, if changes in the overall cost of capital have only small effects on aggregate investment, then attempting to generate more investment through such a tax policy might be ineffective. For example, firms may base their capital investment decisions primarily on their expected future sales, with little regard for the current cost of financing the investment. The true magnitude of the investment effect lies at the heart of the current debate, but several other arguments both for and against the preferential tax treatment of capital gains income merit examination, as well.

The Case for a Lower Tax

Several disadvantages to treating capital gains as ordinary income exist. First, the taxation of capital gains only when an asset is sold results in the "bunching" of income at those times. Under a progressive income tax system, if an asset is held for a number of years, taking all of the profit as income in one year could push a tax payer into a higher tax bracket than he would have been in had the gains been realized as they accrued.2

A more troubling aspect of this bunching is the effect of inflation on the return to stockholders and, thus, on their willingness to buy stock. Because capital gains currently are not indexed for inflation, some of the perceived gain is illusory and represents no real increase in purchasing power. For example, if you buy stock worth $1,000 today, sell it for $1,500 in 10 years, and pay taxes on the entire $500 appreciation, much of your taxable income from the sale would come from aggregate inflation instead of an increase in the real value of the stock. In extreme cases, the effective tax rate on the real capital gain may exceed 100 percent.

Probably the most troubling feature of the capital gains tax is the "lock-in" effect. If individuals face a high tax rate, they are unlikely to sell their securities and pay taxes on the capital gain. This lock-in effect is especially problematic for small, start-up companies because investors who are"locked" into previous investments have a reduced incentive to sell those stocks in favor of new offerings by young companies.

The problem is made worse by the fact that when investors leave assets to their heirs, the heirs can usually avoid paying taxes on the assets' appreciation from the original purchase price. In the previous example, if instead of selling your stock at $1,500, you held on to it and left it to your heirs, they could sell it immediately upon receiving it and pay no taxes on the capital gain you accrued during your lifetime. This effect creates a strong disincentive for many people to sell assets, especially ones they have held for many years.

The Case for the Status Quo

Although there are many recognized drawbacks to a relatively high capital gains tax rate, the arguments against cutting the rate are also compelling. The opposition is based on several grounds. First, although there would be an initial rise in government tax revenue, most researchers agree that this rise would be transitory, based only on the increased asset sell-off immediately following the tax change. In the long-run, the government would have to cut spending or raise taxes in other areas unless it chose to incur even greater deficits.

Second, a reduction in the tax rate would further undermine the progressivity of the tax system because relatively wealthy individuals tend to receive capital income (see Table 1). The magnitude of this effect is difficult to pin down, however, since investors' behavior would inevitably change following any tax law modification. For example, if you knew that your capital gains would be taxed at a lower rate than other types of income, you would probably rearrange your portfolio to make sure that as much income as possible looked like capital gains rather than other types of income. Not surprisingly, substantial disagreement about the relative impact of a tax cut on various income groups exists. The Treasury Department estimates that the most recently proposed capital gains tax cut would reduce by almost 10 percent the total tax bill for Americans earning more than $200,000, while the Congressional Joint Committee on Taxation estimates the effect at less than 3 percent.3

In addition, allowing capital income to escape full taxation may spawn many economically inefficient schemes to disguise income as capital gains for tax purposes, rather than putting it toward its most efficient use. Much of the overbuilding of the real estate market in the early 1980s, for example, has been blamed on tax-induced incentives, rather than market forces. Although we would like to encourage people to invest in small, high-growth firms, it is possible to have too much investment in this sector if it comes at the expense of slower-growing, but more stable, firms.

And the Answer Is...

In the final analysis, it is an empirical issue whether the costs of a capital gains tax reduction outweigh its benefits. We need more accurate estimates of whether or how much investment will increase and what will happen to long-run government revenue before we can determine the best policy from an economic perspective. From a political perspective, lawmakers must figure out how to sell a policy that encourages economic growth, which benefits everyone in the long run, but which many voters perceive as benefiting only the rich. In the coming months, Congress and the president will be hard-pressed to strike an acceptable balance.

Thomas A. Pollmann provided research assistance.

Endnotes

1. An investment tax credit allows firms to charge off investment spending directly against their taxable income, thus reducing their total tax burden and directly reducing the cost of investment. The investment tax credit was revoked in the Tax Reform Act of 1986, along with several other benefits to capital, such as assorted tax deferrals, individual retirement accounts and partial exclusions for capital gains. In return, Congress lowered the marginal tax rates for individuals and corporations. [back to text]
2. This argument has lost some force, however, because income tax rates became less progressive following the Tax Reform Act of 1986. [back to text]
3. See Harper (1995). [back to text]

References

Aaron, Henry J. "The Capital Gains Tax Cut: Economic Panacea or Just Plain Snakeoil?," Brookings Review (Summer 1992), pp. 30-33.

Gravell, Jane G. The Economic Effects of Taxing Capital Income (Cambridge: The MIT Press, 1994).

Harper, Lucinda. "Treasury, Congress Disagree How Much GOP's Gains-Tax Cut Benefits the Rich," Wall Street Journal (March 23, 1995).