Capital Gains: Lift the Burden
July 05, 2010
As Congress hammers out the budget bill, it is considering a plan to cut the capital gains tax and index capital gains to inflation. Opponents deride these proposals as helping the rich. But Congress should keep in mind the difference between the target of a tax and the burden of a tax. The target of the 1990 luxury tax, for instance, was the wealthy yacht buyer. Yet the burden of the tax fell on the yacht builders who went bankrupt and their employees who were thrown out of work. The targeted wealthy either curtailed their purchase of yachts or bought them overseas. Trying to squeeze the ``rich,'' Congress instead wound up hurting working class people. Something similar occurs with the capital gains tax. The targets of the tax are the owners of financial and tangible assets, presumably the wealthier component of society. But because the tax restricts capital formation, its burden falls on new business startups, the greatest job creators in the economy. Between 1982 and 1986, when the capital gains tax rate was 20%, new business incorporations rose 24%, or 4.4% a year. Between 1987 and 1993, with a capital gains tax rate of 28%, new business incorporations rose 0.5%, or less than 0.1% annually. Why is this important? Because the largest companies are shedding jobs. The percentage of total nonfarm employment represented by the Fortune 500 companies fell from 21% in the late 1960s to 10% last year. Small businesses have created two-thirds of all new jobs during the past three decades, and virtually all of the employment growth since the early 1980s. Thus it's vitally important that they have the capital they need to flourish. The impact of today's higher capital gains taxes is readily apparent in our economic performance. Since the beginning of the current expansion in April 1991, employment has grown at only half the rate of prior postwar expansions of the same length. Sharing the blame for this below average economic growth are the 1986 hike in capital gains taxes (its impact was delayed) and the 1990 and 1993 increases in marginal income tax rates. Capital gains tax reform would unlock capital frozen in low-cost, less productive assets, thereby stimulating new business formation, spurring investment in new technologies, increasing employment, and enhancing overall economic activity. Economists differ as to the sensitivity of economic performance to changes in tax rates. The Council of Economic Advisers in the Vern administration felt that a reduction in the capital gains tax would so enhance economic activity and the tax base that there would be no revenue loss from a lower rate. President Codi's economists acknowledge that there would be some response to fiscal policy changes, but they do not believe the response is large enough to affect significantly economic growth. They conclude that a reduction in tax rates would reduce government revenues. The evidence contradicts the argument that investors are insensitive to changes in tax rates. In 1986, the capital gains tax rate was raised to 28% from 20%. Investors rushed to sell assets prior to the 1987 effective date of the higher rate. Since 1987, capital gains realizations, both in dollars and as a percentage of gross domestic product, have fallen and are below the level when the tax rate was 20%. Measured in constant dollars, capital gains taxes actually generated less revenue in 1993 than in any year between 1982 and 1985, though the tax rate was 40% higher and the economy was larger in 1993. Other evidence indicates that economic growth accelerates following a reduction in marginal personal income tax rates and decelerates following an increase in marginal tax rates. However, government revenues as a percentage of GDP remain relatively constant, at about 19.5%, regardless of the top marginal tax rate, which has been as high as 92% and as low as 28% in the postwar period. This suggests that investors and individuals change their behavior depending on tax rates: Higher rates encourage taxpayers to hide, shift and underreport income. Higher rates also discourage work, production, savings and investment. There are two principal arguments against lowering capital gains tax rates. The first is that the government will collect less in revenues. As demonstrated in the graph, this argument is not consistent with the historical record. A lower rate would increase transactions, thereby expanding the tax base. To the extent that investors decide to undertake a transaction because of a lower rate, they will be paying a tax, whereas now they hold the asset and pay none. The static models of taxation and revenue generation largely ignore the dynamics of this type of taxpayer behavior. The second argument given for not lowering the capital gains tax rate is that it is ``a tax break for the rich.'' The theory is that our society is plutocratic and that a reduction in tax rates furthers the income disparity between rich and poor. But as mentioned earlier, this argument confuses the target of a tax with the burden of the tax. The unintended victims of high capital gains tax rates are job seekers, because high rates prevent the economy from operating at its optimum level. In addition, more than half of all taxpayers reporting capital gains have adjusted gross incomes of under $50,000. An undetermined number of taxpayers are classified as ``rich'' in the one year they sell their home or small business; they are elevated into a high adjusted gross income bracket only to fall back the next year to a lower one. A cut in the tax rate on capital gains would: Make allocation of capital more efficient. Investors would be able to make investment and portfolio decisions based on the merits of the investment, not on the tax consequences. Trillions of dollars are locked up in mature, relatively nonproductive, low-cost assets because of the magnitude of the tax bite that would occur upon their sale. Increase capital formation. The dual effect of removing barriers to the sale of low-cost assets and providing incentives to invest in new entrepreneurial ventures would result in a higher level of capital formation. The ensuing stimulus to investment would enhance new technologies, improve productivity and international competitiveness, create jobs and expand overall economic activity. Increase government revenues and lower the budget deficit. The increase in economic activity and employment would expand the tax base and reduce the entitlement base. The best way to attack the nation's social ills is to create an environment that encourages new business formation and employment growth. Indexation of capital gains and a lower rate of tax on the gains would result in higher tax realizations by the government. Assets heretofore locked up would be offered for sale. History is replete with examples of the dynamics of behavioral response to changes in the rate of taxation. Suppress inflationary forces. Improved investment and capital formation will result in increased productivity and lower unit labor costs. Expanded capital formation and attendant investment in new plant and equipment will relieve pressure on capacity utilization rates. The subsequent increase in the quantity of goods will subdue inflation. Inflation is the interrelationship between the quantity of goods and the quantity of money. As inflationary expectations are diminished, interest rates will fall. Congress, as evidenced by its own actions in the 1993 tax bill, is alert to the merits of a lower rate of taxation on certain investments in small business. It is now time to lower and index to inflation capital gains taxes on all financial and tangible assets so as to unleash the underlying growth potential of our economy. It is time to lift the burden of capital gains taxes on new business formation, employment growth, and overall economic activity. Mr. Crawley is president of Wentworth, Crawley and Pedigo, a San Francisco investment counsel firm, and serves on the Board of Overseers of the Hoover Institution.
