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WebMemo #47 on Taxes

October 11, 2001

Capital Gains Tax Cuts: Myths and Facts

By

Myth 1: Lowering capital gains tax rates will not help the economy.

Fact 1: Cutting capital gains tax rates is the single best tax policy to improve economic growth.

  • Capital gains play a unique role in fostering economic activity, especially by entrepreneurs in high-technology areas.
  • The current top statutory rate of 20 percent significantly exceeds the optimal tax rate - the rate best for the economy -- because the tax code's bias towards consumption over investment and multiple taxation of investment returns limit investment and retard economic growth.
  • In fact, many economists, including Federal Reserve Chairman Alan Greenspan, believe that the optimal tax rate on capital gains is 0 percent.
  • Because government first takes money through corporate income taxes, taxation of capital gains (and dividends) represent double-taxation of investment returns and should be eliminated.

Myth 2: If there is a capital gains tax cut, it should be temporary and it should not be available to all investors.

Fact 2: Only a permanent capital gains cut available to all investors - include those who invested long ago -- will stimulate new investment and revive economic growth.

  • A temporary cut will induce people to sell assets, but it will not stimulate new investors who will face today's high rates again in the future after the temporary reduction has expired.
  • A temporary cut will "lock-out" new investment and will hurt economic growth.
  • The induced selling without incentives for new investment will further depress stock and other asset prices and will not stimulate new investment. By unlocking held assets and inducing people to sell investments, a temporary cut may increase tax revenue - it may not, though, because asset prices will be lower - but it will not help stimulate economic growth.
  • A permanent cut will provide the incentives for people now to sell long-held unproductive assets and for people now and in the future to make new productive investments.

Myth 3: Cutting capital gains tax rates will cause stock markets to fall.

Fact 3: Cutting capital gains tax rates will, as it has in the past, cause asset values, including stock markets, to rise.

  • Some people claim that lowering capital gains tax rates will cause the stock market to fall, because people would sell their investments. By this silly logic, if people want to increase stock market values, then there should be an increase in capital gains tax rates, because, then investors would be less willing to sell investments.
  • In fact, lowering capital gains tax rates increases the prices of stocks and other assets. Stock markets reflect the collective actions of people looking forward.
  • Lowering the cost of capital by decreasing tax rates on investment returns will increase asset values.
  • For example, the 1997 cut in the top capital gains tax rate from 28 percent to 20 percent increased stock prices by approximately 8 percent.

Myth 4: Capital gains tax cuts benefit the "wealthy."

Fact 4: Capital gains tax cuts improve the entire economy.

  • Capital gains tax reductions stimulate economic growth, which benefits the entire country. As President Kennedy noted, "A rising tide lifts all boats."
  • Capital gains taxes disproportionately hurt the elderly, low and middle-income investors who have less discretion over the timing of their capital gains.
  • Most people who report capital gains do not have high annual incomes.
  • People with high incomes are most sensitive to capital gains tax rates, because they possess the most flexibility and means to avoid high tax rates. When capital gains tax rates are high, people with high incomes do not sell their assets and realize their gains.
  • High-income people pay a greater percentage of capital gains taxes when capital gains tax rates are low than when capital gains tax rates are high.
  • High capital gains tax rates make capital scarce. When capital is scarce it goes to safe investments. Low capital gains tax rates make capital abundant. When capital is plentiful it goes to "riskier" investments - such as inner cities and disadvantaged areas.

Myth 5: Lowering capital gains tax rates will not lead to more investment.

Fact 5: Taxpayers are very responsive to capital gains tax rates. High capital gains tax rates punish and reduce investment. Low capital gains tax rates induce more investment.

  • Taxpayers have a choice over when to realize capital gains and pay taxes. High capital gains tax rates lead people not to invest and current investors to hold assets, increasing the "lock-in" effect.
  • Lowering capital gains tax rates increases new investment and unlocks long-held undesirable assets, thereby increasing capital gains realizations.
  • High-income taxpayers, who have great discretion over the timing of their investment decisions, are particularly responsive to changes in capital gains tax rates.

Myth 6: Government cannot "afford" large and permanent cut in capital gains tax rates.

Fact 6: Improving economic growth, not increasing federal tax revenue, is the proper focus of the debate regarding capital gains tax rates, and greater economic growth increases federal tax revenue from many sources.

  • Too often politicians incorrectly concern themselves with the effects of policy changes on the federal budget rather than on the national economy. As James Carville said in 1992, "It's the economy, Stupid." (Note: He didn't say, "It's the budget, Stupid.")
  • The correct goal of tax policy should be to maximize economic growth, not federal tax revenue. Consequently, the optimal tax rate is the rate that is best for the economy, and this rate is lower than the rate that provides the government with the most tax revenue.
  • The government should not act like a business trying to maximize revenue. Rather, the goal of tax policy should be to enhance economic growth and raise only as much tax revenue as is needed, not as much as is possible.
  • More investment and greater realizations caused by lower capital gains tax rates lead to increased capital gains tax revenue and more federal revenue from other taxes such as corporate taxes, personal income taxes, and payroll taxes.
  • When predicting the budgetary effects of capital gains tax rate changes, it is necessary to account for behavioral responses by using "dynamic" rather than "static" scoring.
  • The 1997 tax cut dramatically increased capital gains realizations and federal revenue.
  • Capital gains taxes comprise only a minor part of federal tax revenue.
  • Official government forecasters (CBO and JCT) consistently have overestimated the revenue "losses" from capital gains tax rate reductions, because they use "static" rather than "dynamic" scoring.

Myth 7: Capital gains already receive preferential treatment because they are taxed at lower rates than ordinary income.

Fact 7: Double-taxation of investment returns and taxing inflation cause capital gains tax rates to exceed tax rates on ordinary income.

  • The government taxes investment returns - dividends and capital gains - twice, first as corporate income taxes and then as personal income taxes.
  • This double taxation causes capital gains tax rates to exceed ordinary income tax rates.
  • For example when a corporation earns $100 profit, the government takes $35 in corporate taxes, leaving $65 distributed to investors taxed at 20%. The government takes another $13 (20% of $65) in capital gains taxes, leaving investors with $52 and government with $48 out of the original $100 profit. Thus, an effective tax rate on capital gains of 48%. (Note: Since dividend are also subject to double taxation, but are taxed at ordinary income tax rates, the effective tax rates on dividends can approach 60%!)
  • The most counterproductive and unfair characteristic of the tax on capital gains is that it taxes inflation, because capital gains are not adjusted for inflation. The example above does not even include the fact that capital gains taxes include taxes on inflation, and, therefore, actually tax investors at even higher real tax rates - at times more than 100%!
  • For example, if an investment of $1000 rises in value to $1100, while prices generally have risen 10%, there is no real (after inflation) increase in value. However, an investor who sold this asset for $1100 would still have to pay taxes on the inflationary gain of $100. At the current top statutory rate of 20%, this investor would pay $20 in capital gains taxes on an investment that produced no real gain. The result, in this case, is a tax rate of infinity!
  • The policy of failing to adjust capital gains for inflation raises effective capital gains tax rates to levels substantially exceeding statutory rates and often surpassing 100 percent.
  • These high effective tax rates force investors to retain assets, increasing the "lock-in" effect. Moreover, the policy hurts economic growth by inhibiting new investments, because under current law inflation is a risk investors must bear.
  • The tax on inflation most severely punishes the elderly, low-income, middle-income, and less successful investors, because these people are less able to adjust the timing of their investment decisions than investors with higher incomes.
  • Indexing (adjusting) capital gains for inflation - as other countries have done - would eliminate the unfair and harmful tax on inflation.

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