President George W. Bush signed the Tax Increase Prevention and
Reconciliation Act of 2005 (H.R. 4297), which Congress passed last
week. His signing assures that millions of taxpayers and millions
more workers and business owners will enjoy low tax rates on
capital gains and dividends and a potentially stronger economy
through 2010. Had the President not signed this legislation into
law, taxes would have increased in 2009, and the cost of capital, a
key factor for economic growth, would have risen.
Under current law,
individual long-term net capital gains realizations and qualified
dividend income are taxed at preferential rates. Taxpayers in the
lowest two tax brackets pay a 5-percent tax rate on capital gains
and dividend income through 2007 and no taxes on capital gains and
dividend income in 2008. Taxpayers in all other brackets pay a
15-percent tax rate on capital gains and dividend income through
rates are an important part of The Jobs Growth Tax Relief and
Reconciliation Act (JGTRRA) of 2003. Along with JGTRRA's partial
expensing provisions, they have played a role in helping spur
economic activity by boosting disposable income and business fixed
investment. JGTRRA's preferential tax rates on capital gains and
dividend income were set to expire at the end of 2008.
The bill signed by President Bush today extends JGTRRA's
preferential rate structure for capital gains and dividend income
through the end of 2010.
But this is not a complete victory for taxpayers: taxes on both
types of capital income will revert to their pre-JGTRRA levels in
Economic Effects of
H.R. 4297's Capital Gains and Dividend Provisions
preferential rate structure on capital gains and dividend income
will have small-but positive-effects on both gross domestic product
(GDP) and employment. Personal consumption and business fixed
investment are also likely to post modest gains as a result of
H.R.4297. These gains will be modest because H.R. 4297 is only a
temporary extension of an expiring provision. Real GDP,
consumption, and investment would all respond far more positively
to a permanent extension of JGTRRA's preferential tax rates on
capital gains and dividend income.
capital gains and dividend provisions are likely to influence
economic activity through two primary channels. They will increase
personal disposable income by lowering federal tax payments. And
they will reduce the cost of capital to businesses by raising the
value of U.S. equities. Higher personal disposable income is likely
to provide an immediate boost to economic activity. The lower cost
of capital is likely to provide economic benefits over the medium
H.R. 4297's capital gains and dividend provisions will lower income
tax payments. The Joint Committee on Taxation (JCT) estimates that
extending JGTRRA's rate structure on capital gains and dividend
income will reduce federal tax revenues by a total of some $18
billion in fiscal years 2009 and 2010 and over $50 billion between
fiscal years 2008 and 2016.
personal disposable income will likely exceed JCT's estimates of
the revenue effects of extending JGTRRA's preferential rate
structure. This is because JCT's conventional revenue estimates
ignore the influence of tax policy on macroeconomic behavior and
aggregates. However, households are likely to allocate some part of
H.R. 4297's tax cuts to higher personal consumption. Higher
personal consumption is, in turn, likely to encourage businesses to
increase output, investment, and staffing in the short run. Center
for Data Analysis (CDA) analysts considered the feedback effects of
higher personal disposable income on consumption, employment, and
incomes. As a result of those feedbacks, total gains in personal
disposable income could exceed JCT's revenue estimates by several
The impact of H.R.
4297's capital gains and dividend provisions on the cost of capital
is likely to boost personal consumption and business fixed
investment over the medium term. This effect is likely to be
largest for the extension of JGTRRA's preferential tax rates on
capital gains realizations.
A cut in tax rates
on capital gains influences the cost of capital through two
channels. First, lower capital gains tax rates reduce the
before-tax rate of return businesses must pay investors, making it
possible for businesses to expand their operations.
Second, lower tax rates on capital gains provide firms with a
greater incentive to retain their earnings, thus increasing the
firms' market value. An increase in the market value of firms
translates into an increase in the value of equity markets. This
positive effect of lower capital gains tax rates on equity markets
may be offset to some extent by lower tax rates on dividend
For firms, lower
tax rates on capital gains and dividends can imply a reduction in
the cost of financing new investments with equity. In 2003
congressional testimony, R. Glenn Hubbard, then Chairman of the
President's Council of Economic Advisors, estimated that the
Administration's 2003 Jobs and Growth Initiative could reduce the
corporate sector's cost of capital for equity-financed equipment
investment by more than 10 percent.
Kevin Hassett of the American Enterprise Institute independently
estimated that the Administration's proposal would reduce the cost
of new equipment investment by 4 percent to 7 percent.
Such reductions in
the cost of capital encourage businesses to invest more. CDA
analysts assume somewhat smaller reductions in the cost of equity
Nevertheless, they project modest gains in both real
non-residential investment and the economy's stock of capital from
2009. Concomitant with an increase in the economy's capital stock
is an increase in its potential output.
lower tax rates on capital gains and dividends imply an increase in
the value of equities and wealth. In a frequently cited study by
the American Council for Capital Formation, the Standard and Poor's
chief economist, David Wyss, attributes about 7.5 percent of the
increase in the S&P 500 between 1997 and 1999 to the 1997
Taxpayer Relief Act's (TRA 97) lower tax rates on capital gains.
In a reduced-form calculation, James Poterba estimates that
JGTRRA's 2003 dividend tax cuts could increase aggregate U.S.
equity values by about 6 percent.
Economic theory suggests that such increases in equity wealth will
encourage higher personal consumption (a "wealth effect").
assume smaller increases in the value of U.S. equities (as measured
by the value of the S&P 500 index of common stocks) than do
Wyss and Poterba.
For Poterba's calculation, this is in large part because there is
some dispute in the economics literature regarding the magnitude of
the impact of dividends tax cuts on equity values. Under the "new"
view of the economic effects of dividends, the value of equities
Under the "old" view, that same increase in the value of U.S.
equities is phased out over time.
literature does not uniformly support one view over another. For
example, Alan Auerbach and Kevin Hassett find that a change in
dividend taxes-particularly a permanent change in dividend
taxes-could have a significant effect on equity markets.
However, a Federal Reserve Board working paper, using a methodology
similar to that of Auerbach and Hassett, found little evidence that
cuts in capital taxation have boosted U.S. equity prices.
CDA analysts took this ambiguity in the literature into account
when analyzing the cost-of-capital effects of H.R. 4297's dividend
A Step in the Right
capital gains and dividend provisions are a step in the right
direction. Extending JGTRRA's preferential rate structure on
capital gains and dividend income will help spur economic
higher personal disposable income is likely to boost personal
consumption, encouraging businesses to increase investment spending
and staffing to meet higher demand in the short term. Farther out,
lower costs of capital and higher U.S. equity values could bolster
both personal consumption and business fixed investment. Higher
business fixed investment will, in turn, raise both the economy's
capital stock and its potential output.
However, any gains
in real GDP, personal consumption, and business investment spending
are likely to be modest. This is because H.R. 4297's capital gains
and dividend provisions are only temporary. Real GDP, consumption,
investment would all respond more positively to a permanent
extension of JGTRRA's preferential tax rates on capital gains and
L. Foertsch, Ph.D., is a Senior Policy Analyst in the Center
for Data Analysis at The Heritage Foundation.