One intriguing tax-overhaul fight involves capital gains--the taxation of profits on the sale of stocks, bonds or property.
Because capital-gains rates are lower than rates on ordinary income, they have traditionally been seen as a tax dodge for the rich. Now the Senate would eliminate the preferential rates. Hold it, cry high-technology companies and venture capitalists. The lowering of capital-gains rates in 1978 and 1981 triggered an investment boom in computers and electronics. Raising rates now would smother risk-taking, entrepreneurship and innovation.
The argument is beguiling--and wrong. Entrepreneurship and innovation are the economic chic of the 1980s. But the case for a preferential capital-gains rate incorrectly presumes that entrepreneurship and risk-taking are so good for the country that they deserve special encouragement. Bribing too many people to start new companies may mean too many new companies. Many end up bankrupt.
The capital-gains issue goes to the heart of the tax-overhaul debate. Can government, through tax preferences, manipulate spending in socially useful ways? A complex tax system presumes that the answer is yes. The argument for a simpler tax system, with lower rates and fewer preferences, is that government can rarely predict the precise consequences of tax breaks and that the unintended side effects often offset benefits.
Anyone who believes that entrepreneurship and risk-taking are always desirable should be sobered by a study of the disk-drive industry by Harvard Business School professors William Sahlman and Howard Stevenson. Disk drives store computer data, and the industry's story is a classic boom and bust. Between 1977 and 1984, venture-capital companies poured more than $400 million into dozens of new companies. The proliferation of firms accelerated technological innovation, but by late 1984 the industry was in a shambles. Excessive investment had created overcapacity and depressed profits.
Typically, start-up companies are financed by venture-capital funds. If the company succeeds, the venture capitalists sell stock to the public at huge profits. Many venture capitalists escaped the disk-drive debacle, Sahlman says, because they sold stock before the crash.
Change the details and similar stories could be written about personal computers and other computer-related products. The boom-bust cycle puts the capital-gains preference in a different perspective. Venture capitalists argue that lower rates made risky investments more attractive. If they are right, the preference may have promoted destructive overinvestment. Congress cut the top rate in 1978 to 28%, from a theoretical maximum of 49%, and in 1981 to 20%. Between 1978 and 1983, commitments to venture-capital funds jumped from $600 million to $4.5 billion.
The truth is, though, that venture capitalists may exaggerate the role of capital gains. About half the venture-capital money came from tax-exempt investors such as pension funds. And some of the computer industry's turmoil was inevitable. New technologies unleash chaotic competition as companies strive to develop the best products, the lowest costs and the best service. But the basic point is simple: Tax policy doesn't control all the vagaries of human motivation, talent and technological opportunity that create innovation. At most, high taxes crudely discourage peoples' natural risk-taking instincts while preferential taxes or subsidies encourage them.
Capital gains will be a major item when House-Senate conferees meet to reconcile their tax-overhaul bills. The House bill keeps a preferential rate while the Senate taxes capital gains as ordinary income. It will be said that the Senate's higher rates won't raise revenues because they will discourage people from selling stock. This is a technical argument that only time can settle. It will be said that a preference is justified to offset inflation. But with inflation at less than 2%, the problem can be left for another time.
Against these points stands the great defect of a capital-gains preference. It promotes wasteful tax avoidance by wealthy taxpayers who search for investments that will produce capital gains, not ordinary income. The issue may hinge on capital gains' effect on risk-taking and innovation. And here the evidence is clear: Government's wisest policy is to stay neutral and let people follow their natural inclinations. The high capital-gains rate of the 1970s may have dampened risk-taking, but with low overall tax rates a special preference wouldn't be necessary. And the top rates in the Senate bill (27% to 32%) seem low enough.
Starting things is part of our national culture and an economic virtue. But it should not be confused with the propagandizing of venture capitalists and high-technology firms, which reflects myopia and self-interest. What they think is good for them isn't necessarily good for the country.