As part of the most sweeping tax reform legislation in decades, House and Senate conferees appear to have decided to tax capital gains at the same rate as ordinary income. While numerous other features of the emerging tax law are laudable, this one is not. It is unfair, inefficient and even loses revenue.
Some people believe that raising capital gains taxes will increase the perception of fairness in the tax code and make tax shelters more difficult to organize. These are fine goals, but they can be accomplished more directly while avoiding the potentially damaging effects of taxing capital gains as ordinary income.
This is not just a matter of socking it to the wealthy, who own a disproportionately large share of the property subject to capital gains taxes. This issue is important to the economic well-being of everyone. The risk capital and entrepreneurship that would be choked off by increased taxation of capital gains would have generated investment, jobs, productivity growth and higher wages.
It is not just the founders of new companies who are better off because of the preferential treatment of capital gains. Workers, customers and society in general have all benefited from entrepreneurial activity. And these social benefits are hundreds of times larger than whatever individual fortunes may have been made. A tax break on capital gains recognizes the extra risks involved in entrepreneurial activity and encourages greater risk taking.
Cut Increased Revenue
Most countries do not tax capital gains at all. But in the United States, the Tax Reform Act of 1969 sharply increased the maximum tax rate on capital gains. Subsequently, President Jimmy Carter sought to treat capital gains as ordinary income. After carefully considering the matter, in 1978 Congress cut the share of long-term capital gains to be treated as ordinary income to 40% from 50%. This reduced the maximum tax rate on capital gains to 28% from 49%. When the maximum tax rate on ordinary income was cut to 50% from 70% in 1981, the maximum capital gains tax rate fell to 20%. It is now proposed to raise it to between 27% and 35%.
What actually happened when capital gains taxes were reduced in 1978? The Treasury Department reports that long-term gains, after allowing for losses, almost doubled between 1978 and 1981. The tax cut on capital gains apparently increased tax revenue by about $2.5 billion over what it would have been under the pre-1978 tax law.
Excluding some portion of capital gains from taxation sometimes is attacked as unfair. But equity or fairness has many dimensions. In an inflationary economy, a substantial fraction of any gain is the result solely of inflation, not of the increased real value of assets. In the high inflation year of 1973, for example, individuals reported $4.5 billion in nominal capital gains on tax returns. When adjusted for inflation, this $4.5-billion gain turned into a $1-billion capital loss. Yet taxes were still paid on these "gains."
Thus, even liberal tax reformers usually propose taxing only "indexed" capital gains, not nominal capital gains. Amazingly, the House and Senate conferees seem to be neglecting this important point. It simply is unfair to tax inflationary gains; at the very least, the basis of assets ought to be adjusted for inflation. But even this--full taxation of inflation-adjusted capital gains--is likely to deter entrepreneurship.
Taxation of capital gains deals with an activity that is enormously sensitive to tax rates. People do not have to sell their stock or other appreciated assets. In fact, the full taxation of nominal capital gains is likely to leave people holding on to their assets longer than they otherwise would--worsening the so-called lock-in effect. Holding the asset until death and leaving it as part of one's estate avoids capital gains taxes entirely. We are likely to see much more of this if capital gains are taxed in full as ordinary income.
This lock-in effect is ironic, because so much of the tax reform bill is designed to reduce the tax system's interference in economic decisions. Many investors, who ought to be moving their capital from its current use to other, potentially higher-return uses, are inhibited from doing so because of capital gains taxes. Even at relatively modest ordinary income tax rates of 27% or 30%, we are still likely to see a substantial increase in the lock-in effect.
Fairer and More Efficient Solution
Another feature of capital gains taxation that the conferees seem to be intent on ignoring is the asymmetrical treatment of capital losses. We currently limit deductibility of capital losses against ordinary income and allow only modest tax-loss carryforward provisions. Thus, someone taking a major risk--such as starting a venture--faces taxes if they hit it big but limited offsets if they fail miserably.