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Revised Tax Law Needed to Put American Capital to Work in the Economy

February 12, 1989|GEORGE MAROTTA | George Marotta is a research fellow at Stanford's Hoover Institution and a certified financial planner in Palo Alto

Everyone agrees that the United States is lagging badly in the competition for international markets. Temporarily, a declining dollar is keeping us in the game by making our products less expensive to foreigners. But a strong Japan and a soon-to-be economically unified Europe will continue to challenge our economic supremacy.

What the Bush Administration adopts now as an economic game plan will be very important in determining whether America can remain competitive over the long term.

A decrease in the capital-gains tax rate from the current maximum of 33% may well be the most important action we could take at this time. (Formerly, capital gains on properties held more than six months qualified for "long-term" treatment and a top capital gains tax rate of 20%.) President Bush has proposed a maximum rate of 15% on investments held for at least three years.

Most economists agree that a lower capital-gains rate would increase U.S. savings, support the current economic expansion and increase America's international competitiveness. Although many will argue that such a reduction would favor the wealthy class, there are many reasons to support such a move:

--The United States is disadvantaged in international competition because of the high cost of capital. Interest rates are high because our savings rate--at about 4% of gross national product--is one of the lowest, if not the lowest, among the major industrialized countries. High interest rates favor debt investment rather than stock ownership. The U.S. capital-gains tax rate is now the highest among our major competitors. This reduces our ability to innovate and compete. Japan, France, West Germany, Hong Kong, Taiwan and Korea all exempt long-term capital gains from taxation.

--A reduction in the capital-gains tax rate may actually increase tax revenues, according to recent academic and governmental studies. The rush to sell stocks at the end of 1986 in order to take advantage of the last days of the low 20% top rate proves that the size of the capital-gains tax base is highly sensitive to the tax rate. Conversely, as rates rise, individuals enter into fewer transactions. Thus, while more revenue is collected per dollar of "realized" gain, there are fewer gains realized, shrinking the tax base and revenues. A decrease in rates could help reduce the budget deficit.

--Reducing the capital-gains tax rate is needed to create more jobs. From $25,000 to $50,000 of capital is needed to create one new job. Small businesses with fewer than 100 employees provide most of the new employment opportunities. Between 1978 and 1985, the number of small company start-ups more than doubled, rising from 270,000 to 640,000, creating 15 million new jobs.

The formation of small businesses is very sensitive to the capital-gains tax rate. The number of offerings of stock in new firms has exploded every time there has been a reduction in the top capital-gains tax rate, as there was in 1979 and in 1983.

--Although the United States is the "leader" of the capitalistic free world, we are very unfriendly to capital. Capital gains are taxed also at the state level, increasing the overall rate well above the federal maximum of 33%. California and New York have the highest combined rates of 39.2% and 38.6%, respectively.

Many states had budget surpluses in 1987, which were the result of heavy selling of common stock to take advantage of the low capital-gain tax rates expiring at the end of 1986. In contrast, state deficits in 1988 were the result of the higher rates that became effective at the beginning of that year.

--Liberals will argue that lower capital-gains taxes favor the rich. However, such taxes are really on the creation of wealth. This tax is a voluntary one. It can be avoided by not selling an asset in which a gain exists. No transaction, no "realized" gain, no tax! Furthermore, an asset held until death will escape all capital-gains taxes, as they receive a "stepped-up basis" to the heirs.

Actually, the 1986 capital-gains tax increase fell most disproportionately on the average investor. The average marginal tax rate on the capital gains faced by all but the highest taxpayers has more than doubled, rising to 23% from 10.4%.

--Much of the so-called "gains" on capital are really not gains at all, but simply inflation. For example, while the cost-of-living index has gone up about 200% since 1970, the Dow Jones Industrial Average, which was about 1000 in 1970, would have to go 3000 just to keep up with inflation. However, if you bought stock in 1970 and sold it now, the government would tax the gain from 1000 to the present level 2286, a gain of 1286--even though there has been no gain in real purchasing power.

Congress gave homeowners over 55 years old a one-time tax break on $125,000 of realized gain on the sale of their home to compensate for inflation gains. They need to apply the same treatment to common stocks, and to homeowners under 55. (Britain has no capital-gains tax on principal residences).

It seems ironic that while the whole world, including China and even the Soviet Union, are discovering the benefits of the free markets and the advantages of the capitalistic system, the United States remains most unfriendly toward existing capital and the creation of needed new capital.

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