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Do We Really Need a Gains Tax Cut? In the Long Term, Yes

May 11, 1997|TOM PETRUNO

From the breathless manner with which proponents of a capital gains tax cut have pleaded for it in the 1990s, you would think the U.S. stock market has merely been limping along, barely able to attract investment because of Uncle Sam's grabbing hand.

Instead, as most investors well know, in this decade we have enjoyed the longest sustained bull market in U.S. history. The fact that the government takes as much as 28 cents of every $1 in long-term capital gains obviously hasn't been enough to discourage investors from throwing hundreds of billions at stocks.

As the debate in Washington over how to implement the landmark balanced-budget accord begins to ramp up, the capital gains tax cut that is part of that accord--although undetailed either by President Clinton or Republican leaders--is sure to come under attack by key Democrats in Congress. And one argument certain to be used is that the stock market doesn't need a lower gains tax to keep doing what it has been doing.

Indeed, the torrent of money pouring into stock mutual funds isn't likely to stop soon just because the government fails to cut the gains tax. Many people are simply chasing performance: Because the stock market has been so hot for so long, the assumption is that it will continue to be hot--and so for now, stocks are seen as the place to be, taxes or no.

Moreover, the only important tax issue for many baby-boomer investors is the tax-shelter issue: If they're investing through tax-deferred retirement plans, such as a 401(k), the capital gains tax rate is virtually irrelevant.

Ditto for the mutual fund managers who are getting those baby-boomer dollars. Taxes aren't

even an afterthought for most of them. Same with pension funds, which are tax-exempt by law.

Who, then, believes that a drop in the top capital gains tax rate from the current 28% to about 20%--back to what it was for most of the Reagan Era--is so critical?

For zealots like Bill Archer, the Texas Republican who heads the tax-writing committee of the House of Representatives, a key issue is the long-term cost of capital for American businesses.

The greater the tax burden imposed on capital formation, the higher the cost of raising equity capital for businesses.

The basic idea here is that if investors know they will sacrifice to the government some significant portion of the capital they risk, they will consciously or subconsciously "raise the bar" and demand that businesses pay more to attract that capital.

That, in turn, may cause businesses to decide that many projects or ideas aren't worth funding. In the aggregate, a decline in investment by American businesses ultimately may mean a far less robust economy.

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It's not a specious argument in the long run. But in the 1990s, business capital spending has been quite strong, especially on computers and related equipment. U.S. companies have been world leaders in raising productivity through investment in new technology.

More important, there has hardly been a shortage of smaller American companies going public in the 1990s, as individual investors have flung record sums at stock mutual funds, and fund managers have in turn been eager financiers of new businesses.

Now, contrast our healthy economy and capital markets with those of Europe. Germany, for example, has no long-term capital gains tax, period. Great for individual investors.

Yet Germany is no hotbed of entrepreneurial spirit. And its key stock market index, the DAX, is up 99% since year-end 1989, while the Dow Jones industrial average has rocketed 160%. (Of course, some would argue that our market should have a higher rate of return, precisely because a capital gains tax is imposed.)

Beyond the economic implications, the question of "fairness" also has become an inescapable aspect of the debate over the capital gains tax in America.

How much is too much for the government to charge for this tax? And who benefits most if the tax is cut--the mass of society, or just the "wealthy"?

Investing icon Warren Buffett didn't help the Republican cause last week. At the annual meeting of his holding company, Berkshire Hathaway, Buffett told shareholders that the 28% maximum capital gains tax rate is "just about right," adding that "I just don't think it's inappropriate in a country like this to have me taxed at 28% if I sell my Berkshire shares."

In terms of the tax's importance to the federal budget, in recent years it has supplied in the neighborhood of $30 billion annually to Uncle Sam's coffers, or about 3% of total federal revenue. Democrats will argue that that's a small price to pay, given the size of our capital markets. Republicans will argue that precisely because the tax is so small, in relative terms, it's not asking much of the government to pare it back for the sake of long-term economic growth.

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