Eliminate the Capital Gains Tax

By Newt Gingrich and Emily Renwick Thursday, August 13, 2009

Filed under: Economic Policy, Big Ideas, Government & Politics, Numbers

President Barack Obama’s budget for 2010 presented a number of tax cuts to spur economic growth. Most notably, his budget called for a reduction of the capital gains tax for small businesses. Apparently, President Obama recognizes the powerful, positive economic impact a capital gains tax cut would have for small business owners.

Since the cut would be good for small businesses, why would President Obama not give it to other businesses too? Businesses large and small across the United States are struggling in the current economy. Businesses large and small are cutting jobs because of unfavorable economic conditions made worse by burdensome government policies like the capital gains tax. President Obama should extend this pledge to eliminate the capital gains tax on small businesses to every American family and business in order to encourage economic growth and competitiveness.

The capital gains tax is an unequivocal burden on the capital we need to grow, prosper, and compete in a 21st century global economy. Any American or business that sees an appreciation of the value of their income (capital) must pay up to 39.6 percent in additional taxes on this appreciation (depending on the length of the investment and the marginal tax rate of the individual or business). Considering inflation, the effective rate paid on investments is even higher. As we are coming out of the recession, the United States should do everything within its power to create a financial environment that allows businesses to rapidly grow and prosper.

Part of our economic problem is that the United States has one of the highest tax rates on capital gains in the world. Many industrial countries have no taxes on capital gains including Austria, Belgium, Germany, Greece, Luxembourg, Mexico, New Zealand, Portugal, and Turkey. Countries that do not impose capital gains taxes on stocks include Argentina, China, Greece, Hong Kong, Israel, Malaysia, Mexico, the Netherlands, Pakistan, the Philippines, Poland, Singapore, Spain, Sri Lanka, Taiwan, and Thailand. In order to compete with economic growth in Shanghai, America must match China’s 0 percent capital gains rate.

Moreover, the actual revenue received from a capital gains tax is disproportionate to the burden imposed. The Congressional Budget Office (CBO) reports that in 1990 capital gains tax receipts totaled $32 billion, making up just 6.8 percent of total individual income tax receipts. By 2000, this number rose to $119 billion, making up 11.8 percent of the total. Notwithstanding the current economic meltdown, CBO estimates that for 2008, capital gains tax receipts will be close to $106 billion, making up 9.2 percent of the individual income tax receipts. While discouraging economic growth and driving investors across the Atlantic, receipts from the capital gains tax are barely making a dent in government revenue.

Given the current economic problems, we call on Congress to immediately eliminate the capital gains tax. In this article, we describe the historical and present-day impact that the capital gains tax has on federal revenue. We will then discuss the main benefits of zeroing the capital gains tax rate, including the positive influences upon economic growth and job creation, capital formation, and venture capital funding. Finally, we describe the immediate advantages a capital gains tax cut would have for the average American.    

History of Capital Gains Tax Legislation

Originally capital gains were taxed as regular income at each individual taxpayer’s income tax bracket. In response to the higher income tax rates in World War I, legislators in 1922 introduced lower tax rates of 12.5 percent on capital gains on assets held for more than two years. This was to offset the reduction in capital gains revenue generation resulting from the higher capital gains tax rate. During the 1930s, legislation was passed to allow taxpayers to exclude percentages of their capital gains from being taxed. Specifically, “in 1934 and 1935, 20, 40, 60, and 70 percent of gains were excluded on assets held 1, 2, 5, and 10 years, respectively. Beginning in 1942, taxpayers could exclude 50 percent of capital gains on assets held at least six months or elect a 25 percent alternative tax rate if their ordinary tax rate exceeded 50 percent,” wrote Gerald Auten of the Urban Institute.

The capital gains tax was increased in the Tax Reform Acts of 1969 and 1976. In 1978, however, the tax rate was reduced to 28 percent. In 1981, more tax rate reductions lowered the rate to a maximum of 20 percent. The Tax Reform Act of 1986 raised the maximum capital gains tax rate back up to 28 percent by repealing the exclusion of long-term gains. Specifically, taxpayers were no longer allowed to exclude 50 percent of their capital gains on assets they had held for more than six months. The capital gains tax rate for the highest income brackets was cut to 20 percent as part of the Taxpayer Relief Act of 1997, which also exempted the sale of a personal residence of up to $250,000 for singles and $500,000 for married couples who filed jointly. The act created multiple tax rates based upon the type of capital asset and the length of holding time.

One year later, under the Republican majority, we introduced the Economic Growth Act of 1998, which would have further cut the capital gains tax to 15 percent. In arguing for this tax decrease, I said at the time, “the capital gains tax is in fact a tax on job creation . . . cutting the capital gains tax rate helps anyone who is preparing for retirement, starting a business, saving for college tuition, or planning to buy a house.”

The capital gains tax rate was once again lowered in 2003. Former President George W. Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, better known as the “Bush tax cuts.” In this act, Congress reduced the lowest level from 8 percent to 5 percent; and the highest level for an investment held more than one year from 20 percent to 15 percent. In 2008, the act removed the capital gains tax entirely for individuals in the lowest two income brackets. The Bush tax cuts must be renewed by 2011, otherwise the capital gains tax rate will once again go back to the pre-2003 rates of 20 percent and 10 percent on most capital gains, and 18 percent and 8 percent for property purchased in or after 2001 and held for more than five years.

Economic Arguments for Eliminating the Capital Gains Tax

Past efforts to decrease the capital gains tax rate have been influenced by convincing evidence that a cut would increase economic growth. The investor class is integral to a functioning economy and investors’ decisions are influenced by the tax system in which they operate. Likewise, assets are in part priced with the calculation that if the stock is sold, the investor will have to pay tax on realized capital gains. As a result, buyers, knowing that they have to pay taxes, reduce the price that they are willing to pay for assets, thus driving down stock prices.

With a capital gains tax cut, the value of the stocks will see an immediate boost. This increase in value is known as “the capitalization effect.” The capitalization effect then explains how a capital gains tax cut will increase the stockholders’ after-tax returns on traded assets. Leading economists, such as Douglas Shackelford, have found that the capitalization effect would set in almost immediately after a capital gains tax cut, meaning that prices for investments would rise as investors capitalize on the reduced tax rate.

Some analysts have suggested that the immediate increase in stock values would be offset by an economic principle known as the “lock-in effect.” This effect occurs when investors, recognizing that they have to pay taxes on their gains, will lock in and hold rather than sell their assets. After a capital gains tax cut, we could see a potential sell-off of stocks, increasing trading volumes and leading to a temporary fall in asset values. However, we have seen through market observances that the capitalization effect is likely to have a more permanent impact than the lock-in effect. In other words, the lasting impact of a capital gains tax cut is likely to be an increase in asset values.

Additionally, because investors have to pay a tax on their gains, they often are penalized for diversifying their investment portfolio with a wide range of investment products. The capital gains tax distorts what the investors’ pre-tax optimal allocation of assets would be, potentially creating more challenges in investment for Americans. Taxing investment gains clearly raises the opportunity cost of asset transactions, leading to various inefficient outcomes.

Given the capitalization and lock-in effects, the current tax regime is distorting the true value of assets. Of course, there may be other unknown factors that could influence the prices of stocks, but our research indicates that the overarching impact of a capital gains tax cut would be an increase in stock values.

Philosophical Arguments against the Capital Gains Tax

Proponents of the capital gains tax argue that the tax is another way for the government to obtain revenue. These advocates argue that any income gained from investments should be taxed the same way that wages and gross yearly income are taxed. The problem with this argument is that in most cases capital gains are not traditional income. And in effect, the income that will give rise to the capital gains will be taxed as income and so the capital gains tax is a second level of tax. In other words, a higher capital gains tax rate discourages saving and investment.

In fact, Americans who set aside a portion of their after-tax income for savings in investments are the main victims of a capital gains tax. Individuals may intend to draw on these gains to finance the purchase of a new home or automobile, to pay for college tuition, or to supplement their Social Security income during retirement.

As a result, many economists refer to the capital gains tax as a “double tax.” Economist Bruce Bartlett argues that this penalizes many stockholders:

The fact is that capital gains arise only in the case of an income-producing asset. The value of the asset is simply the discounted present value of the future flow of income associated with that asset (rent in the case of real estate, interest in the case of bonds, and corporate profits in the case of stocks). Thus, if the income stream (rent, interest, profits/dividends) is taxed, then any additional tax on the underlying asset (real estate, bonds, stocks) must necessarily constitute a double tax on the same income.

A double tax is a destructive and unfair way for the government to gain additional revenue. Moreover, in some cases, the capital gains tax unfairly taxes investment gains that may not be gains at all. The capital gains tax, as written, does not account for changes in the price level. The result of this is that an individual may be unfairly taxed on gains that merely reflect the rise in the general price level, or may even reflect a real loss of value on an investment. To illustrate, consider an example where an individual purchases property for $100 in 1950 and proceeds to sell it for $500 in 2000. Looking at this without any other factors, the government would tax the $400 profit at a rate of 15 percent. The problem is that in these 50 years, the investor actually lost money on this investment because the inflation rate over 50 years was much higher than the 400 percent increase in the value of the property. That is, the $100 in 1950 would have grown to $714.61 in 2000 due to inflation. Thus, we can see that the investor is penalized for investing by both losing real purchasing power and by being taxed due to a nominal increase in income. While taxing individuals at progressively higher rates for higher income is a controversial topic, this act of taxing people even when they have a real negative income from investment is clearly unfair.

Empirical Benefits of Eliminating a Capital Gains Tax  

Beyond the theoretical justifications for cutting the capital gains tax, how much wealth would actually be added to the economy? The Treasury Department conducted a study examining the economic consequences if we preserved President Bush’s tax cuts by ensuring that capital gains were taxed at 15 percent. The Treasury’s study found that if we made Bush’s tax rate permanent on capital gains and dividends, we would see an increase of national income of 0.4 percent. If we went one step further and eliminated the capital gains tax, we could potentially see an increase in gross domestic product of twice that amount. Dustin Chambers of Salisbury University argues that the increase in stock prices would be profound, ranging from an increase of 9.2 percent to 20.5 percent.

The exact size of the increase in the return in investments is uncertain, since it is based on forecasts. What is certain, however, is that when the cost of investment falls, as it does with the elimination of the capital gains tax, the net return on investment will rise. Most importantly, the short-term and long-term wealth of the U.S. economy will unambiguously improve. As Former Federal Reserve Chairman Alan Greenspan once observed, if you want the highest economic growth rate the best capital gains tax rate is zero.

Conclusion

Since the collapse of the economy in the fall of 2008, policy officials have been looking for a quick way to jump-start the economy. If we were to immediately eliminate the capital gains tax we would see a drastic improvement in job creation and economic growth.

First and foremost, businesses would have more of an incentive to invest capital in all areas of their business, including labor, capital, and research and development. Moreover, businesses would be able to finance their debt at a lower cost if capital gains were not taxed. In today’s market, businesses seek out new stocks or bonds to finance their investments. Those assets will be more desirable if investors do not have to pay the capital gains tax on the revenue gained from the investment. As these corporate assets become more appealing, this will drive down the cost of capital for companies, facilitating investment by companies so that they can grow and hire more employees.

In addition to facilitating development for small businesses and corporations, a capital gains tax cut would also have a significant stimulative affect on venture capital funding. As Stephen Moore and Phil Kerpen contend:

Venture capital funds are the economic lifeblood of high-technology companies in industries that are of critical importance to the U.S. international competitiveness: computer software, biotechnology, computer engineering, electronics, aerospace, pharmaceuticals, and so forth. The high capital gains tax rate appears to have contributed to the drying up of funding sources for those promising new frontier firms. [Italics added.]

Likewise, J.R. Johnson, an entrepreneur and the co-founder of virtualtourist.com, argued that Congress should encourage investment by the private sector through a decrease in the capital gains tax rate:

No longer standing around, testing the water by dipping a toe into the pool, entrepreneurs would be cannonballing into the deep end—rushing to create jobs before the exemption ends. This will build some of the companies that will carry us out of these difficult economic times. Rather than rely so heavily on government to spend our way out of this recession, let’s fully encourage people who create small businesses to do it for us.

Additionally, research points to an increase in corporate acquisitions, as a decrease in capital gains taxes leads to lower transaction cost, more attractive stock portfolios, and more appealing corporate investment packages for potential shareholders.

Given the budding economic growth, Congress should immediately pass legislation that eliminates the capital gains tax. While this legislation would have an insignificant impact on federal revenue, zeroing the capital gains tax would have an immediate and significant impact on renewing economic growth and spurring individual prosperity. Congress cannot afford to wait any longer to eliminate the tax. Our jobs and our economic prosperity depend on it.

Newt Gingrich is a senior fellow at the American Enterprise Institute and was Speaker of the U.S. House of Representatives. Emily Renwick is his research assistant. Sourabh Mishra of Dartmouth College contributed to this article. The authors would like to thank J.D. Foster at the Heritage Foundation for his constructive review.

Image by Darren Wamboldt/Bergman Group.