' 399 December 27, 1984 THEFEDERALTAXDEBATE CAPITAL GAINS INTRODUCTION The taxation of capital gains is among the most controversial issues in public finance. It is likely to become more so as the Treasury Department's recent tax reform proposal is scrutinized.

Under the Treasury plan, capital gains would be taxed at ordinary income rates, raising the maximum marginal tax rate on long-term capital gains from.the current 20 percent to 35 per cent. Such gains would be indexed to inflation so that taxes would be paid only on gains that exceeded the inflation rate.

This proposal has been greeted warmly by liberal tax reformers and with alarm by venture capitalists who, rightly, see the change as benefiting old capital at the expense of new capita1.l Venture, capitalists will probably argue strongly for maintaining the current tax system, which excludes from taxation 60 percent of all long-term gains and taxes the balance at ordinary income rates .

What the U.S. economy needs, however, is neither the current capital gains tax policy nor the Treasury proposal true reform that abolishes the capital gains tax completely.

This would ignite risk taking and encourage the expansion of venture capital fun ds, leading to more businesses and jobs Needed is a See Peter Behr, "Tax Plan Scares Venture Capitalists," The Washington Post November 29, 1984, pp. Bl-B2 This is the first of a series of studies analyzing federal taxes. Among the topics examined by subs e quent studies will be corporate and value-added taxes 2 REDUCTION IN RATES The Tax Reform Act of 1969 sharply increased the maximum tax rate on capital gains in response to liberal arguments that preferential treatment for capital gains allowed many wealt h y individuals to escape paying what was called their "fair share of taxes. In the 1976 presidential campaign, Jimmy Carter repeat edly said that capital gains ought to be treated no differently than ordinary income special treatment of capital gains in 19 7 8 His Treasury Department proposed ending During hearings on this reform proposal, Congress concluded that Carter was absolutely wrong. What was needed, decided the lawmakers, was not less but more preferential treatment for capital gains It was argued, f o r example, that the 1969 capital gains tax hike had hurt high-tech companies severely.3 In addi tion it was demonstrated that such a high capital gains tax so inhibited risk investment that the government's revenue from the capital gains tax was below wha t a lower tax rate would yield As a result of its investigations, Congress cut the maximum capital gains.tax in 1978 from about 49 percent to 28 percent the maximuxu federal income tax rate on ordinary income at the time was 70 percent income was cut to 50 percent in 1981, the maximum capital gains rate fell to 20 percent. The evidence strongly suggests that this capital gains tax cut led to the positive effects that its proponents had predicted When the maximum tax rate on ordinary THE ECONOMICS OF CAPITAL GAINS TAXES When Congress was considering the reduction in capital gains tax rates in 1978, the move was strongly opposed by the Carter Administration and liberal journalists the fact that most capital gains are realized by those with upper incomes. In 19 8 1, for example, 45 percent of all long-term capital gains (in excess of short-term capital losses) accrued to taxpayers with incomes above $100,000.5 Hence, any cut in the capital gains tax rate was seen as simply a giveaway to the rich Criticism centered on On numerous occasions Carter said that one of his principal goals was to treat all income the same for tax purposes.

Committee on House Administration, The Presidential Campaign 1976 (Wash ington, D.C U.S. Government Printing Office, 1978), pp. 152, 15 8 U.S. Congress, House, Committee on Ways and Means, The President's 1978 Tax Reduction and Reform Proposals, 95th Congress, 2nd session (Washing ton, D.C U.S. Government Printing Office, 1978), part 3, pp. 1307-1338.

See also, Robert J. Samuelson, "Making Life Difficult for Congress,"

National Journal, March 18, 1978, p. 437.

Robert J. Samuelson, "Pounding the.Carter Tax Proposal From All Sides,"

National Journal, May 13, 1978, pp. 757-759; Editorial How to Unsoak Internal Revenue Service, Statistics of Income--1981, Individual Income Tax Returns (Washington D. C U. S Government Printing Off ice, 19831 p. 41 See U.S. Congress, House May 19, 1978. 3 It is true that wealthy individuals benefit from a lower tax rate on capital gains in the sense that if they had realized the same amount of capital gains and been taxed at ordinary income tax rates, their tax liability would be higher. Brookings Insti t u tion scholar Joseph Pechman has estimated, however, that in this case individuals with incomes above $1 million would pay 16.4 percent more in federal income tax in 1985.6 most of these capital gains would not be realized at the higher tax rate, as invest o rs'would simply hold on to their assets rather than sell them But, of course It would appear that raising capital gains taxes does not necessarily lead to an increase in federal tax revenues reduction is more likely A The Mobility of Capital This importan t characteristic of capital gains taxes is known as the iilock-inii effect. Capital gains are taxed only when realized As long as an asset is not sold, no taxable.income results even if it has increased in value substantially. Thus a high tax rate on capit a l gains encourages investors to hold on to assets that have appreciated in value rather than sell them and pay the tax. The higher the tax rate on capital gains the more pronounced this effect is going to be Capital needs to be Ifmobileif to be efficientl y used. But if capital is locked in to particular investments because of the capital gains tax, the nation suffers from plants that are not built, jobs that are not crealted, and goods that are not produced.

Capital was less mobile in the 1970s because wea lthy people were less willing to buy or sell corporate stock for fear of realizing gains that would be taxed at excessive rates preferred instead to invest in paintings, estates, and similar assets which produced nontaxable ffpsychicif income, thereby loc king their wealth into illiquid nonfinancial and nonincome This has important economic implications.

They Joseph A. Pechman, Federal Tax Policy, 4th edition (Washington, D.C The Brookings Institution, 1983), p. 360 For a theoretical discussion, see Charles C. Holt and John P. Shelton The Lock-In Effect of the Capital Gains Tax," National Tax Journal December 1962, pp. 337-352; Jonathan A. Brown, "The Locked-in Problem in U.S. Congress, Joint Economic Committee, Federal Tax Policy for Eco nomic Growth and S tability, 84th Congress, 1st session (Washington D.C U.S. Government Printing Office, 1955), pp. 367-3

81. For some empirical data, see Martin Feldstein and Joel Slemrod, "The Lock-in Effect of the Capital Gains Tax 1978, pp. 134-135; Shlomo Yitzhaki An Em pirical Test of the Lock-in Effect of the Capital Gains Tax," Review of Economics and Statistics November 1979, pp 626-629 Some Time-Series Evidence," Tax Notes, August 7, 4 producing forms tied up in tangible assets, compared with 29 percent in the mid=1 9 60 According to the Federal Reserve Board, corporate equities as a share of household financial assets fell from 35.3 percent in 1968 to just 15.6 percent in 1978..9 By 1978, 39 percent of all household wealth was Inflation and Capital Gains Taxes Inflati on made the capital gains tax all the more oppressive.

Investors knew that much, if not all, of any gain they might report would be the result solely of inflation, not of any real gain.1 Martin Feldstein and Joel Slemrod, individuals paid $500 million in e xcess federal tax in 1973 because paper capital gains were not adjusted for inflation. Their research shows that in that year individuals realized some 4.5 billion in nominal capital gains on corporate stock. When adjusted for inflation this $4.5 billion I IgainIl actually turned into a $1 billion capital loss Yet taxes were still paid on these Irgains.lfll gains tax.on the selling and switching of common stock and the realization of gains, thereby denying funds to new and growing companies He concludes tha t the capital gains tax at pre-1978 rates discouraged significant amounts of stock selling so much so, he predicted, that a reduction in the capital gains tax rate would increase federal revenue.12 According to a 1979 study by former Reagan Advisor Feldste in has also analyzed the lock-in effect of the capital 8 9 10 11 12 Balance Sheets for the U.S. Economy, 1945-83 (Washington, D.C Federal Reserve Board, Division of Research and Statistics, Flow of Funds Section April 1984 series 702.

Ibid.

For data on the impact of inflation on financial and tangible assets, see Jack Hibbert, Measuring the Effects of Inflation on Income, Saving and Wealth (Paris: Organization for Economic Cooperation and Development 1983).

Martin Feldstein and Joel Slemrod Inflation and the Excess Taxation of Capital Gains on Corporate Stock National Tax Journal, June 1979, pp 107-118.

See Martin Feldstein and Shlomo Yitzhaki The Effects of the Capital Gains Tax on the Selling and Switching of Common Stock Journal of Public Economics, Fe bruary 1978, pp. 17-36; Martin Feldstein, Joel Slemrod, and Shlomo Yitzhaki The Effects of Taxation on the Selling of Corporate Stock and the Realization of Capital Gains Quarterly Journal of Eco nomics, June 1980, pp. 777-7

91. See also Joseph Minarik Th e Effects of Taxation on the Selling of Corporate Stock and the Realization of Capital Gains 93-110; Martin Feldstein, Joel Slemrod and Shlomo Yitzhaki The Effects Comment Quarterly Journal of Economics, February 1984, pp of Taxation on the Selling of Cor p orate Stock and the Realization of Capital Gains Reply Qiarterl; Journal of Economics, February 1984 pp. 111-120. 5 Impact on Federal Revenues The question of whether the capital gains tax cut would increase federal revenue has dominated most of the discu s sion on the topic. The Treasury Department's consultant on this issue Professor Gerald Auten of Bowling Green State University, concludes that, through 1981 at least, the tax cut increased capital gains tax revenue by about 2.5 billion over what would hav e been raised by the pre-1978 tax law.13 data from the IRS indicate that realizations of capital gains have increased substantially since 1978, especially among the wealthy-far outstripping inflation during the period The most recently available Table 1 LO N G-TERM GAINS NET OF LONG-TERM LOSSES in billions Adjusted Gross Income Class 1978 1981 Percent Change 0-$25,000 $9.7 $13.2 36.1 25,000-$50,000 9.0 I 10.2 13.3 50,000-$100,000 6.6 11.2 69.7 100,000-$500,000 8.6 19.0 120.9 Over $500,000 3.7 14.9 302.7 Total $37.7 $68.6 82.0 (average Source: Internal Revenue Service, Statistics of Income, Individual Income Tax Returns 1978 and 1981 Even if capital gains tax revenues themselves do not rise, total tax revenues undoubtedly will be higher because of higher profit s and larger payrolls resulting from the increased investment caused by the tax cut.

Raising tax revenues, however, was not, nor should it be the justification for the tax cut investment, especially risk investment.14 On this score, the tax Its real purpos e is to stimulate l3 Gerald E. Auten, "Capital Gains Cuts," in Charls E. Walker and Mark A. Bloomfield, eds., New Directions in Federal Tax Policy for the 1980s (Cambridge, Massachusetts: Ballinger 19831, p. 136 The capital gains tax has long been known t o have a particular impact on entrepreneurial activity. See Thomas H. Sanders, Effects of Taxation on Executives (Boston: Division of Resarch, Graduate School of Business Administration, Harvard University 1951 pp. 210-214 An Evaluation of the 1978 and 198 1 Tax l4 L 6 cut is a huge success commitments to venture capital funds increased from just $39 million in 1977 to $11.5 billion by the end of 1983 capital is the principal fuel for American entrepreneurial advances in computers, biotechnology, and many ot h er high-tech industries since 1978 Economist George Gilder explains that new Venture Effect of Rate Reductions on Business Formation The capital gains tax cuts of 1978 and 1981 very importantly improved the ability of firms to raise funds through equity o fferings. The average daily volume of transactions on the New York Stock Exchange, for example, increased from 28.6 million shares in 1978 to over 85 million shares in 19

83. University of Minnesota economist Joel Slemrod attributes much of this to the cap ital gains tax cut.16 In addition, new issues of corporate common stock have increased three-fold since the 1978 tax cut spurting after both the 1978 and 1981 tax reductions (see Figure 1).

The increase in ney issues and volume and the increase.in potential after-tax returns have contributed to a sharp rise in the market value of corporate equities.

As Table 2 shows, the market value of corporate equities in inflation-adjusted dollars fell 2 4 percent in the five years prior to the capital gains tax cut and has risen 46 percent in the five years since is that proprietors' equity in noncorporate business--generally small businesses--has increased 185 percent in real terms since 1979, compared t o a decline of 16.7 percent between 1975 and 1979 see Table 3 have been formed successfully as a result of the tax cut according to studies by David Birch at MIT, small firms with fewer than twenty em loyees are responsible for two-thirds of net Another i m portant indication of the capital gains tax success This suggests that many more small businesses And new jobs in the U.S. P7 Equity.and Tax Neutrality Many liberals ignore this evidence and continue to argue that capital gains ought not, as a matter of e quity, be taxed l5 l6 George Gilder, The Spirit of Enterprise (New York 1984 p. 44.

New York Stock Exchange Fact Book 1984, p. 73; Joel Slemrod Stock Transactions Volume and the 1978 Capital Gains Tax Reduction Public Finance Quarterly (January 1982 pp. 3- 16; see also Michael K. Evans The Truth About Supply-side Economics (New York: Basic Books, 1983 pp 163- 185.

David L. Birch Who Creates Jobs The Public Interest, Fall 1981, pp 3-14 Simon Schuster l7 25 20 15 10 5 0 Figure 1 NEW ISSUES OF CORPORATE COMMON STOCK billions of 1972 dollars) r I I I I I I I I I I I I 72 73 74 75 76 77 78 39 80 81 82 83 Source: Economic Report of the President, 1984, p.322. 8 Table 2 Year 1983 1982 1981 1980 1979 1978 1977 1976 1975 1974 1973 1978-1983 1973-1978 MARKET VALUE OF CORPORATE EQUITIES in billions Current Dollars 2,151.5 1,810.5 1,568.5 1,635.6 1,230.7 1,028.3 995.4 1,051.9 892.5 676.9 948.1 PERCENTAGE CHANGE lo9 .o 8.5 Year 1984 1983 1982 1981 1980 1979 1978 1977 1976 1975 Source: Federal Reserve, Flow of Funds Accou nts.

Table 3 PROPRIETORS' EQUITY IN NONCORPORATE BUSINESS in billions 1979-1984 1975-1979 1972 Dollars 999.1 873.0 801.9 916.7 753.1 683.6 710.7 794.8 709.5 588.2 896.6 Current Dollars 60.3 44.0 16.1 18.9 28.0 15.5 16.4 19.2 17.2 14.4 PERCENTAGE CHANGE 289 .0 7.9 Source: Federal Reserve, Flow of Funds Accounts 46.0 24.0 1972 Dollars 27.1 20.4 7.8 9.7 15.7 9.5 10.9 13 7 13.0 11.4 185.0 16.7 Based on figures for first two quarters of 1984. 9 differently than ordinary income.18 Tax reform proposals, such as th e Bradley-Gephardt bill, eliminate special treatment for capital gains rate on capital gains is zero, because capital gains are not income in an economic sense rate while also taxing the income from capital, necessarily imposes a double tax on capital, whi c h is indefensible on equity grounds and seriously detrimental to the economy. This seems to be appreciated in a number of countries known for their concern for equity While Britain, for instance, now deals with capital gains much as the U.S. does, Belgium , Italy, Japan, the Nether lands, West Germany, Australia, and other nations in effect do not tax long-term capital gains.19 The equity argument is spurious. In fact, the only fair tax Taxing capital gains, even at a low Legal Issues The Supreme Court has h ad difficulties with the question of whether a capital gain constitutes income within the meaning of the 16th Amendment, which established the federal income tax. In Eisner v. Macomber (1920 the Court limited the definition of income for tax purposes in a n important way. This case involved the payment of a stock dividend from a corporate surplus, and the Court held that such a dividend did not constitute income to the taxpayer, merely the transfer of capital; it became income only when the stock was sold m e nt only gives government the power to lay and collect taxes on income and capital is not income. There is, therefore, no express authority to tax capital.20 on unrealized capital gains. Proposals are periodically made for taxing unrealized capital gains, a lthough practical difficulties make this almost impossible.21 For example, in the absence of a market transaction, how would the value of an asset be determined And without a stream of income of some sort, with what would the taxpayer pay the tax Capital thus is not subject to tax, because the 16th Amend This is why no tax is paid l8 l9 See, for example, Alan S. Blinder, "Capital Gains The Washington Post, July 22, 1982.

Comparison of Individual Taxation of Long and Short Term Capital Gains on Portfolio Stock Investments in Ten Countries (New York: Securities Industry Association and Arthur Anderson Co 1980).

Ronald Foulis, What is Capital Gain and How Should It Be Taxed?" American Bar Association Journal (April 1978), p. 510 Presumably, this raises questions about the constitutionality of the estate and gift tax as well.

James Wetzler, "Capital Gains and Losses," in Joseph A. Pechman, ed Tax Them Like Income 2o 21 Comprehensive Income Taxation (Washington, D.C 1977), pp. 115-162; Revision the Individual I ncome Tax (Washington, D.C Congressional Budget-Office, July 1983), p. 78 Brookings Institution Ilo ELIMINATING THE CAPITAL GAINS TAX The very issue of whether capital gains are actually income rarely has been raised in recent years, but Harvard's Martin Feldstein. drawina on the work Droduced in the 1930s at Yale by Irving Fisher of taxation the principle arsues that incoie from capital ought to be fre;!

He points out that existing taxes on capital viola of horizontal equity, which holds that individuals te who would be equally well off-in -the absence of a tax should be equally well off if there is a tax.22 To put the matter simply: gains from the sale of long-term assets do not arise out of current production and are not current income. They merely repr e sent the conversion of an asset from one form into another. Hoover Institution economist Roger Freeman has noted that Congress already recognizes this principle with regard to the sale of homes arising from the sale of a primary residence, provided it is r einvested in another primary residence of equal or greater value within 24 months, is free of tax It can be argued says Freeman that there is no reason to treat a 'rollover' in other types of investment differently--except the political reason that millio n s sell their houses for more than they paid for them (or plan or hope to) but only one taxpayer in 14 enjoys other types of capital gains. 1123 Under current law, any capital gain In sum, although capital gains-realized or not-represent added wealth, they do not represent income. To tax capital gains, therefore, means taxing capital. Not only is this contrary to the 16th Amendment, which vests in the federal government only the power to tax incomes, but it has extremely adverse economic effects. It discour ages the formation and mobility of capital thereby reducing the standard of living of all Americans.

Writes Lawrence Seltzer of Wayne State University Capital gains and losses, it is contended, are not valid elements of true income, as the term is widely u sed more or less regular and recurring receipts, or, in any event, only those that are more or less expected. An occasional, sporadic gain or loss, especially if unsought and unexpected, does not function like income in guiding conduct or in determining t he allocation of economic The traditional concept of income includes only 22 Martin S. Feldstein, "Taxing Consumption," The New Republic, February 28 1978, pp. 14-17; see also Martin Feldstein On the Theory of Tax Reform,"

Journal of Public Economics (1976 ), pp. 77-104; idem, "The Welfare Cost of Capital Income Taxation," Journal of Political Economy, April 1978 part 2, pp. S29-S51; Michael A. Schuyler, Consumption Taxes: Promises Problems (Washington, D.C Institute for Research on the Economics of Taxatio n , 1984), p. 28. 11 economists, for their not specifically for resources. For this reason, many general analytic purposes, though those of taxation, confine the concept of .income to more or less expected or recurring receipts. Similarly the accountant usu ally excludes capital gains and losses from his measure of current income.

Further it is urged that capital gains do not constitute disposable income for the country as a whole In many instances they do not represent addi tions to the total wealth of the c ountry but merely changes in the value of titles to some of this wealth A reduction in corporate income tax rates, for example may well raise the market prices of common stocks by several times the amount of the annual tax reduction without adding commens u rately, if at all, to the nation's wealth. In other instances, capital gains may reflect real additions to the country's wealth, as when new mines or oil resources are discovered, but these addi tions cannot currently be consumed. They represent only the capitalized values of expected future incomes.

They are capital, not income, is contended; and taxes on them, therefore, tend to reduce capital accumulation.

Further, to tax capital gains as income, it is argued, puts a double tax on the recipient: first, on the capital value of future incomes; then, on the incomes themselves as they are received. A man who reinvests a capital gain of $50,000 will be subject t o income tax on. the future incomes he obtains- from the gain; and these incomes constitute his real gain. To tax him also on the principal value of the gain itself is to tax him twice.

CONCLUSION The case against the capital gains tax is strong on economi c and equity grounds. There are legitimate reasons for going beyond advocating a lower rate or indexing capital gains for income tax purposes, as Treasury Secretary Regan proposes. There are strong reasons for opposing the Treasury recommendation that the partial exclusion of long-term gains from tax be ended.

Capital gains should be completely free of tax free of the capital.gains tax.

Indeed, the vast bulk of capital gains are already effectively Capital gains on the sale of 23 Roger A. Freeman, Tax Loo pholes (Washington, D.C American Enterprise Institute, 1973 p. 43. 24 Lawrence H. Seltzer, "Capital Gains and the Income Tax," American Economic Reivew (May 1950 p. 372 12 homes bv individuals are almost never taxed, and most caDital gains 0; corporate eq u ities are realized by' financial inktitutions trading on behalf of pension funds, which again are not subject to the-capital gains tax. And because they-are more difficult for the IRS to locate than other sources of income, capital gains taxes are often e v aded.25 Rather than tinkering with the issue as proposed by the Treasury Department, the Administration should move directly toward tax neutrality by abolishing the capital gains tax repeal could trigger events dwarfing those that followed the capital gai n s tax cuts of 1978 and 1981 risk and innovation would be rewarded, and the entire nation would benefit in goods and earnings from this mobilization of U.S. economic'potential Its Investment would soar Prepared for The Heritage Foundation by Bruce Bartlett Polyconomics, Inc.

Morristown, New Jersey 25 See Eugene Steuerle Is Income from Capital Subject to Individual Income Taxation Public Finance Quarterly, July 1982, pp. 283-3

03. It should be remembered that under current law even if the capital gains tax were abolished wealthy individuals with capital gains would still be subject to the minimum tax.