The Myth of the Capital Gains Tax Cut

My friend asked me to help him convince a friend of ours that keeping the capital gains tax low (it's currently at 15%) is not necessarily such a good thing. So I'll give it a shot.

It seems as though the theory that low capital gains tax spurring investment has become one of those vestiges from the past thirty-five years of "white is black and black is white" economics that continues to have legs beyond the devastation of the past eight years. (Here, I should again plug Jonathan's Chait's The Big Con - it's a good overview of the absurdity of supply-side economics and how it's been sold to the American public).

To recap, capital gains are profits from stocks, bonds, real estate investments and other capital assets. Capital gains accrue when an asset is sold. All you really need to know is that the Joint Committee on Taxation and Treasury both count raising capital gains taxes as raising revenues. And there are no unbiased studies to prove capital gains tax cuts stimulate the economy.

Yet, in the April 2008 debate between Hillary Clinton and Barack Obama, ABC's Charlie Gibson said of capital gains tax cuts that "in each instance, when the rate dropped, revenues from the tax increased. The government took in more money. And in the 1980s, when the tax was increased to 28 percent, the revenues went down." Gibson went on to assert that "history shows that when you drop the capital gains tax, the revenues go up." Neither candidate really challenged Gibson on this assertion, unfortunately, but he misinformed the public in a fairly insidious way.

It just makes sense that there would be a short-term spike in revenue before a hike in the capital gains tax because investors might be more inclined to sell off their assets at the lower rate - and vice-versa. But the long-term effects are an entirely different story. Charlie Gibson & Co. seem to think that capital gains tax revenue fell when the rate was raised as part of the 1986 Tax Reform Act that was signed by President Reagan. The reality is that capital gains realizations surged in anticipation of the rate increase (which took effect in 1987). In other words, an increase in the rate actually increased revenues, albeit temporarily. After that, with fewer gains to realize, realizations predictably declined, and eventually returned to their normal level -- until the Clinton adminstration, when the stock market went up so much that realizations boomed. Capital gains tax revenues as a percentage of GDP under the Bush II Administration never reached the levels of the Clinton years when the rate was higher.
 
But what about the argument that capital gains tax cuts spur investment? Proponents of a capital gains tax cut have no historical evidence to point to when trying to prove the benefits of these cuts. They try the populist tack, saying that it's a tax on "ordinary Americans" when the reality is that in 2002, only 21 million (less than 20%) owned individual stocks outside an employee-sponsored plan. When politicians talk about eliminating the capital gains tax, it is only these 21 million households who will pay lower taxes, because retirement investments are tax deferred while you hold them, and then taxed at regular income tax rates when you take the money out. So the supposed economic benefits are so minor as to be insignificant.

In 1980, one of the nation's top economists, Lawrence Summers (then a conservative) conducted a study that found that eliminating the capital gains tax completely would raise U.S. output by only 1 percent over the next 10 years. Taxes on capital gains were significantly lower in the 80s than in the 70s, but savings and investment did not rise, as conservatives had advertised.

Still, you can find any number of conservative think tanks spouting all kinds of "evidence" that the capital gains cut will restore America to a Golden Age of Prosperity. Surely these economists are motivated more by politics than by economic fundamentals.

The economist John Kenneth Galbraith noted that supply side economics was not a new theory. He wrote, "Mr. David Stockman has said that supply-side economics was merely a cover for the trickle-down approach to economic policy—what an older and less elegant generation called the horse-and-sparrow theory: If you feed the horse enough oats, some will pass through to the road for the sparrows." Galbraith claimed that the horse and sparrow theory was partly to blame for the Panic of 1896. And yet, this same old horse and sparrow garbage keeps getting trotted and flown out every year because it's politically expedient.

Republicans are now upset because the Obama Administration has hinted at a 20% capital gains tax rate. This is equal to the lowest rate that existed in the 1990s (and the rate that President George W. Bush proposed in 2001). And it is almost a third lower than the rate that President Reagan signed into law in 1986.

So how does this myth get perpetuated? Tax talk is not sexy and an incurious media has decided to focus on being "fair and balanced" on these type of economic issues rather than right or wrong. It's important to remember that our economy has never lacked for capital, just common sense.

If you'd like to learn more about this issue, Michael Kinsley has a good, quick summary in Slate Magazine from 1997 titled Eight Reasons Not To Cut The Capital Gains Tax.