The Hidden Entitlements

2. Capital gains (except homes)

Capital gains are profits reflecting increased values of stocks, bonds, investment real estate and other "capital assets." Capital gains are treated much more favorably than other types of income, especially for the highest income people. In fact, total current capital gains loopholes are estimated to cost $258 billion over the next seven years. In terms of cost and maldistribution--and contentiousness--tax breaks for capital gains are at the top of the list.

Capital gains are not taxed at all unless and until they are "realized"--generally upon sale of an appreciated asset. And even when gains are realized, top-bracket individuals pay lower tax rates on capital gains than on so-called "ordinary" income.

As a result, investment markets that primarily service the well off are often designed to maximize the share of profits that are in the form of capital gains--both realized and unrealized. Indeed, on individual tax returns, total realized capital gains exceed stock dividends by 73%.

Which is not to say that capital gains are common for most taxpayers. In fact, only one tax return in every twelve filed reports any capital gains at all. On returns with total income up to $75,000, stock dividends exceed reported capital gains. Interest income exceeds capital gains all the way up to $200,000 in income. But for the highest income people--making more than $200,000 a year--realized capital gains exceed the total amount of dividends and interest combined.

Almost two-thirds of total capital gains reported on individual tax returns go to people whose incomes exceed $200,000. In contrast, only 7.8% of the total gains are reported by the three-quarters of tax filers with incomes of $50,000 or less. Thus, more than any other type of income, capital gains are concentrated at the very top of the income scale.

In part because the taxation of capital gains is more important to the rich and politically powerful than the treatment of any other type of income, capital gains taxation has been extremely controversial over the years. At the onset of the income tax, realized gains were taxed at the same rates as other income--up to 77% during the World War I period. When the Republicans regained the White House after the war, however, the maximum capital gains rate was set at 12.5%--half the regular top rate of 25% from 1925 to 1931. The top regular rate rose to 63% in 1932, but the 12.5% top capital gains rate was briefly retained.

The onset of the Great Depression and public disillusionment with stock speculation of the Roaring Twenties, however, led to increased capital gains tax rates in the 1930s. For a short period, realized gains were taxed under a complicated schedule that taxed gains from very short-term investments in full, but excluded as much as 70% of gains from sales of assets held for more than 10 years. This system was widely criticized as unwieldy and complex, and in the early 1940s it was scrapped. For the next 25 years, taxpayers had the option of excluding half of their capital gains or paying a maximum rate of 25% (useful to those whose regular tax brackets exceeded 50%).

In the late 1960s, the special 25% maximum rate was repealed. In conjunction with other tax changes, the top capital gains rate rose to about 39% by the mid-1970s. Then in 1978, congressional Republicans joined by a substantial minority of Democrats pushed through a major capital gains tax cut. Reluctantly signed by President Carter, it lowered the top rate to 28%, by excluding 60% of realized capital gains from tax. The 1981 cut in the top regular tax rate on unearned income reduced the maximum capital gains rate even further, this time to only 20%--its lowest level since the Hoover administration.

In conjunction with sharply increased depreciation write-offs in 1981, the 1978 and 1981 capital gains tax cuts caused a proliferation of tax shelters. Unneeded, unprofitable and often empty office buildings sprung up all across the country in response to the new tax subsidies (helping set the stage for the savings and loan crisis later in the decade). Esoteric capital-gains-based tax shelters in items like collectibles, freight cars and llama breeding abounded. Tax-shelter "losses" reported on tax returns jumped from about $10 billion a year in the late seventies to $160 billion a year by 1985. And since the goal of most of the shelters was not only to defer taxes, but to convert ordinary income into lightly-taxed gains, reported capital gains jumped as well.

Proponents of low capital gains tax rates like to argue that a surge in capital gains after 1978 and 1981 proves that capital gains tax cuts cause the well off to cash in far more unrealized gains, thereby mitigating or even eliminating the apparent revenue loss from a special low capital gains tax. To be sure, reported gains (before exclusion) did increase rapidly in the late seventies and early eighties. In nominal terms, they rose from $45 billion in 1977 to $80 billion in 1980 to $176 billion by 1985. Adjusted for the growth of the economy, this represents a 90% increase in reported gains from 1977 to 1985. Even if all the increase in capital gains realizations could somehow be attributed to the tax cuts, these figures would still indicate that the tax cuts lowered revenues, since the capital gains tax rate was cut about in half between 1977 and 1985. But much of the increase in reported gains simply reflected the stock market's recovery from the oil-price shocks of the seventies--and thus would have happened even absent the tax changes.

Moreover, a very large share of the increased capital gains in the first half of the eighties represented tax-shelter conversions of ordinary income into gains. This kind of tax-induced surge in reported gains actually means a pure revenue loss. If, as Michael Kinsley has noted, we cut taxes in half for people named "Newt," then we surely would find that Newts reported much more income on tax returns. Indeed, total taxes paid by people named Newt might even go up. But that would merely reflect millions of people changing their names to Newt to avoid taxes, not some magical supply-side effect on Newts' incentives to work, save and earn money. The same is true of tax breaks for income called "capital gains."

So do lower tax rates on capital gains cause people to cash in more gains than they otherwise would (not counting tax-shelter effects)? The answer is probably yes, but the long-term magnitude of such induced realizations is probably quite low. A recent study by Congressional Budget Office economists Leonard Bermun and William Rudolph compared capital gains realizations by a sample of particular taxpayers over time. They found large transitory effects when a taxpayer's individual circumstances changed and when the federal government made major revisions in capital gains taxation.3 But on a long-term basis, the study found very little correlation between the tax code's treatment of capital gains and levels of realizations. In fact, in technical terms, the study found that "[t]he permanent elasticity is not significantly different from zero."4

Despite all the debate over how much reduced capital gains taxes might affect the level of asset sales, it's really a side issue. The heart of the case for a capital gains tax break is that it supposedly encourages savings, investment, jobs and economic growth. And that case is astonishingly weak. Just look at what happened when capital gains taxes were cut in the past.

The 1978 Revenue Act, enacted in November of 1978, cut the maximum capital gains tax rate from 39% to 28%. Over the 12 months prior to enactment of that change, the real GDP grew by 5.8%. But after the 1978 capital gains tax cut was approved, the economy faltered. In fact, the GDP dropped by 1% over the next year and a half. The annual growth rate for the two years following the 1978 capital gains tax cut was only 0.3%--5.5 percentage points lower than the growth rate prior to the cut.

In August of 1981, another capital gains tax cut was enacted, this time cutting the top rate to 20%. Over the 12 preceding months, the economy had grown by 3.5%, but in the 12 subsequent months the GDP fell by 2.8%. In the two years after the 1981 capital gains tax cut was enacted, the annual growth rate was only 1%--2.5 percentage points below the growth rate prior to the cut.

Contrary to the assertions of capital gains tax cut proponents, capital gains tax cuts have never led to improved economic performance. Tax laws that have increased the capital gains tax, however, typically have been followed by increased growth. After capital gains taxes were increased in the 1976 Tax Reform Act, for example, the economy's growth rate jumped from 3.9% in the preceding year to 5.2% over the next two years. Likewise, following enactment of the 1986 Tax Reform Act, the growth rate rose from 2.2% in the previous year to 3.8% over the next two years.

The record of capital gains tax cuts when it comes to jobs is equally dismal. In fact, the unemployment rate rose sharply after both the 1978 and 1981 capital gains tax cuts. Conversely, the jobless rate fell notably after the 1976 and 1986 capital gains tax hikes were enacted.

History belies the claims that low capital gains taxes stimulate the economy. The long-term economic case against capital gains tax loopholes is even stronger. In essence, capital gains tax cut proponents seem to believe that free markets don't work, that the government needs to step in with subsidies designed to override the signals the market sends about the level and allocation of capital. But this idea that the government should be making investment decisions for business is terrible economics.

The truth is that paying people and corporations to make investments that otherwise make no business sense undermines economic growth. Capital gains tax breaks and other supply-side loopholes of the first half of the 1980s inspired construction of tens of thousands of unneeded office buildings and led to myriad other dramatic and wasteful misallocations of American capital and effort. But they completely failed to produce increases in total savings or investment.

Details on existing capital gains tax breaks:

28% maximum rate: One of the greatest achievements of the 1986 Tax Reform Act was to tax realized capital gains at the same rates as wages, dividends or other income. (Previously, realized capital gains had been 60 percent tax-exempt). But in 1990, Congress reinstated a small capital gains preference, by capping the capital gains rate at 28% while setting the top regular income tax rate at 31%. In the 1993 budget bill, this capital gains preference was greatly expanded to provide what amounts to a 30% capital gains exclusion for top-bracket taxpayers (the difference between the new 39.6% top regular tax rate and the continuing 28% maximum capital gains rate). The 1993 act provided an additional 50% capital gains exclusion for profits from certain "risky" investments that are considered likely to fail. Ninety-seven percent of the tax savings from the current special maximum capital gains tax rate for individuals goes to the best off one percent of all families.

Indefinite deferral of tax on unrealized capital gains: Capital gains are not taxed until assets are actually sold. As a result, investors can put off tax on their gains indefinitely. (They can also avoid tax on realized gains by selectively realizing losses on other investments in the same year.) This deferral is unavailable, of course, to other kinds of income such as savings account interest, even if the money is left in the bank. Multi billionaire Warren Buffett, for example, has structured his investment company so that it hasn't paid a dividend since 1966. Instead, Buffett's $14 billion or so in accrued capital gains remain unrealized and thus untaxed.

Capital gains tax breaks for gifts and inheritances: Currently, heirs can sell inherited property and pay no tax on capital gains that accrued prior to the time they inherit. In other words, capital gains taxes on inherited property are completely forgiven.

In the case of gifts, the recipient takes over the giver's "basis" in the donated property--generally the cost when the property was first acquired. That carryover of basis--instead of taxing the gain--allows a continued deferral of unrealized capital gains.

Special additional industry-specific capital gains tax breaks: Historically, favorable capital gains treatment has normally been limited to profits from the sale of investments (stocks, bonds, etc.). But several industries have succeeded in getting part of their normal business profits treated as capital gains. Special capital gains treatment is currently available for sales of timber, coal, and iron ore and for certain agricultural income.

Other special capital gains breaks include: Recently proposed capital gains tax changes:
A large reduction in the capital gains tax was the centerpiece of the Republican "Contract with America" tax program that was vetoed by President Clinton at the end of 1995. The GOP hoped to replace the current 28% maximum capital gains tax rate with a 50% exclusion (thus a 19.8% maximum rate), plus indexing the basis of assets for inflation. In the final bill approved by Congress, capital gains cuts constituted about three-quarters of the plan's $10,500 average annual tax cut for the best off one percent. CTJ estimated that the GOP capital gains changes, if enacted, would cost $113 billion over the next seven years--mostly benefiting the very rich.5 Going even further, the Armey-Forbes "flat tax" plan would entirely eliminate taxes on capital gains.

In contrast, in his fiscal 1997 budget, President Clinton has proposed several revenue-raising reforms in capital gains taxation. They are basically directed at narrowing the definition of what qualifies for preferential capital gains treatment.

Although capital gains taxation has become an increasingly partisan issue in recent years, that was not always the case. The Revenue Act of 1978 that sharply reduced capital gains taxes was passed with significant Democratic support in Congress and signed by Democratic President Jimmy Carter. In contrast, it was Republican President Ronald Reagan who signed the Tax Reform Act of 1986 (drafted and passed by the GOP-controlled Senate led by Sen. Bob Dole) that for a time taxed capital gains at the same rates as other kinds of income.

The reason why economic conservatives might worry about special tax breaks for capital gains was aptly summarized in testimony by the Treasury before the House Ways and Means Committee in January 1995 concerning the Republican "Contract":
"Increasing the preferential treatment of capital gains would create economic efficiency losses and make the tax system more complex by encouraging taxpayers to convert ordinary income into capital gains."

Numerous economists, including some very conservative ones, have echoed Treasury's serious concerns about the GOP's proposed capital gains tax cuts. They note that capital gains are already the lowest taxed form of capital income (due to deferral and preferential rates), and they fear the likely waste of capital resources from new tax shelters.6


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