One of the greatest sources of unfairness in our tax system is the preference for investment income. Specifically, the profits investors enjoy when they sell an asset for more than they paid to acquire it (capital gains) are usually taxed at lower rates than other types of income. One argument used to justify this policy is the claim that investors will stop buying and selling assets if the profits from these sales are taxed like other types of income. CTJ’s recent report on revenue options explains that this is untrue.
Most capital gains go to the richest one percent of taxpayers, leading people like Warren Buffett to criticize this tax preference for allowing some millionaires to pay lower effective tax rates than many taxpayers much further down the economic ladder.
So what’s stopping Congress from ending the tax preference for capital gains and simply taxing this income at the same rates as all other income? After all, President Ronald Reagan singed into law a tax reform that did exactly this. Is it such a radical proposal to bring back Reagan’s policy of taxing all income at the same rates?
One obstacle to ending the tax preference is misinformation about how revenue would be affected. The Wall Street Journal and other sources of anti-tax ideology claim that increasing tax rates on capital gains would not raise any revenue because investors would respond by selling fewer assets, meaning there would be fewer capital gains to tax.
Even the people who provide official revenue estimates for Congress — the Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) — assume that this behavioral response exists, to a lesser but still significant degree.
Another non-partisan research institution that serves Congress, the Congressional Research Service (CRS), concluded in 2010 that JCT overestimates these behavioral responses and consequently underestimates how much revenue can be saved by allowing President Bush’s expansion of the capital gains preference to expire for the rich.
The recent report from CTJ on options to raise revenue explains why CRS is right and JCT is wrong. And why the Wall Street Journal is really, really wrong.
We don’t simply propose to allow Bush’s expansion of the capital gains preference to expire. We propose repealing the entire capital gains preference. We estimate that even if some behavioral responses do affect the revenue impact (meaning some investors do hold onto assets longer in response to the tax change) our proposal would still raise more than half a trillion dollars over a decade.
As our report explains, most of the ways in which investors respond to such a tax change are short-term responses. JCT seems to rely on research that confuses short-term responses for long-term responses. CRS points out that some studies from the last several years corrected for this mistake and found much smaller long-term behavioral responses.
See the CTJ report for more detail. As wonky and arcane as all this sounds, you can bet that the debate over capital gains tax changes and revenue will receive more attention as Congress starts talking about tax reform and about ways to get wealthy investors to pay their share.