Eight Reasons Not to Cut the Capital-Gains Tax

A bad idea that won’t go away.

There may be more unrealized capital gains within shouting distance of my office than at almost any other place on Earth. So it will not win me any friends in the Microsoft cafeteria to say that a capital-gains tax cut is a terrible idea. According to the Feb.14 Wall Street Journal, this terrible idea is closer to becoming a reality than at any time since tax reform eliminated the capital-gains break a decade ago. Republicans remain avid, and President Clinton is apparently willing.

This article is an act of self-plagiarism. I have written all this before, more than once. But obviously, the lesson didn’t sink in. So let’s try again. Consider the arguments.

1The capital-gains tax is a burden on the economy. That’s true. But so are all taxes. When you tax any activity, you get less of it. The best tax system is one that affects economic decisions as little as possible, one that spreads the burden equally over all economic alternatives. Tax butchers more than bakers, and you’ll have too much bread and not enough meat. Tax capital gains less than dividends and interest, and a similar distortion takes place.

You might think you know better than the free market how many butchers we need, and how much of available capital should go into stocks instead of bonds. But if so, you are more like a socialist than like a Republican.

2But capital gains are special, the engines of entrepreneurship and growth. No. There is nothing special about capital gains. Simple accounting alchemy can turn almost any form of income into a capital gain, and will do so if the tax rate is different enough. Capital gains are often–but not always–the reward for risk taking, whereas dividends and interest are usually the payoff of safer investments. And risk taking is swell. But the market will reward a higher risk with a higher payoff–if the risk makes sense, and if you believe in the market.

3The current tax system is unfair to capital gains. No, the current tax system already favors capital gains.

a) The top federal income-tax rate on capital gains is 28 percent. The top rate on other income is almost 40 percent. At lower income levels, wage income is subject to Social Security and Medicare taxes of more than 7 percent (15 percent including the employer’s share). Capital gains, like all investment income, are exempt.

b) Dividends and interest are taxed every year, even if they just sit and accumulate. Capital gains are not taxed until they are “realized” by the sale of an asset. (No billionaire’s total history of declared income is anywhere close to a billion dollars.) The difference between compounding before tax and compounding after tax is enormous.

c) Inherited property, when sold, is taxed only on gains since it was inherited. All gains in the previous owner’s lifetime are capital-gains tax-free. This is known as the “angel of death loophole.”

4The capital-gains tax hits phantom gains due to inflation. True, but so does the tax on interest. (Five percent interest at a time of 3 percent inflation is a real return of just 2 percent. But you owe taxes on all 5 percent.) More important, the deduction for interest paid–still allowed on borrowing for houses and for business reasons–also ignores inflation. You can deduct the full interest payment, even though part of it is just making up for inflation’s erosion of what you owe.

Ignoring Polonius, most people are both borrowers and lenders, so much of the injustice comes out in the wash. To index only capital gains would cause huge and costly distortions. To index the whole system would be hopelessly complicated.

5Capital-gains tax cuts pay for themselves. Unlikely, but impossible to disprove to the satisfaction of capgains theologians. The mere fact that capital-gains tax revenues rise for a while after a rate cut, or decline after a rate hike, proves nothing. People arrange their affairs to suit the tax law. Give a tax break to people who wear blue sweaters, and revenues from people with blue sweaters will go up–not because blue-sweater folks will work harder, but because more people will wear blue sweaters. Total tax revenues will go down. Likewise, give a tax break for capital gains, and there could be more revenue from capital gains but less from other sources.

At the moment, many folks are holding off on selling stocks in the hope of a tax break. Capital-gains tax revenues could rise–and the stock market could fall–when the question is settled, no matter which way.

6A lower capital-gains tax rate will “unlock” money from old investments and free it for more productive use. Not really. When I sell an “old” investment, someone else buys it for the same amount. The net effect on the investment capital pool is zilch. (This comically obvious point is comically often overlooked in the capgains debate.)

It’s true that capital-gains taxes make people reluctant to sell profitable holdings, and the economy would be more efficient if investment decisions could be made without tax considerations. But that’s true of all taxes and all economic decisions. A better way to “unlock” profitable investments would be to reduce the huge incentive to hold on until you die, by closing the “angel of death” loophole. But no one in Congress is suggesting that.

7President Kennedy cut the capital-gains tax and set off the 1960s boom. No, he didn’t, however often Jack Kemp may say he did. Kennedy proposed a small cut in the top capgains rate. Other parts of the proposal would have raised capgains taxes. But it never happened, and so probably did not cause the boom.

8It is unfair that there are limits on the deduction of capital losses but no limits on the taxation of capital gains. No, it isn’t unfair. But this is real aficionado stuff. If you really care, click here.

By contrast, it is not unfair that two-thirds of the value of the proposed tax cut will go to the top 1 percent of taxpayers, and anyone who flings around statistics like that one is an anti-growth class-warfare-monger, etc., etc., etc. Well, it sseems unfair to me, and I cannot see what’s wrong with pointing that out. But you don’t have to agree that it’s unfair. Let’s just agree that it’s stupid and unnecessary. I’ll settle for that.