Date: Sun, 3 Mar 1996 22:12:26 -0600 (CST)
From: Chegitz Guevara <mluziett-AT-shrike.depaul.edu>
Subject: FW: http://epn.org/epi/epcaga.html (fwd)



Marc, "the Chegitz," Luzietti
personal homepage: http://shrike.depaul.edu/~mluziett
political homepage: http://shrike.depaul.edu/~mluziett/chegitz.html

o/~ When an eel lunges out and it bites off your snout, 'ats amore o/~

---------------Original Message---------------
Copyright 1995 by Economic Policy Institute. Readers may redistribute this
article to other individuals for noncommercial use, provided that the text
and this notice remain intact. This article may not be resold, reprinted, or
redistributed for compensation of any kind without prior written permission
from the author. If you have any questions about permissions, please contact
The Electronic Policy Network, P.O. Box 383080, Cambridge, MA 02238,
query-AT-epn.org, or by phone at (617) 547- 2950.

Preferred Citation:, Dean Baker, The Illusory Rewards of a Capital Gains Tax
Cut, Issue Brief #104 (Economic Policy Institute, 1995
[http://epn.org/idea/economy/epcaga.html]).

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                               EPI Issue Brief
                              Issue Brief #104
                          Economic Policy Institute
                              January 25, 1995

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The Illusory Rewards of a Capital Gains Tax Cut

Dean Baker

The Congress has returned once again to the question of whether returns to
capital should be accorded more favorable tax treatment than returns to
labor. The Job Creation & Wage Enhancement Act in the Republicans' "Contract
With America" calls for lowering the top rate on capital gains to 19.8% from
the current 28% (already a bargain compared to the top income tax rate of
39.6%) and indexing any gains to the rate of inflation. Proponents of the
change argue that lowering the rate will lead to increased investment and
provide a tax benefit to the broad middle class. Both are far from likely.

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There is no evidence that a capital gains tax cut will have any positive
impact on investment and economic growth.

In theory, the only mechanism through which lowering the capital gains tax
rate can increase investment, and thereby economic growth, is by raising
stock prices. A lower capital gains tax would lead to larger after-tax
returns and therefore greater incentives for individuals to purchase shares
of stock or other assets that might produce capital gains. This can in
principle make it cheaper for firms to raise money for new investment, and
thereby increase investment.

In reality, it is all but impossible to increase investment through this
route. To begin with, the effect of a tax cut on stock prices is not likely
to be very significant, since a large portion of stock holdings (the
one-third held by pension funds and similar institutions) is not currently
subject to the capital gains tax. Also, since these institutions tend to be
the most active traders, they play a disproportionate role in determining
share prices. Furthermore, many individuals pay no taxes on capital gains,
since stock shares can be passed along to descendants without capital gains
liability.

Under the current system, when individuals accrue capital gains during their
lifetimes, the gains are effectively taxed at a far lower rate than for
other income because the tax can be deferred until the asset is sold. If an
individual has a $100,000 capital gain on a stock or small business, he can
defer paying taxes on this money until he sells the asset. On the other
hand, if the individual receives $100,000 for working or from interest on
savings, he has to pay taxes from the income immediately. This deferral of
taxes constitutes a large subsidy to recipients of capital gains. While
there is no evidence that this favorable treatment increases the money
available for firms to invest, it does provide a large tax break to wealthy
shareholders.

It is sometimes claimed that lowering the capital gains tax will "free up"
money that is currently tied up by the threat of high taxes. While giving a
tax break might free up money for wealthy shareholders, it would do nothing
for the market as a whole. The price of stocks is determined by the large
numbers of active traders. If a wealthy shareholder decides to unload his
holdings of a particular stock, then other money will flow into that stock,
leading to little change both in the stock's price and in the amount of
money available to be invested elsewhere.

Michael Boskin, President Bush's chairman of the Council of Economic
Advisors and a strong proponent of a capital gains tax cut, estimated that a
cut of roughly this magnitude would lower the effective rate of interest by
only 10 to 15 basis points, or between 0.1% and 0.15%. Interest rates
regularly fluctuate this much in a single day. By comparison, in the last
year and a half long-term interest rates have risen by over 200 basis
points.

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A capital gains tax cut will encourage tax shelters and divert resources
from productive uses.

If people pay a lower tax rate on capital gains than on other income, they
have an incentive to hide their other income as capital gains. Tax lawyers
and accountants will devise methods for highly paid professionals and other
wealthy people to have their income taxed at the low capital gains rate
instead of the rates that ordinary people pay on their income.

Instead of promoting investment and economic growth, this reaction will take
the economy in the opposite direction. Some of the country's most creative
people will find that the best way to become wealthy is to outsmart the tax
system. In addition, billions of dollars that could have gone to productive
investment will be tied up in tax shelters. And, by allowing wealthy
individuals who are willing to take advantage of loopholes to pay a lower
tax rate than the average working person, the credibility of the tax system
will be undermined.

It was for these reasons that President Reagan and Congress eliminated
special treatment for capital gains in the Tax Reform Act of 1986. As
President Reagan said when he signed the 1986 tax bill:

By closing loopholes and lowering rates, we're going to bring America's
investment money out from under the shelters and back into the productive
economy where it belongs. We will no longer use the tax code to make
economic and social policy. Instead, we're going to let market forces shape
our economy into a sleek and efficient powerhouse of growth.

Bringing back special treatment for capital gains completely subverts the
momentous tax reform accomplished in 1986. The only growth it would promote
is in the tax shelter industry.

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The loss of tax revenue from a capital gains tax cut is likely to be
substantial over the long-term.

In the short term, a capital gains tax cut may have little effect on revenue
or may even increase it, as people rush to take advantage of lower rates. In
the longer term, the rush will dissipate and the gains will return to their
former levels, but the tax rate will be 50% less. This effect will be
aggravated by the creation of tax shelters through which much ordinary
income will be taxed at the lower capital gains rate. When these dynamic
effects are taken into consideration, a capital gains tax cut is likely to
lead to a huge revenue loss over the long term.

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The beneficiaries of a capital gains tax cut will be almost exclusively the
wealthiest people in the country.

Most working people will never have any capital gains on which to pay tax.
The one capital gain that most people receive in their life is on their
home, but this gain is virtually excluded from taxation under current tax
law. By contrast, the richest 1% of the population typically receive about
90% of all capital gains. Thus a capital gains tax cut would be a huge
windfall to the people who need it least.

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For more information, see:

Chirinko, Robert S. 1993. "Business Fixed Investment Spending: A Critical
Survey of Modeling Strategies, Empirical Results, and Policy
Implications"Journal of Economic Literature, Vol. 31, No. 4, pp. 1875-1911.

Fazzari, Steven M. 1993. Investment and U.S. Fiscal Policy in the 1990s.
Briefing Paper. Washington, D.C.: Economic Policy Institute.




----------End of Original Message----------

Cordially,

David Price

System Administrator
People Escaping Poverty Project
Moorhead, MN 56560

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03/01/96        17:10:25







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