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Poor Gain (Proportionately) the Most From Capital Gains Tax Cut
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As Congress considers whether to reduce the tax on capital gains, much of
the debate has focused on who would benefit from such a reduction. Opponents
claim that those with high incomes would gain disproportionately.
An economic analysis concludes that a lower capital gains tax rate would
increase savings and act as an engine of economic growth. After all effects
are considered, some income groups gain more or less relative to other income
groups, but all income groups would be net gainers from the type of capital
gains tax cut proposed. More significantly, as a percentage of income, families
in the lowest-income group would gain the most.
Background. Capital gains were taxed at lower rates than other forms
of income from the 1920s until the passage of the Tax Reform Act of 1986.
During his presidency, George Bush proposed lowering the maximum tax on
capital gains from 28 percent to 15.4 percent for assets held more than
three years, 19.6 percent for assets held more than two years and 23.8 percent
for assets held more than one year. This proposal was initially opposed
by some congressional Democrats who claimed that it benefited upper-income
taxpayers at the expense of those with lower incomes. Later they proposed
a trade-off linking a capital gains tax reduction to a tax increase on higher
incomes. However, no capital gains tax relief was adopted as part of the
1990 tax bill. President Clinton expressed support for some sort of capital
gains tax relief, but none was included in the 1993 tax bill, either.
Supporters of a reduction in the capital gains tax rate contend that it
would increase the value of real estate and other assets (benefiting all
holders of assets), stimulate savings (lowering the cost of capital and
stimulating investment) and encourage entrepreneurship (leading to economic
growth).
Most economists believe that such a tax cut would mitigate the "locked-in
effect" of investors holding onto assets they already own which have
increased in value, rather than selling them, paying the capital gains tax
and purchasing new assets. This effect may cause a misallocation of risk
and may reduce savings.
Additionally, a number of studies have found that a capital gains tax cut
would actually increase federal revenues. For example, a study published
by the National Center for Policy Analysis estimated that adoption of the
Bush proposal would have produced $185 billion in additional federal tax
revenue over the following decade.
The Economic Model. Both the direct and indirect effects of a reduction
in the capital gains tax rate were analyzed using what economists call a
Computable General Equilibrium (CGE) model. The representation of the U.
S. economy used for this study incorporates data from 14 primary production
sectors, 14 consumption sectors, a foreign sector and government. It divides
households into six income groups.
Tax rates in the model were changed to study the effects throughout the
economy of the capital gains cut proposed by President Bush. Although the
reduction now under consideration differs in detail from the Bush proposal,
its effects would be similar.
Who Benefits? Upper-income groups would receive substantial benefits
from a capital gains tax cut, but so would other income classes. Not only
would all income groups realize capital gains at a greater rate, their incomes
also would increase due to the growth of the economy as a whole. Taking
both direct and indirect benefits into account, the model indicates:
- The greatest total gains in income go to the highest-income
group (earning $50,000 or more), which is not surprising since higher-income
families tend to own the most capital.
- However, the highest percentage gains in income go to the lowest-income families ($0-$9,999).
The overall results of the reduction in capital gains tax rates are somewhat mixed.
- The lowest-income group ($0-$9,999) has the greatest percentage gain,
and the percentage gain in income declines with increasing income among
the three lowest-income groups ($0-$9,999, $10,000-$19,999 and $20,000-$29,999).
- The percentage change in income is greater for the $30,000-$39,999
group than for the $20,000-$29,000 group, but smaller than the percentage
gain of the two lowest-income groups.
- The smallest percentage change in income is for the second highest-income
group ($40,000-$49,999).
- And the highest-income group ($50,000 plus) enjoys a percentage increase in income second only to the lowest-income group.
Moreover, expansion of the machinery and finance sectors would assure increased future economic growth because capital in these sectors is taxed at a relatively high rate compared to capital in other sectors, and these two sectors represent the bulk of net investment. This makes them very important for economic growth.
Savings Increase. The computer simulation of a capital gains tax rate reduction shows that output would increase in every sector of the economy and that savings would increase substantially (0.26 percent). Savings increases because it can be used for investment, and households would enjoy greater after-tax returns due to the decrease in the capital gains tax rate.
This increase in savings is associated with an increase in production-sector financial services and consumer financial services. The increases in savings and consumer financial services, like the expansion in the producer financial services and manufacturing sectors, bode well for future economic growth.
After savings and financial services, the largest increase in output occurs in the housing sector (0.24 percent). Gains in personal income associated with reduced capital gains taxes lead to higher demand for housing, reinforced by savings increases and a fall in interest rates.
Effect on Government Revenues. Another objection that is raised to the capital gains tax reduction is that it would reduce government revenues. In this model, government revenues do fall, but only by 1.40 percent. The loss is small because the initial revenue reduction associated with the tax cut is offset by increased revenue associated with the general increase in economic activity as secondary effects of the tax reduction expand the economy overall.
Conclusion. The model indicates that all income groups would experience higher income as a result of a reduction in the capital gains tax rate, with the lowest-income families enjoying the highest gains. Further, the lower rate would encourage saving and stimulate economic growth, yielding an increase in tax revenues that would almost completely offset any revenue loss from the tax cut.
This Brief Analysis was adapted from Barry J. Seldon and Roy G. Boyd, "A General Equilibrium Analysis of a Reduction in Capital Gains Taxes," Public Finance Quarterly, Vol. 23, No. 2, April 1995, pp. 193-216.