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Stimulating Growth with a Capital Gains Tax Cut

Daily Policy Digest

Tax Issues

Monday, October 08, 2001

There is no question that lowering the cost of capital by lowering the capital gains tax will increase economic growth above what it would be otherwise. But what would the short-run impact be?

Former Treasury Secretary Bob Rubin, for example, says it would increase selling pressure and push the stock market down further, based on the well-documented "lock-in" effect. The capital gains tax discourages investors from selling assets that have appreciated in value since taxes are paid when gains are realized. If the capital gains tax were cut, many people will sell assets.

Offsetting this effect, however, are two others that theoretically will cause asset prices to rise:

To the extent that the capital gains tax is capitalized into asset prices, a reduction in this tax should cause all asset prices to rise.

As people realize gains, they must reinvest them in new assets, and as capital is reallocated from appreciated assets to assets with greater capital appreciation potential, the market as a whole should rise.

Whether cutting the capital gains tax will cause the stock market to rise and over what time period is not definitively known.

After the 1978 capital gains tax cut, which lowered the top rate from 49 percent to 35 percent, the S&P 500 index rose 45 percent from 1978 to 1982 (see figure).

More recently, a study of the 1997 capital gains tax cut by Mark Lang and Douglas Shackelford found that it raised stock prices significantly as soon as it became clear that Congress and the White House had reached a deal.

Thus there is good reason to believe that cutting the capital gains tax will have a positive impact on stock prices.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, October 8, 2001.

For text
http://www.ncpa.org/edo/bb/2001/bb100801.html

For more on Taxes & Economic Growth
http://www.ncpa.org/pi/taxes/tax2.html

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