Opinion Editorial | |
| Wednesday, March 5, 1997 | |
Capital Gains Tax Debate Rages OnBruce Bartlett
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For many years, the capital gains debate has been a sterile argument about the revenue effect of cutting the tax rate. Supporters of a cut have said reducing the capital gains tax would stimulate asset sales and enough new investment to pay for much or all of the lost revenue. Opponents are skeptical, arguing that a tax decrease would only enlarge the deficit.
Both sides have heavyweight economists with complex computer models spewing out estimates supporting their positions. But the capital gains issue probably cannot be resolved empirically. The decision to cut the tax or leave it where it is ultimately needs to be based on fundamental tax principles.
The critical question is this. Are capital gains income? If they are, then the argument for taxing capital gains less than wages, interest or dividends is inherently weak. If capital gains are not income, the only correct tax rate is zero.
The first Supreme Court case regarding capital gains in fact concluded that capital gains are not income. In Gray vs. Darlington (1872), the court was asked to decide whether the increase in value of a bond constituted taxable income. It said no.
"The mere fact that property has advanced in value between the date of its acquisition and sale does not authorize the imposition of the tax on the amount of the advance," the court wrote. "Mere advance in value in no sense constitutes the gains, profits or income specified by the statute. It constitutes and can be treated merely as increase of capital."
This decision was rendered moot by the demise of the Civil War income tax upon which it was based. Re-establishment of the income tax in 1913, however, led the court to reverse itself in 1918 and declare capital gains to be taxable income. Legal scholars have faulted the court's reasoning and said the decision to tax capital gains was based more on the government's revenue needs during World War I than constitutional principles.
A recent article in the Louisiana Law Review concluded, "in the early development of our capital gains tax structure, this country chose the wrong path ... an incorrect approach to the taxation of capital transactions, resulting in a needlessly complex taxation system." The reason why capital gains are not income in any meaningful sense is because the concept of income denotes a flow of something regularly recurring, such as wages. However, capital is by its nature a stock of something, and capital gains are always speculative and unpredictable.
Another problem with capital gains is that in most instances taxing capital gains is a double tax. For a bond, interest is already taxed. In the case of a share of corporate stock, capital gains only result from an increase in the flow of profits and dividends. Since profits and dividends are also taxed, the capital gains tax is in effect a third layer of taxation on the same income.
Unfortunately, these arguments are seldom made in favor of a lower capital gains tax. Historically, Congress has been more impressed by the negative impact of capital gains taxes on saving and investment.
Nevertheless, those favoring a lower rate would strengthen their hand by arguing it is a matter of principle, rather than expediency.
Bruce Bartlett is a senior fellow at the National Center for Policy Analysis.
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