The 1997 Budget Deal - What It Means to Taxpayers

Policy Backgrounders | Taxes

No. 144
Wednesday, February 04, 1998
by Bruce Bartlett

Capital Gains

Another key priority of Republicans in Congress was to cut the capital gains tax rate, a goal frustrated by strenuous Democratic opposition since 1989. Since 1986, the top rate had been 28 percent.11 President Clinton's commitment to support a reduction was viewed as a major victory for Republicans. The final legislation reduced the top tax rate on long-term capital gains realized after May 6, 1997, to 20 percent (10 percent for taxpayers in the 15 percent bracket). However, several important wrinkles were added.

"The top tax rate on capital gains was lowered, but assets must now be held for 18 months to get it."

First, assets must be held at least 18 months to obtain the 20 percent rate, whereas the minimum holding period for the 28 percent rate had been one year. Since gains from assets held less than 18 months will now be taxed at ordinary income rates that go as high as 39.6 percent, the tax rate may go up on gains from the sale of some assets.

Second, the legislation lowers the top rate to 18 percent on assets purchased after December 31, 2000, and held for more than five years. (For taxpayers in the 15 percent bracket, the top rate is 8 percent.) In addition, a taxpayer holding a capital asset used in a trade or business on January 1, 2001, may elect to treat that asset (for tax purposes) as though it had been sold on that date for its fair market value and reacquired for the same price.12

Third, a capital gain of up to $250,000 ($500,000 for couples filing jointly) on the sale of a principal residence is exempt from tax. This is not indexed for inflation.

Congress did not explain why holding periods were lengthened or why the new 18 percent rate does not take effect until 2001. One likely explanation for the longer holding periods is that Congress, possibly at the behest of the Treasury Department, was simply continuing a tradition. James Repetti of Boston College Law School traces the holding period tradition to a long-standing prejudice against speculation. Policymakers have feared that elimination of any holding period would increase volatility in the stock market.13 In recent years, there has also been a growing view that investors are too focused on short-term profits, making it more difficult for corporate CEOs to manage efficiently for the long term. Typical is the view of former Labor Secretary Robert Reich suggesting one way to "seek more patient capital":

Stockholders who took a longer view would be rewarded; speculators, penalized. Thus the capital gains tax rate they paid on selling their stock would depend on how long they retained it. On assets held for a year or less, the capital gains tax rate would be high (50 percent); on assets held for five years or more, the rate would be very low (10 percent).14

However, economic analysts generally have been critical of holding periods for capital gains. Economist Steven Kaplan found that even a short holding period greatly increases the lock-in effect; that is, it causes investors to hold assets they would otherwise sell. This results in inefficiency and reduced liquidity in financial markets because the holding period prevents people from buying and selling freely. Nor did Kaplan find that holding periods discouraged speculation.15 Repetti has argued that holding periods cause stock prices to vary from their fundamental values, resulting in a reduced benefit for society. He wrote that holding periods decrease the supply of securities by encouraging investors to hold when real economic factors would dictate a sale.16

Economic analysts also have been critical of the benefits of encouraging "patient capital." There may be a public policy reason to encourage the production of long-term assets to overcome the effects of other bad policies. But once the assets exist, economists find no good reason to care how long any particular person holds them. Indeed, holding requirements make the assets less valuable to an owner.17

"Once assets exist, there is no good reason to care how long any particular person holds them"

Simply requiring people to hold financial assets longer does not increase investments in long-lived tangible capital. Nor is encouraging long-term investment good per se. For example, in the early 1980s investors increased their investments in structures, the most long-lived class of assets, which turned out to be a bad thing. These investments were not justified by good business fundamentals but were encouraged by certain features of the tax and banking laws. Eventually, many of the investors went bankrupt or defaulted on loans, at great cost to the taxpayer. By contrast, in recent years there has been an upsurge of investments in short-lived assets such as computers. Yet no one has argued that this is a bad thing for the economy.

The goal of tax policy should be to raise revenue while affecting economic decision making as little as possible. A tax that had no effect on behavior would be neutral. Although absolute neutrality is impossible, tax policy should be as neutral as possible.

On the Congressional timing of the capital gains provisions, one can only speculate. By applying the new 18 percent (and 8 percent) capital gains rate to assets acquired after December 31, 2000, Congress ensured that there would be a bump in capital gains realizations in 2001. Many investors will want to realize their gains in 2001 and repurchase the assets, hoping that future gains will be taxed at a lower rate. This will give the Treasury a revenue windfall of about $1.5 billion to help balance the federal budget.18

Finally, exempting up to $500,000 in gains on home sales every two years should greatly simplify the tax law at a relatively small cost in revenue. At present, all gains are exempt only if the seller buys another principal residence of equal or greater value within two years. Moreover, a one-time exemption of $125,000 applies to those over age 55. The new law eliminates both of these provisions.

"Exempting up to $500,000 in gains on home sales every two years should greatly simplify the tax law."

The tax exemption for gains on home sales is one of the smaller provisions of the tax bill, but one that may be more significant for many taxpayers than they realize. Previous law encouraged homeowners to buy ever more expensive houses even when they would have preferred something smaller and less expensive. This may have contributed to housing price inflation and reduced availability of moderately priced housing. To make matters worse, much of the burden of the tax fell on those in distressed situations - people forced to sell a home due to divorce, job loss or other family crisis. In addition, previous law often made it difficult for people to use the rollover provision when they moved from areas of the country with expensive housing to less expensive areas.19

In summary, the capital gains provisions of the Taxpayer Relief Act simplified and complicated the Tax Code at the same time. Investors will welcome the lower rates, and this may encourage some additional saving and investment.20 However, there is little justification for extending holding periods, which may offset some of the efficiency gains from lower rates. The home sale provision is a gain for simplification, but the lack of indexing could reduce the value of the exemption sharply in coming years.

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