Why the Capital Gains Tax Rate Should Be Zero

Policy Reports | Taxes

No. 245
Friday, August 31, 2001
by Bruce Bartlett

Executive Summary

Proponents of cutting the capital gains tax rate cite economic studies showing increases in economic growth and realizations of gains, and even higher revenue for government. Opponents argue that a capital gains tax cut is unfair because it only benefits the rich. But neither side argues from a position of principle. The real question is: Are gains in the value of assets income like any other form of income - such as wages, dividends, rent and interest? Or are they not income?

For most of American history, the question was moot, because the definition of income is important only if income is taxed. However, during the Civil War, Congress instituted an income tax and the question of taxing capital gains arose. In the case of Gray v. Darlington, the U.S. Supreme Court ruled that capital gains are not income:

The advance in the value of property during a series of years can, in no sense, be considered the gains, profits, or income of any particular year of the series, although the entire amount of the advance be at one time turned into money by sale of the property.... It constitutes and can be treated merely as increase of capital.

Even after the 16th Amendment authorized an income tax, several Supreme Court decisions indicated that capital gains are not income.

  • In Lynch vs. Turrish, 1918, the Court ruled that realizing a capital gain did not constitute income. "Indeed," the Court said, "the case decides that such advance in value is not income at all, but merely increase of capital and not subject to tax."
  • And in Eisner vs. Macomber, it ruled stock dividends were not taxable income, holding that "Enrichment through increase in value of capital investment is not income in any proper meaning of the term."

But then, in a series of decisions beginning in 1921, the Court stated definitively that capital gains are taxable as income. Since capital losses were fully deductible against gains, taxation of capital gains netted little revenue for the federal government, and may even have lost it money. Because income tax rates were so high, up to 73 percent in 1921, there was a lock-in effect as investors held on to appreciating assets until they had losses to offset the income tax. So in 1921 Congress created a preferential tax rate on capital gains of 12.5 percent.

Since then, the debate has centered mainly on whether or not capital gains should be taxed as ordinary income. Proponents of this approach depend primarily on the definition of income developed by economists Robert M. Haig and Henry Simons, which defines income as all consumption during the course of a year plus the change in net worth.

The Haig-Simons definition of income implicitly supports the double taxation of capital. Capital gains only arise in the case of an income-producing asset (with the exception of collectibles). Thus an asset's value is simply the discounted present value of the future flow of income (rent, interest or dividends) associated with it. Taxing both the income stream from a capital asset, and the value of the underlying asset, is taxing the same income twice.

The Haig-Simons definition of income is an ideological opinion supporting a more egalitarian society. It ignores the crucial distinction between capital and the income produced by it. Furthermore, it suggests gains should be taxed as they accrue, whether or not the asset is actually sold! However, Haig-Simons supports the full deductibility of losses in capital value, and the adjustment of capital gains for inflation. If these two adjustments were allowed, most capital gains would disappear.

  • Indeed, from 1917 to 1921, when capital losses were fully deductible from ordinary income, the federal government had negative revenue from the capital gains tax.
  • Economist Robert Eisner found there were no real capital gains whatsoever from 1946 to 1977.
  • After adjusting for inflation, households suffered a real loss of $321 billion on nominal capital gains of $3 trillion during this period.

Insofar as a reduction in the capital gains tax is a move toward ultimate exclusion of capital gains from taxable income, it is welcome. But supporters of a lower rate would greatly strengthen their case if they argued that capital gains should not be taxed at all as a matter of principle.

Read Article as PDF