The Bush Capital Gains Tax Cut after Four Years: More Growth, More Investment, More Revenues

Studies | Taxes

No. 307
Thursday, January 10, 2008
by Stephen Moore and Tyler Grimm


Executive Summary

In May 2003, President George W. Bush signed into law his investment tax cut.  This package included accelerated reductions in income tax rates, a cut in the dividend tax from 39.6 percent to 15 percent and a reduction in the capital gains tax from 20 percent to 15 percent.  The purpose of the Bush tax cut was to provide an incentive for more domestic capital investment, more business spending and a turnaround in the stock market, which lost $6 trillion in value after the technology bubble burst in 1999-2000.  The terrorist attacks of September 11, 2001, caused a further plunge in the stock market, a drought of business investment and job layoffs.  Bush declared that a change in fiscal policy — particularly tax policy — was necessary to stimulate a fragile economy and avert a long and deep recession similar to what the United States experienced in the late 1970s and early 1980s.

This study examines how the economy has responded to this investment tax stimulus, with special emphasis on the reduction in the tax on capital gains (income from the sale of an investment).  It also examines the historical evidence of how the economy has responded to changes in the capital gains tax rate.  It concludes that the lower capital gains tax rate has had positive effects on the economy and government finances.  The most important of these effects are as follows:

  • The rate of business capital investment has undergone a U-turn — from negative business investment spending in the two years before the tax cut to an average annual increase in business investment of more than 10 percent in the three years after the tax cut.
  • Contrary to forecasts of revenue decline, federal revenues overall and from the capital gains tax increased in the four years since the investment tax cuts.  Total federal revenues increased $740 billion (2003-07), and capital gains tax revenues increased from $55 billion the year before the tax cut (2002) to an estimated $110 billion in 2006 (all figures adjusted for inflation to constant 2006 dollars).
  • There was a sizable “unlocking effect” from the lower tax rate, meaning that investors voluntarily sold stock and other assets at a much higher volume once the tax rate was reduced.  The amount of capital gains realizations more than doubled, from $301 billion in 2002 to an estimated $683 billion in 2006.
  • The rich did not get a huge tax cut from the capital gains cut; in fact, the percentage of income taxes paid by the rich increased from 34 percent to 39 percent from 2002 to 2005 (the most recent year for which data are available).
  • The capital gains tax cut did not only benefit wealthy Americans; more than half of all tax filers with capital gains had incomes of less than $50,000 in 2005 and more than two-thirds had incomes of less than $100,000.

These findings validate the Bush Administration’s original case for the investment tax cut, particularly the reduction in the rate of tax on capital gains. These tax cuts are scheduled to expire after 2010. This would mean that the capital gains tax would rise from 15 percent to 20 percent and the dividend tax from 15 percent to 39.6 percent or higher. Two of the major Democratic presidential candidates, Barack Obama and John Edwards, have suggested raising the capital gains tax rate all the way to 28 percent — higher than the rate when Bill Clinton left office.  This analysis suggests that raising the capital gains tax rate would have negative effects on the U.S. economy and on the federal budget deficit in both the short term and long term.

We conclude that it is not only critical that Congress extend the life of the tax cuts by making them permanent, but also that it do so sooner rather than later, to help boost the economy now and to reduce the growth-dampening effects of economic and fiscal policy uncertainty.


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