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

How the Capital Gains Tax Is Unlike Other Taxes

The capital gains tax is different from almost all other forms of federal taxation in that it is a voluntary tax.  Since the tax is paid only when an asset is sold, taxpayers can legally avoid payment by holding on to their assets — a phenomenon known as the “lock-in effect.”  Today there are still trillions of dollars in unrealized capital gains that have not been taxed.  Over the past 40 years, the appreciation of capital assets has outpaced realized capital gains 40-fold.  That suggests that a capital gains tax reduction could potentially “unlock” hundreds of billions of dollars in stored-up wealth.1

There are many unfair features in the current tax treatment of capital gains.  One is that capital gains are not indexed for inflation:  the seller pays tax not only on the real gain in purchasing power, but also on the illusory gain attributable to inflation.  The inflation penalty is one reason that, historically, capital gains have been taxed at lower rates than ordinary income.  In fact, Princeton University economist Alan Blinder, a former member of the Federal Reserve Board, noted in 1980 that up until that time, “most capital gains were not gains of real purchasing power at all, but simply represented the maintenance of principal in an inflationary world.”2

“Taxes on capital gains are a minor source of federal revenue.”

Another inequity of the tax is that individuals are permitted to deduct only a portion of the capital losses they incur, whereas they must pay taxes on all of the gains.  That introduces an unfriendly bias in the tax code against risk-taking.3 When taxpayers undertake risky investments, the government fully taxes any gains realized if the investment has a positive return.  But the government allows only a partial tax deduction (of up to $3,000 per year) if the venture goes sour and results in a loss.

At least one other large inequity of the capital gains tax is that it represents a form of double taxation on capital formation.  This is how economists Victor Canto and Harvey Hirschorn explain the situation:

A government can choose to tax either the value of an asset or its yield, but it should not tax both.  Capital gains are literally the appreciation in the value of an existing asset.  Any appreciation reflects merely an increase in the aftertax rate of return on the asset.  The taxes implicit in the asset’s aftertax earnings are already fully reflected in the asset’s price or change in price.  Any additional tax is strictly double taxation.4

“Some state capital gains taxes add more than 50 percent to the federal tax.”

Take, for example, the capital gains tax paid on pharmaceutical stock.  The value of that stock is based on the discounted present value of all the company’s future proceeds.  If the company is expected to earn $100,000 a year for the next 20 years, the sales price of the stock will reflect those returns.  The “gain” that the seller realizes from the stock’s sale will reflect those future returns, causing the seller to pay capital gains tax on the future stream of income.  But the company’s future $100,000 annual returns will also be taxed when they are earned.  So the $100,000 in profits is taxed twice — when the owners sell their shares of stock and when the company actually earns the income.  That is why many tax analysts argue that the most equitable rate of tax on capital gains is zero.5

In addition to the federal tax levy on capital gains, many states impose their own capital gains tax (see Table II).  In California, Iowa and New Jersey, the combined federal-state capital gains rate can reach around 24 percent.

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