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

Policy Reports | Taxes

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

Did the 2003 Tax Cut Increase the Budget Deficit?

“Tax cuts encourage revenue-increasing activity.”

The impact of a capital gains tax cut on federal revenue collections has long been an issue of contentious debate — both in the academic literature and in public policy circles.  In the current era of emphasis — at least rhetorical emphasis — in Washington on maintaining a surplus and paying down debt, it is predictable that the budgetary effect of capital gains tax changes would dominate public discussion.

In theory, a capital gains tax cut would create several countervailing positive and negative revenue effects.  The revenue-losing effects are:

  1. A static revenue loss from asset sales that would have occurred without the tax cut but benefit from the lower rate;
  2. A reduction in trading in anticipation of changes in the tax rate, as was witnessed in 1986; and
  3. A paper shifting of reported income from ordinary sources — such as wages taxed at the “normal” rate — to capital gains income with lower rates.

The revenue-gaining effects are:

  1. A short-term unlocking of assets that would not have been sold otherwise (and might never have been sold, but instead bequeathed at death);
  2. An increase in reporting of income (that is, less tax evasion);11
  3. An increase in the value of stock and other capital assets traded over the long run; and
  4. An increase in long-term economic growth from the higher capital formation, which would raise tax collections from income taxes, payroll taxes and other sources.

“Germany, Switzerland and many other countries do not tax capital gains at all.”

The issue is: Which effects dominate — the revenue-losing ones or the revenue-gaining ones?  Unfortunately, there is no consensus answer to that question in the academic literature and the economic modeling forecasts.

Regression analysis has validated statistically that the 1969 rate increase lost revenue, the 1978, 1981 and 1997 rate reductions gained revenue, and the 1986 rate hike lost revenue.12 But the idea that lower rates generated higher revenues is by no means universally accepted.  A time-series regression analysis by Urban Institute economist Joseph Minarik contradicts the favorable assessment of the 1978 and 1981 tax cuts.  According to Minarik,

The 1978 law experience gives no backing to claims of an ongoing revenue pickup [from the tax cut]... The 1981 capital gains tax cut was a revenue loser from day one.  The heart of the issue is revenue.  And here there is no doubt.13

“If rates return to 20 percent, the United States will have higher capital gains taxes than most developed countries.”

“Government revenues rose after every capital gains tax cut of the last 30 years.”

The only truly reliable predictor of the future is the past.  And here the evidence is fairly straightforward.  Over the past 30 years a consistent pattern has emerged:  every time the capital gains tax has been cut, capital gains tax revenues have risen.  Every time the capital gains tax has been raised, capital gains tax revenues have fallen.  Here are some prominent examples:

  • In 1968, real capital gains tax receipts were $34 billion at a 25 percent tax rate.  Over the next eight years the tax rate was raised four times, to a high of 35 percent.  Yet with the tax rate almost 10 percentage points higher in 1972 than in 1968, real capital gains tax revenues were only $27 billion — 21 percent below the 1968 level.
  • In 1978, when the top marginal tax rate was 35 percent, $28 billion in capital gains taxes were collected.  By 1984, after the tax had been cut to 20 percent, revenues from the lower tax rate were $41 billion — 46 percent above the 1978 level.
  • In 1986, the tax rate increased by 40 percent, from 20 to 28 percent.  Did tax revenues climb by 40 percent?  Just the opposite occurred.  In 1990, the federal government took in 13 percent less revenue at the 28 percent rate than it did in 1985 at the 20 percent rate.  In 1991 (and again in 1992), the government collected more than 15 percent less revenue than it did in 1985.
  • In 1996, the year before the capital gains tax rate was cut from 28 to 20 percent, net capital gains on assets sold were roughly $335 billion. A year later, capital gains had leapt to $459 billion.  (The tax cut was retroactive to May 1997.)  In 1996 the Treasury collected roughly $85 billion in capital gains revenues.  In 1997 those tax payments soared to $100 billion.  As Table V shows, capital gains revenues for the period from 1997 to 2000 were nearly double what they were during the preceding period.14
  • After the 2003 capital gains tax cut, federal revenues increased in four years by $740 billion.  The budget deficit fell from $401 billion in 2004 to $160 billion in 2007.  Capital gains revenues increased from $55 billion in 2002 to an estimated $110 billion for 2006.  Every indicator shows that the 2003 investment tax cuts helped increase growth, stock market values and federal tax receipts.15


 Capital Gains Realizations and Tax Rates

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