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

Was the 2003 Capital Gains Tax Cut “Fair”?

For nearly three decades, the so-called tax fairness issue has dominated the capital gains tax debate.  Who are the winners and who are the losers from a capital gains tax cut?  Every new analysis seems to provide a different answer to that question.

For example, when President Bush proposed the reduction in the capital gains rate in 2003, his critics argued that about 60 percent of the tax break would go to the richest 1 percent of Americans.  But if we start by looking at the impact of the investment tax cut as a whole, we find that the share of taxes paid by the richest 1 percent and 5 percent of Americans actually increased after the tax cuts were enacted [see Table VI].  In 2005, the percentage of income taxes (which includes dividends and capital gains) paid by the richest 1 percent hit an all-time high of 39 percent.  The top 5 percent paid nearly 60 percent of the income tax, close to an all-time record.

Thus, the 2003 tax cuts continued the trend of the 1990s of increasing the share of income taxes paid by the wealthiest taxpayers [see Figure VII].

“The share of taxes paid by the rich has risen.”

Examining just the taxes on capital gains, one finds that although the wealthy pay the most in capital gains taxes, millions of middle-income Americans claim capital gains on their tax returns as well.  In fact, 2005 Internal Revenue Service data indicate that 47 percent of all returns reporting capital gains were from households with incomes below $50,000 [see Figure VIII].  Seventy-nine percent of all returns reporting capital gains were for households with incomes below $100,000 and half had incomes below $50,000.22 Moreover, these tax return data overstate the income status of those with capital gains, since these sales of assets are often irregular or even once-in-a-lifetime events.  For example, when someone sells a home or ranch, the income from the sale may be $1 million, but the seller may have never earned more than $50,000 in his working life.  He appears “rich” in the income statistics because of the cash from the one-time sale.

In the public finance literature, that is called “bunching.”  Minarik of the Urban Institute writes:

The bunching problem arises when a taxpayer realizes a long-term gain relative to his average income.  Such a taxpayer bears a far higher liability on that gain upon realization than he would under accrual taxation or a proration or averaging provision.23

“Nearly four-fifths of households reporting capital gains have incomes less than $100,000 and half have incomes below $50,000.”

Studies have found that the bunching problem creates an illusion that capital gains taxpayers are wealthier than they are in reality.  A more meaningful measure of income, for the purposes of examining the equity effects of capital gains taxes, is “recurring income” — that is, income received on a regular or recurring basis.  When income tax data excluding income from capital gains are examined, the share of capital gains income appears to be much more evenly distributed.  In 1985 only one-quarter of all capital gains were realized by those with incomes above $200,000, excluding the capital gains income.  Forty-five percent of the gains went to Americans with non-capital-gains incomes below $50,000.

Until recently, the bunching problem had long been recognized by policymakers and tax experts as a convincing justification for a capital gains differential.  A 1923 House of Representatives report on capital gains taxes identified the full taxation of capital gains as “an injustice to the taxpayer, in that an investment frequently accumulated over a period of many years was . . . arbitrarily attributed to the year the sale took place.”24 The introduction of a differential tax rate for capital gains three-quarters of a century ago was heralded as a victory for tax fairness.  Similarly, in 1982 the CBO argued that one rationale for the then-60 percent exclusion of long-term capital gains was “to reduce the burden on a taxpayer that occurs when a capital gain accruing over several years is realized, requiring the taxpayer to pay tax at progressive rates on several years’ income all in one year.”25

“High capital gains taxes punish the elderly, not the rich.”

Bunching is most common among people entering retirement.  A large percentage of capital gains beneficiaries are the elderly, who wind up selling a family business or a portfolio of stock that has accumulated over the individual’s working life and is meant to serve as a nest egg for retirement.  The elderly are two and a half times more likely to realize capital gains in a given year than are tax filers under the age of 65.  The elderly are also likely to derive a larger share of their income from capital gains than are younger workers.  A study by the National Center for Policy Analysis examining IRS data from 1986 found that the average elderly tax filer had an income of $31,865, 23 percent of which was capital gains.  The average nonelderly filer had an income of $26,199, 9 percent of which was from capital gains.26 Hence, the high capital gains tax rates punish the elderly, not the rich.  The high tax rate is also a severe penalty against couples who have frugally saved during their working years to sustain themselves during retirement.

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