Capital Gains: Not Now

There are several excellent reasons for changing the federal capital-gains tax, but President Bush’s proposal to cut the rate to 15% is not necessarily the best way and now is certainly not the proper time. About the only certain thing the reduction would achieve is a tax break for the wealthiest Americans, those with incomes of $200,000 or more, without any guarantee that it would achieve the goal of spurring investment.

Adopting a supply-side argument, Bush contends that the cut actually would result in added revenue to the U.S. Treasury, by generating new economic activity that would be taxed at regular income rates. But other experts vehemently disagree. The Congressional Joint Committee on Taxation says revenue would increase in the first year and drop $13.3 billion over the next five years. Even Treasury Department projections indicate that any increase in tax revenue would turn to a loss several years into the program, with the red ink increasing to $11 billion or more by 1996. Many economists doubt that the program, as revised and limited by Bush for political expediency, would boost investment much. Given the doubts, the odds that the tax reduction would only add to the federal budget deficit are too great at this point.

Another reason that carries considerable weight in Congress is that all of the provisions of the massive 1986 tax-reform program finally have gone into effect--just weeks ago, in fact. This is not the time to begin tinkering with the tax system again, especially in a way that favors only the rich. The new capital-gains system, after all, was part of a deal designed to provide more equity in the tax structure and to do away with tax shelters that distorted the way people made investments. In exchange for the new lower personal income-tax rates, the wealthy were required to give up something. Part of the something was the preferential treatment for capital gains.

Until 1986 the maximum effective tax on capital gains held for at least six months was 20%. Now, capital holdings such as stocks can be sold at anytime and the net increase in value is taxed just like all personal income, generally at a maximum rate of 28%.

In the Treasury Department’s tax-reform program of 1984, department experts noted that one justification for the lower capital-gains rate then in effect was to compensate for the tendency to overtax capital gains because of inflation. The Treasury plan proposed that capital gains be indexed for inflation and then taxed as ordinary income. Thus, the seller of the property would pay a higher tax rate, but only on its real value, not at a higher imaginary value created by inflation. Congress went through with only half the plan, however: The tax rate was raised but capital gains still are not indexed for inflation.

Indexing, of course, would cost the Treasury revenue. But that might be offset by another reform promoted by a number of economists: the taxing of capital gains at the death of the holder. Under the existing system, when the inheritor sells the property, he pays taxes on the capital gain accruing only from the point of the inheritance. The amount of gain realized during the possession of the dead person goes untaxed.

Another possible revision with greater popular appeal--one that would benefit lower and middle-income taxpayers, as well--would be the elimination of the capital gains on home sales. And some officials like the idea of granting the lower capital gains rate to those willing to invest in high-risk ventures, the sort of new businesses that economists say the country needs to be competitive with other nations. This, however, could trigger a new rush to tax shelters. A major goal of the 1986 law was to eliminate shelters.

Congress has already seen enough of the Bush plan to be of two minds about what it would mean to the federal budget. Rep. Dan Rostenkowski (D-Ill.), chairman of the House Ways and Means Committee, says the potential for revenue loss will make the plan hard for members to swallow. Sen. Lloyd Bentsen (D-Tex.), chairman of the Senate Finance Committee, agrees that the prospect of lost revenue would be a problem, but he puts less stock in the congressional estimate than does Rostenkowski. The Bush approach is worth considering, but only as part of a more general reform of the capital-gains tax system, and only with assurance that the economic effects will benefit a majority of Americans.