One group of economists fingered the capital gains tax as a key problem area because it had especially pernicious effects on entrepreneurship and risk-taking. Historically, the tax on long-term capital gains had been fixed at 25 percent. But in 1969, congressional liberals raised the rate to 35 percent in order to soak the rich, who realize most capital gains. The result was that venture capital virtually dried up and it was much more difficult to get financing for new business start-ups.
In 1978, a bipartisan effort was made in Congress to cut the capital gains rate back to 25 percent. The problem was that static scoring showed this to be a big revenue loser because it was assumed that the same amount of gains would be realized, only taxed at a lower rate. But one does not need to be a professional economist to see that when you cut the price of something, sales will probably rise.
Advocates of cutting the capital gains rate, including Harvard economist Martin Feldstein, argued that it would produce an unlocking effect that would cause many more gains on old investments to be realized. This would both raise federal revenue and create a pool of capital that would be reinvested in new businesses and industries, thus spurring growth.
After Congress cut the capital gains tax in 1978, the Treasury Department studied the impact and concluded that the tax cut had indeed raised federal revenue. There was also a huge jump in venture capital financing that many economists credit for starting the high-tech revolution we have seen over the last 25 years.
Subsequently, many so-called supply-side economists argued that there were other types of tax cuts that might also pay for themselves and those that would do so partially, thus reducing the actual revenue loss below those in official estimates. Few economists today would disagree with the statement that an across the board tax rate reduction would have reflows of about 35 percent. That is, static revenue loss estimates are 35 percent too high. (Similarly, revenue gains from tax rate increases would tend to be 35 percent too high.)
This is a long way from saying that all tax cuts will pay for themselves, as some overly exuberant conservatives sometimes argue. In any case, if a few extra dollars will improve Treasury’s tax analysis, it is all to the good.