The Bush administration appears to be shying away from it, but many analysts believe that cutting the capital gains tax is the best thing Congress can do to aid the economy quickly.
Although the argument in favor of it is sometimes overstated by those for whom cutting the capital gains tax has become virtual dogma, the evidence supports the idea that it would help the stock market and the economy as a whole.
In the long run, there is no question that lowering the cost of capital by lowering the capital gains tax will increase economic growth above what would otherwise be the case. But there is a legitimate question as to what the short-run impact would be. Former Treasury Secretary Bob Rubin, for example, has said that it would increase selling pressure and push the stock market down further.
Rubin's analysis is based on the well-documented "lock-in" effect of the capital gains tax. For decades, economists have known that it discourages investors from selling assets that have appreciated in value. Since taxes are paid only when gains are realized, investors have the option of deciding when to realize such gains, and hence when they will incur a tax liability.
If the capital gains tax were cut, therefore, then many people will sell assets they would not otherwise have sold. The result will be a short burst of selling as people realize gains that may have accrued over many years. Obviously, such selling will put downward pressure on the stock market.
Offsetting this effect, however, are two others that theoretically will cause asset prices to rise. First, to the extent that the capital gains tax is capitalized into asset prices, a reduction in this tax should cause all asset prices to rise. Second, as people realize gains, they must reinvest them in new assets. As capital is reallocated from assets with past appreciation, but poor prospects for the future, into assets with greater capital appreciation potential, the market as a whole should rise.
The academic literature shows clearly that a cut in the capital gains tax increases trading volume in the stock market. Empirical studies of the 1978 capital gains tax cut and the 1986 tax increase confirm this. However, whether cutting the capital gains tax will cause the stock market to rise and over what time period has not definitively been answered.
One problem that you run into in trying to correlate stock prices with tax changes is figuring out when the impact becomes capitalized. Since markets are forward-looking, it is not enough to just look at prices before and after the new tax law.
Expectations of a lower capital gains tax should cause prices to rise long before the effective date.
The 1978 capital gains tax cut, which lowered the top rate from 49 percent to 35 percent, shows a big jump in the stock market when the legislation was introduced with strong bipartisan support, and another jump when approved by the House and Senate.
However, by the time Jimmy Carter signed it into law, the market had given up all its gains.
At the time, economist Michael Evans was on record as saying the capital gains tax cut would cause the S&P 500 index to rise by 40 percent by the end of 1982. This forecast was considered far outside the realm of respectable opinion and was dismissed by most economists. But in the end, Evans was right on the money. The S&P 500 index rose 45 percent between the end of 1978 and the end of 1982.
More recently, a study of the 1997 capital gains tax cut, which lowered the top rate from 28 percent to 20 percent, by University of North Carolina economists Mark Lang and Douglas Shackelford, found that it raised stock prices significantly as soon as it became clear that Congress and the White House had reached a deal on taxes. Stocks not paying dividends tended to gain at the expense of those with dividends, which is consistent with the theory that those who invest for capital gains buy riskier stocks than those who invest for income.
Of course, it goes without saying that stock prices react to many things other than changes in tax policy. Nevertheless, there is good reason to believe that cutting the capital gains tax will have a positive impact on stock prices. This does not mean that the federal government ought consciously to aim policy at higher stock prices. But given the beating that investors have suffered in recent days, the growth of stock ownership among the middle class, and the importance of a strong capital market to investment and growth in the U.S. economy, anything positive the government can do that would also have the effect of raising stock prices is definitely something worth doing.