Following his Waco economic conference, President Bush told
reporters about several tax initiatives that he may soon propose to aid
beleaguered investors. Although he did not specifically mention cutting the
capital gains tax rate, it is almost certain that some action in this area
will be included. Final decisions have not been made, but a final proposal
is expected soon after Sept. 11.
I hope that the administration will avoid making purely
pragmatic arguments for cutting the capital gains tax, which should be cut.
While such arguments worked in 1978, they have been much less successful
since. What is desperately needed is a principled case for why capital gains
should not be taxed at all.
While it may seem commonsensical that capital gains are a form
of income just like any other, in fact this is not the case. As the great
economist Irving Fisher once explained, it confuses the fruit and the tree.
Trees grow and they also produce fruit. The fruit is income and is justly
taxed. But growth of the tree is an increase in capital. More capital will
produce more income in the future, which will be taxed, but taxing the
capital itself is counterproductive.
We already tax income very heavily. This includes taxes on
wages, rent, dividends and interest. Alternatively, we could say that we are
taxing the returns to human capital, real estate, corporate stock and
saving. Since we do not tax increases in the stock of human capital, such as
when someone acquires new skills or education, taxing wages is a single tax.
But if we tax increases in the value of real estate, stock or bonds, while
also taxing rent, dividends and interest, then it is a double tax.
As Fisher would say, we are taxing the tree and the fruit, when
we should only be taxing one or the other. Taxing capital gains is like
chopping limbs off of trees. We only end up with less fruit in the future.
Not taxing capital gains -- not chopping limbs -- would allow the tree to
grow, which will produce more fruit in the future and increase government's
take of it.
Therefore, in principle, capital gains should not be taxed at
all. Capital gains are not income, except in the minds of those incapable of
complex thought. The present 20 percent maximum tax rate on capital gains,
while the top rate on wages is more than twice that, is not a preference or
giveaway, but the mitigation of something that is wrong in the first place.
Viewed in this light -- a position once held by the U.S. Supreme
Court in the case of Gray vs. Darlington (1872) -- cutting the capital gains
tax is simply the redress of an illegitimate form of taxation.
This is not to say that cutting the capital gains tax will not
also have beneficial economic effects. Indeed, the experience of the 1969
and 1986 increases in the capital gains tax, and the 1978, 1981 and 1997
reductions, strongly suggests that capital gains realizations will expand by
more than enough to actually raise federal revenue.
According to the Treasury Department, there is almost an exact
inverse relationship between the long-term capital gains tax rate and
realizations as a share of the gross domestic product. When the rate goes
up, realizations go down. When the rate goes down, realizations go up.
Generally speaking, the magnitudes are such that the government makes money
when the rate is cut and loses money when it is increased.
Ironically, the principal argument against cutting the capital
gains tax is that it will primarily benefit the rich. But if revenues are
rising, how can this be the case? The answer is that revenue estimators
assume that the same assets would have been sold anyway at the higher tax
rate. No matter how much evidence is presented to the contrary, they refuse
to acknowledge that higher taxes on the rich are in fact higher taxes on the
rich. Somehow, they always make it look like a tax cut.
Among those most consistent in their belief that capital gains
taxes are wrong in principle is Federal Reserve Board Chairman Alan
Greenspan, who has said so on many occasions. "I've always been supportive
of either lowering the capital gains tax or preferably eliminating it
completely," Greenspan told the Senate Banking Committee a few years ago.
"There's no question in my mind that a capital gains tax cut would be
helpful with respect to the issue of property values and economic growth,"
Given current economic and financial conditions, the latter
point undoubtedly means more to most people than the theoretically correct
approach to capital gains taxation. President Bush should not be shy about
making BOTH arguments.