A principled case for capital gains tax cuts

Posted: Sep 05, 2002 12:00 AM
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," he added. 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.