March 3, 1989
"Plan is an Unfair Revenue-loser"
San Jose Mercury News
By Timothy Taylor
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GEORGE Bush's proposal to lower the capital gains tax rate is self-contradictory. Half of it is an incentive to sell capital assets more often, and half is an incentive to sell them less often.

The first half, cutting the top tax rate on capital gains from 33 percent to 15 percent, is supposed to reduce what economists call the "lock-in" effect. You see, a capital gain (like when a stock increases in price) is only taxed when the asset is actually sold.

Thus, if the capital gains tax rate were reduced, there are bound to be some investors who didn't want to sell if taxed at 33 percent, but who would be willing to sell if taxed at 15 percent. Bush believes that the lower tax rate will "unlock" so many investors that their greater volume of stock trading will more than compensate for the reduced tax rate, and government revenues will increase.

The second half of Bush's proposal, though, restricts the tax break to those who have held their stock for at least a year, for starters. By 1994, investors will have to hold stock for three years to get the lower capital gains rate. This provision is intended to encourage patient, long-term investment; in other words, it creates a new lock-in effect.

The revenue effect of this self-contradictory plan should be minimal. The Bush administration estimates that reducing the lock-in effect would gain $3 billion a year. On the other hand, the non-partisan Congressional Budget Office agrees that lower tax rates "unlock" some investors, but doesn't believe the increase in trading will be large enough to offset the lower tax rate. The CBO predicts that Bush's plan will lose a few billion dollars a year.

But a tax break for capital gains is likely to lose revenue for a major reason not addressed by these studies: It is an open invitation for the wealthy to find clever ways to transform ordinary income into capital income, so it can be taxed at the lower capital gains rate.

The top 1 percent of the income distribution receives about 55 percent of all capital gains; these people can hire a lot of high-priced tax wheeler-dealers. The Tax Reform Act of 1986 tried to make this sort of finagling obsolete by eliminating any special break for capital gains income. A lower capital gains tax rate, by providing a juicy reward for legal tax avoidance, would cost the government billions of dollars in lower revenue and higher enforcement costs. The other attractive, fallacious promise of a lower capital gains tax rate, besides higher government revenue, is that it will encourage venture capital, new investment and economic growth. For example, it is an article of faith in the high-tech community that the 1978 and 1981 cuts in capital gains tax rates were the most important cause of the boom in venture capital that started around that time, and thus a source of lifeblood for the Silicon Valley.

The facts are not kind to this myth. Private venture capital firms have raised $19.3 billion since 1979, according to the Venture Capital Journal. A full 60 percent of that total came from pension funds, foreign investors and foundations, none of which was affected by the capital gains tax cut because none of them pays federal income tax. Clearly, most venture capital money has been invested for high returns, not tax breaks.

In addition, if the capital gains tax break is vital to venture capital, then venture capital should have declined sharply when the Tax Reform Act eliminated the capital gains tax break in 1986. Instead, 1987 was the best year ever for raising new venture capital, and preliminary 1988 estimates look nearly as good.

The capital gains tax break performs no better as a prod to overall investment. In 1978, when capital gains tax rates were cut from 49 percent to 28 percent, new U.S. private investment (adjusted for inflation) was $253 billion. Despite the lower capital gains tax rate, investment fell sharply after that to a low of just $64 billion at the pit of the 1982 recession. Investment has climbed slowly since then, getting back to about $245 billion in 1988.

Investment has lagged in the 1980s because the United States has a low private savings rate and huge government budget deficits. Because a capital gains tax break doesn't increase savings, it won't help investment much.

Carefully targeted tax breaks sometimes make sense; tax credits for research and development or for employee incentive stock options are two examples. But Bush's capital gains plan just encourages investors to sell capital assets soon after the asset's third birthday, regardless of the underlying economic value of the investment.

The new rules would create some fun for the tax lawyers, but they won't do anything for the rest of the economy.

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