Diana Furchtgott-Roth
Resident Fellow, American Enterprise Institute Member
Advisory Board, Independent Women's Forum

Testimony before the
Senate Committee on Agriculture, Nutrition, and Forestry

February 26, 1997

Mr. Chairman and Senators of the Agriculture Committee, I am Diana Furchtgott-Roth, a resident fellow at the American Enterprise Institute. Thank you for the opportunity to testify before you on the subject of the economic effects of lowering capital gains taxes. The concept of "capital gains" is quite simple. A net capital gain is realized when an asset is sold for more than its purchase price, and a net capital loss occurs when an asset is sold for less than the purchase price. Long-term gains and losses apply to assets held for more than a year, and short-term gains and losses apply to assets held for less than that period.

The concept of a tax on capital gains is a little less straightforward. In the United States, most transactions are taxed by various combinations of Federal, state, and local tax authorities. For example, the purchase of a house in a given year is subject to state and local taxes; the sale of that same house at a higher price a year later could be subject to state and local taxes as well as a Federal tax on capital gains. This is not a tax on the transaction, nor on the value added of the house, but merely a tax on the appreciation of the asset.

Many countries do not tax capital gains. And among those countries that do tax such gains, U.S. rates are the highest in the world. In 1986 the U.S. raised the capital gains tax rate to even higher levels, with a 28 percent maximum rate. Since then, many proposals to reduce Federal capital gains tax rates have been discussed among academics, business leaders, and politicians. These proposals are wise, and their implementation is long overdue. In the appendix I present just a sample of the fertile academic record on capital gains taxes. A concise overview of the legal and academic issues is presented in a pamphlet entitled Tax Treatment of Capital Gains and Losses prepared by the Joint Committee on Taxation for hearings of the Senate Committee on Finance in February, 1995.

This testimony is divided into two major areas which are frequently examined by tax economists in reviewing any form of tax, namely efficiency and equity. I will begin with efficiency.

Efficiency

High capital gains taxes reduce economic efficiency in the following ways. First, high taxes cause "lock-in" effects, encouraging investors to hold assets even though they would prefer to sell them. Second, high taxes discourage risk taking, because the rewards for taking risks are taxed away, whereas taxpayers do not receive equivalent tax deductions for losses. Third, those factors depress prices of long-term assets. Finally, as a consequence of these effects, economic productivity is lower than it would be otherwise.

Lock-in Effects. Our current tax system places a high tax on long-held assets because no credit is given for inflationary gains. Hence, holders of such assets have little incentive to sell them. For example, consider a farm purchased in 1965 for $100,000 that could sell today for $300,000, a taxable gain of $200,000. In inflation-adjusted 1965 dollars, the value of the farm today is really just $75,000, a loss of 25 percent over the original purchase price. Yet, if this farmer chose to sell the family farm, he would pay the government about $56,000 in capital gains taxes. This adds tax insult to economic injury on a farm that has lost real economic value.

Should the farmer pass the farm on to his son at death, the son would owe no tax on his father's gains, real or inflationary. Estate taxes provide an additional incentive for older individuals to keep appreciated assets, even if these assets could be managed better in other hands. This state of affairs is highly inefficient because the tax system is imposing artificial costs on asset sales. The net result is to discourage investment in assets that can be expected to be held for a long time.

The effects of higher versus lower capital gains tax rates on the extent of capital gains realizations can be seen in Table 1. The increase in capital gains tax rates in 1987 led to extraordinary high rates of capital gains realizations in 1986, the last year of the low capital gains tax rate. The increase in the average effective tax rate, from 15 to approximately 22 percent, was accompanied by a decline in realized gains as a percent of GDP, as shown in the last column of the table. For the eight years from 1978 to 1985, realized gains as a percent of GDP averaged 3.1 percent, but for the eight years from 1987 to 1994 these gains averaged only 2.6 percent of GDP, a decline of about 20 percent.

Table 1 also shows that many capital gains are realized by taxpayers who are not in the highest tax bracket. Between 1987 and 1994, the highest capital gains tax rate was 39.6 percent for short-term gains and 28 percent for long-term gains. Yet, as is indicated by the third column of the table, the average effective capital gains tax rate never exceeded 23.9 percent. Evidence presented by Len Burman and Peter Ricoy at an AEI conference last summer provides further evidence that capital assets are held by taxpayers all across the income spectrum. It is well-known that 98 percent of families earning over $200,000 have capital gains assets (excluding their residences), but what is less-known is that almost one-third of families with incomes under $20,000 and over half of families with incomes from $20,000 to $50,000 have such assets.

Risk-taking. Capital gains are one of the primary rewards for economic risk-taking. Investors take risks by purchasing assets today with the hope and expectation that these assets may appreciate over time. If the asset appreciates, the investor has a capital gain. Otherwise, the investor has a capital loss. Capital gains taxes reduce the reward for risk-taking, thereby reducing incentives for investment and raising the cost of capital for borrowers. Moreover, the structure of the U.S. capital gains tax is asymmetric: gains without offsetting losses are taxed, but losses without offsetting gains provide little tax benefit.

Nowhere are the harmful effects of the capital gains tax more severely felt than in many of the new high technology sectors of the economy. For example, the assets of new start-up companies are pieces of paper without value today, but which may be worth more in the future. Under the Tax Reform Act of 1986, investors in partnerships were not allowed to deduct their losses against ordinary income and all investors had strict limits on the deductibility of losses. High capital gains taxes raise the costs of capital for all investment, but especially for start-up companies, entrepreneurs, and small-time investors who cannot balance losses against previous gains.

Indexation and International Comparisons. Under U.S. tax law, capital gains are not indexed for inflation. Thus, a nominal capital gain of $200,000 is taxed the same whether the original purchase was one year ago or over 20 years ago. As shown in the farm example above, a nominal $200,000 capital gain for a long-held asset may actually correspond to a real loss and a severe tax bias against these assets.

Many countries avoid the bias against long-held assets by indexing capital gains to an inflation rate. Effectively, the longer the asset is held, the smaller is the proportion of nominal capital gains that are taxed. Still other countries completely exempt long-term capital gains from taxation. Table 2 presents a comparison of capital gains tax rates for several major industrial countries. Of the 12 countries listed in Table 2, four (Belgium, Germany, Hong Kong, and the Netherlands) exempt long-term capital gains from taxation, and two (Australia and the United Kingdom) index capital gains for inflation. Of the remaining six countries with fixed rates, the U.S. rates are the highest.

Depressed Prices. All of the inefficiencies from a capital gains tax described above reduce the demand for investment goods, particularly those that are held for long periods of time. Individuals and businesses that might otherwise have invested in these goods have less incentive to do so. And those that do invest, since they are faced with tax-induced high capital costs, spend less on investment than they would otherwise. The net result is to depress artificially the prices of capital assets, whether farms, factories, or other capital goods.

Some economists argue that capital gains are relatively undertaxed due to the advantage provided by the longer holding period. Since capital gains are not taxed as they are accumulated, but at the point that the capital is sold, individuals have some discretion about when to pay the tax. For example, individuals could sell capital during a period when they have little other income are in a lower marginal tax bracket, and so pay less tax.

However, this argument does not give sufficient consideration to the double taxation of corporate profits and capital gains, and the taxation of gains from inflation. A 1992 Treasury Department report proposed several ways to eliminate double taxation, including adjusting capital gains liability to account for previously paid corporate taxes. And in order to assure that no tax is owed on fictitious income, the value of the capital asset should be indexed for inflation, or, if this is too complex, an exclusion should be given.

Effects on Productivity. The distortions caused by the taxation of inflationary or non-existent gains lead to a decline in productivity in the economy. Since capital assets are prevented from reaching their most productive resources, the allocation of resources in the economy is unbalanced. As a result, labor productivity and economic growth are diminished from their optimal levels.

Budgetary Policy. Budgetary policy plays a major role in determining tax policy. While a reduction in the capital gains tax rate may have persuasive efficiency and equity supporting arguments, budget policy may limit the opportunity to reduce the tax rate.

What are the revenue implications from reducing the capital gains tax rate? No one knows with certainty. All economists agree that reducing the tax rate will lead to higher short-term realizations of capital gains, with short-term revenue increases, but whether higher realizations in the long-term will more than offset the lower tax rate is a controversial topic.

Equity

Plans to lower capital gains taxes are being criticized as helping "the rich" and hurting "the poor" using tables showing the effects of tax changes on taxpayers in various income groups. These tables may be of academic interest, but they provide a measure of our ignorance rather than a prototype for tax policy, and should be treated with skepticism. As I mentioned above, evidence shows that capital gains assets are held throughout the income spectrum, and that all taxpayers would gain from lowering the rates.

Despite their shortcomings, income distribution tables are increasingly becoming central to formulating new tax legislation. Their flaws would not matter so much if the tables were not the weapon of choice in policy debates. The centerpiece of tax distribution tables is the measure of income, and it is measured in different ways. Some measures do not include government transfers, such as food stamps, Aid to Families with Dependent Children, Medicaid, and subsidized housing. Others include cash transfers and food stamps, as well as other measures of wealth, such as the income that a homeowner could receive by renting out his house and the value of appreciated yet unrealized capital assets.

Different agencies measure changes in capital gains taxes in different ways. Treasury measures the change in tax without using changes in tax revenues generated by changes in taxpayers' behavior, whereas the Joint Committee on Taxation (JCT) includes such changes in tax revenue. This assumption is particularly significant in the case of capital gains tax reductions. JCT calculates that individuals would take advantage of the low rates to increase investment and to turn over their assets and therefore that taxes paid would rise, whereas Treasury does not include these revenues.

Those supporting the Treasury methodology hold that, if taxpayers choose to realize capital gains and pay taxes, these taxes should not be counted as a burden. To take another example: if a 100 percent tax were imposed on individuals' earnings, no one would work and no additional tax would be generated. Under the JCT measurement method, such a tax would impose no cost. Under the Treasury method, the cost of the tax would be the revenues that would have been collected had individuals continued to work. With a tax increase, the JCT method understates the revenue cost; with a tax cut, the Treasury method understates the revenue gain.

Reasonable arguments have been made for both of the methods of measurement used by the two agencies, and the purpose of documenting them here is not to evaluate the alternatives. Rather, the dramatic change in results caused by the selection of the assumptions shows how easily tables can altered. Further, the tables contain more serious problems such as regional differences in price levels; variation of individuals' circumstances within an income group; and mobility among income groups. These issues pose a greater challenge to the construction of robust and useful distributional tables.

Individuals do not stay in the same income bracket throughout their lives, and a distribution table provides only a snapshot of income levels, many of which are in the process of change. Robert Fogel of the University of Chicago has suggested that much of the increase in income is attributable to aging, as individuals marry and reach their peak earnings years in their 50s, with income moving down after retirement.

A study of income mobility by the Department of the Treasury analyzing the period 1979 to 1988 traced families' income between quintiles and found a substantial degree of movement. Of those in the lowest quintile in 1979, only 14.2 percent remained in that quintile in 1988, and 14.7 percent had moved to the highest quintile. Downward movement also occurs: of those in the top one percent in 1979, 47 percent remained in the same group in 1988, but fewer than 20 percent had been there in each of the ten years.

When income groups are viewed as fluid, with individuals constantly entering and departing over the course of their lives, an increasing amount of income inequality can be a sign of progress, not decline. Families' incomes rise as they progress economically and as married women achieve comparable salaries to those of men. At the same time, jobs with low incomes provide a valuable stepping-stone for individuals entering the workforce.

Conclusion

There can be little doubt that in the United States capital gains are taxed at a rate so high as to be inefficient and inequitable. But taxes on capital gains are just a small part of a much larger problem with the U.S. tax code, a tax code that is systematically biased against savings and investment. Broader, fundamental tax reform is needed, and it is needed sooner rather than later. The centerpiece of this reform should be a shift to a tax based on consumption rather than income. There are many forms of consumption taxes, including the value-added tax, the sales tax, and the flat tax. Any of these could lead to additional savings and investment in the U.S. economy, and quite possibly, more long-term growth.

Reduction of the capital gains tax rate is a small but important part of the reform of the U.S. tax code. It would be good for U.S. farmers. It would be good for all Americans. For these reasons, and those I outlined above, I urge you to support lower capital gains taxes.