A capital gains tax cut will spur the economy

Myth: A capital gains tax cut will spur the economy.

Fact: Historically, economic slumps and unemployment have followed capital gains tax cuts.

Summary

There is no historical evidence that cutting the capital gains tax spurs economic growth. Cuts have usually been followed by economic downturns and reductions in saving and investment. Increases have generally seen the opposite. The theoretical case against cutting capital gains is also strong; most serious economists acknowledge that even eliminating this tax completely will not increase productivity, and may even do significant economic harm.

Argument

Capital gains are profits from stocks, bonds, real estate investments and other capital assets.

The difference between capital gains and other forms of income is like the difference between Joey's lemonade stand and the lemonade he sells. Suppose government imposes a 15-percent tax on each glass of lemonade sold. (Joey, being a precocious Young Republican, will naturally come to resent this.) Such a tax would be an income tax. Now, suppose he wanted to sell his lemonade stand. The profits from this sale would represent his capital gains, which the government taxes too, just like the sale of any glass of lemonade. Of course, the value of the lemonade stand may be hundreds, even thousands of times greater, because of its ability to keep generating profits. But the value difference between the two items is irrelevant; the point is that it is a sale, just like any other sale. If the lemonade stand is 873 times more valuable than the lemonade it sells, then market forces will engineer the correct sales price.

For this reason, liberals argue that the tax on capital gains should be no different from that on normal income. However, conservatives argue that capital gains should be taxed at preferential, lower rates. They argue that by making lemonade stands more profitable, investors will want to invest in more of them, thus increasing the means of production and spurring economic growth.

This sounds like a nice theory at first, until you start looking into it. The problem is that income is income, no matter where it comes from. To charge a 15-percent income tax on a worker but a 10-percent income tax on an owner is a regressive tax, and a recipe for income inequality. It doesn't matter if the item the owner sells is more valuable, due to the asset's ability to keep generating profits. That is something that will be factored into the sales price anyway, and is irrelevant. The only difference is the size of the price.

There is also no distinction between "human capital" and other forms of capital. Workers can improve their worth through better education and fitness, just as an owner can improve his business through modernization. Both will result in higher productivity and income. Hence, taxing a worker's income at a higher rate than a capital asset's income is as illogical as it is unfair.

Yet another problem is that not all capital assets are "good" forms, like productive lemonade stands. They can be -- at least from a production and job-creation point of view -- very close to meaningless, like investments in art, wine, antiques, classic automobiles, property, junk bonds or paper entrepreneurialism. One of the more notorious examples is the tax shelter. Because the sale of capital assets are taxed only when they are profitable, investors hid much of their income in these shelters. In the late 70s, when capital gains became much lower taxed than income, tens of thousands of useless or empty office spaces were opened up nationwide, designed to "lose" money. Many of these tax shelters were for esoteric assets like collectibles, freight cars and even llama breeding. Between 1979 and 1985, tax shelter "losses" jumped from about $10 billion to $160 billion a year. (1)

Another role of tax shelters is to convert highly taxed income into low-taxed capital gains. This represents a pure revenue loss to the IRS, with neutral or even negative consequences to the economy.

Furthermore, taxing capital gains at a preferential rate is a major inconsistency with free market theory, which conservatives otherwise love. If an owner wishes to increase the value of an asset, he should do so the old-fashioned way: by making it profitable. When the government artificially raises the profitability of an asset, especially through highly specific loopholes, then investors will start making sub-standard investments that the free market would otherwise refuse to make. As Citizens for Tax Justice so aptly put it: "In essence, capital gains tax cut proponents seem to believe that free markets don't work, that the government needs to step in with subsidies designed to override the signals the market sends about the level and allocation of capital. But this idea that the government should be making investment decisions for business is terrible economics." (2) The sudden proliferation of useless tax shelters is a perfect example.

But what about the argument that capital gains tax cuts will spur investment? The supposed economic benefits are so minor as to be insignificant. You can find any number of conservative think tanks spouting all kinds of "evidence" that the capital gains cut will restore America to a Golden Age of Prosperity. However, serious economists dismiss these notions as absurd. In 1980, Lawrence Summers (one of the nation's top economists, and then a conservative) conducted a definitive study that found that eliminating the capital gains tax completely would raise U.S. output by only 1 percent over the next 10 years. (3)

The historical evidence bears out the ineffectualness of these tax cuts as well. In November 1978, the top rate for capital gains was cut from 39 to 28 percent. In the prior 12 months, the economy had grown 5.8 percent; in the next year and a half, it fell one percentage point.

In August 1981, the top rate was again cut, this time from 28 to 20 percent. In the prior 12 months, the economy had grown by 3.5 percent; in the following 12 months, it fell by 2.8 percent. Of course, these tax cuts may have suffered from accidentally bad timing in the business cycle, but many conservatives reject business cycle theory, claiming that tax cuts are more responsible for economic performance. In that case, they have a major refutation to explain.

By contrast, capital gains were raised in 1976, and economic growth jumped up from 3.6 percent in the previous two years to 5.2 percent in the next two years. Capital gains were again raised in 1986, from 20 to 28 percent, and economic growth rose from 2.2% in the previous year to 3.8% over the next two years.

The effect of capital gains tax changes on unemployment is even more striking. The unemployment rate rose sharply after both the 1978 and 1981 capital gains tax cuts. By contrast, the jobless rate fell significantly after the 1976 and 1986 capital gains tax hikes were passed.

Taxes on capital gains were significantly lower in the 80s than in the 70s, but savings and investment did not rise, as conservatives had advertised. In fact, they fell:

Disposable personal savings (4)

1980  7.9%
1984  8.0
1985  6.4
1986  6.0
1987  4.3
1988  4.4
1989  4.0
1990  4.2

National Savings, public plus private (5)

1970 - 1979   7.7%
1988 - 1990   3.0

Private investment (5)

1970 - 1979   18.6%
1980 - 1992   17.4

By the end of the 80s, it had become clear that the rich were not investing their liberated tax dollars on "good" forms of investment, like jobs and productive tools and technology. Instead, the money went towards consumption, the good life, and economically meaningless investments like antiques and sport cars. The lack of investment in the national interest became so obvious that Democrats in congress actually proposed guidelines to encourage it. During the 1992 campaign, Bill Clinton proposed a massive infusion of public investment into the nation's aging infrastructure to compensate for the failure of the private sector to do so.

Proponents of a capital gains tax cut have no historical evidence to point to when trying to prove the benefits of these cuts. Given their track record of failure, any future proposals should be rejected out of hand.

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Endnotes:

1. Robert S. McIntyre, "The Hidden Entitlements: Capital Gains," Citizens for Tax Justice, May 1996.

2. Ibid.

3. Cited by Paul Krugman, Peddling Prosperity (New York: W.W. Norton & Company, 1994), p. 75.

4. U.S. Bureau of Economic Analysis, National Income and Product Accounts of the United States, volume 2, 1959-88 and Survey of Current Business, July 1992.

5. Krugman, pp. 126-7.