Message-ID: <18676142.1075843091569.JavaMail.evans@thyme> Date: Thu, 21 Oct 1999 19:42:00 -0700 (PDT) From: levine@haas.berkeley.edu To: e201b-1@haas.berkeley.edu, e201b-2@haas.berkeley.edu Subject: Capital gains tax editorial for next week Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: 7bit X-From: "David I. Levine" X-To: e201b-1@haas.berkeley.edu, e201b-2@haas.berkeley.edu X-cc: X-bcc: X-Folder: \Jeff_Dasovich_Dec2000\Notes Folders\Mba--macroeconomics X-Origin: DASOVICH-J X-FileName: jdasovic.nsf Not Such a Capital Idea by Brad De Long and David Levine Appeared in the San Francisco Chronicle, December 5, 1995, p. A23. In the 1980s Republicans argued that the tax cuts they proposed would make the economy grow faster because the rich would redirect energy from avoiding taxes to entrepreneurship. Unfortunately, the theory was wrong. The most optimistic serious assessment of the effects from the 1981 tax cuts (by supply-sider Larry Lindsay) show supplyside benefits of the tax cut far lower than the burden of the debt they generated. Now Republicans are again proposing tax cuts. Today skepticism infects even the core of the Republican coalition. The Wall Street Journal's editorial pages attacked the tax cuts as being the kind that former Democratic Congressman Rostenkowski might have producedsurely the worst insult they can imagine. Principled Republican economic advisers are silent. There is not even a theory under which the Republicans' capital gains tax cut, child credit, and increase in taxes on families that qualify for the Earned Income Tax Credit (EITC) could boost growth. Start with the capital gains tax cut. It provides no incentives to boost investment. No manager deciding whether to build a factory, buy a computer, or engage in research and development changes his or her calculation of expected profit because of a reduction in capital gains taxes. Some proponents believe the tax cut will boost investment and growth indirectly by increasing savings. They note that the tax cut raises the aftertax returns on savings placed in risky assets such as shares of stock. They then claim higher returns on these assets will, in turn, induce higher savings. Higher savings will drive down interest rates, which in turn, will raise business investment and growth. But this roundabout chain of cause and effect falls apart at the first touch. Both the capital gains tax rate and the after-tax return to savings have wandered all over the place in the past generation. Private savings have barely shifted in response. Thus, each dollar of tax cuts increases private savings by less than a dollar. The net effect of the tax cut is to lower the pool of national savings available to fund investment. Continued hope that lowering tax rates will boost American savings and investment is the triumph of faith over experience. The problem is that this tax cut provides an enormous windfall gain to those who have unrealized capital gains on assets they acquired in the past. The top one percent of American families with unrealized capital gains hold about half of these unrealized gains. While many people realize a small amount of capital gains in any given year, these few families hold trillions of dollars of unrealized gains. Good tax policies provide incentives for people to work, save, and invest. Bad tax policies reward a wealthy few for decisions they made in the past. A capital gains tax cut may well raise revenue in its first year or two, as people liquidate their unrealized gains before the next increase in capital gains rates. But once the first wave of selling is over, a standard guess is that the capital gains tax cut will cost about $20 billion a year. When the government decides to spend $20 billion a year on a tax incentive, shouldn't it choose one likely to boost economic growth for everyone? And shouldn't it be part of a package that avoids further tilting our distribution of income in an unhealthy direction? The overall effect of the Republican tax proposals on the distribution of income gives the impression that the congressional majority is waging a onesided class war: the cuts in the Earned Income Tax Credit and the details of how the child credit is paid add up to roughly $2.2 billion a year in tax increases on families with annual incomes less than $30,000, and tax decreases of some $2.8 billion$7,000 or so per familyon those with incomes of more than $200,000. Early in the nineteenth century, Alexis de Tocqueville wrote in the introduction to Democracy in America of "equality of conditions as the creative element" that made America great. This substantial "equality of conditions" was under threat once, in the generation of the Gilded Age, and almost turned America into a very different and worse country. This year's tax changes are another step in a series that places it under threat again. Brad De Long and David Levine teach economics and business at the University of California, Berkeley. Addendum: Due to space constraints, the editorial omitted three (sometimes offsetting) issues concerning how the capital gains tax treats time. The capital gains tax over-taxes gains because it taxes nominal gains, including gains that are due solely to inflation. Thus, if inflation doubles average prices over a decade, someone who sells an asset that also doubles in nominal value will face taxation although the asset's real value was constant. The capital gains tax under-taxes gains because the tax on unrealized gains is not collected until a sale. This delay is like the federal government lending the value of the uncollected tax at zero interest; at low inflation the under-taxation due to value of this loan is usually larger than the over-taxation due to the first effect. Moreover, if the person dies holding the gain, the tax on unrealized gains is forgiven -- a somewhat bizarre feature of the tax system. This latter feature makes the tax ineffective at collecting revenue from the very wealthy, who merely delay sales of their appreciated assets. A better capital gain tax should tax only real gains, should not forgive taxes on inherited unrealized gains, and (this is trickier) should try to minimize the value of lost tax due to holding appreciated assets. David I. Levine Associate professor Haas School of Business ph: 510/642-1697 University of California fax: 510/643-1420 Berkeley CA 94720-1900 email: levine@haas.berkeley.edu http://web.haas.berkeley.edu/www/levine/