CRS ISSUES OVERVIEW ON CAPITAL GAINS TAX ISSUES AND PROPOSALS.

CAPITAL GAINS TAX ISSUES AND PROPOSALS: AN OVERVIEW

Jane G. Gravelle Senior Specialist in Economic Policy

SUMMARY

An important part of the House Republican Contract with America (now reported out by the Ways and Means Committee as H.R. 1215 and going to the House floor) is its capital gains tax proposals, which allow a fifty percent exclusion and indexation of future gains for inflation. The Ways and Means Committee restricted this provision to individuals and substituted a 25 percent alternative tax rate for corporations. The capital gains tax has been the target of a number of proposals since the Tax Reform Act of 1986 treated capital gains as ordinary income. A major argument for reducing the capital gains tax is that it will reduce the lock-in effect. Some also believe that capital gains tax cuts will cost relatively little compared to the benefits it will bring and will induce additional economic growth, although the magnitude of these potential effects is in some dispute. Others criticize the tax cut as primarily benefitting higher income individuals and express concerns about the effect on the budget, particularly in future years. Another criticism of the tax cut cites the possible role of a larger capital gains tax differential in encouraging tax sheltering activities and adding complexity to the tax law.

WHAT ARE CAPITAL GAINS AND HOW ARE THEY TAXED?

Capital gain arises when an asset is sold and is the difference between the basis (normally the acquisition price) and the purchase price. Capital gain arising from the sale of corporate stock accounts for one-fifth to one-half of taxable gains, depending on relative stock market performance. Gains on the sale of real estate is the remaining major source of capital gains, although a few gains are generated from other assets (e.g., timber sales and collectibles).

The appreciation in value can be real or reflect inflation. Corporate stock appreciates partly because the firm's assets increase with reinvested earnings and partly because general price levels are rising. Appreciation in the value of property may simply reflect inflation. For depreciable assets, some of the gain may simply reflect the possibility that the property was depreciated too quickly.

If the return to capital gains were to be effectively taxed at the statutory tax rate in the manner of other income, real gains would have to be taxed in the year they accrue. Current practice departs from this approach in many ways.

Gains are not taxed until realized; thus, they benefit from the deferral of tax payments. (By contrast, taxes on interest income are due as the interest is accrued). If the asset is held until death, it may be passed on to heirs with the tax forgiven; if the asset is subsequently sold, the capital gain will be the difference between sales price and the market value at the time of death. This treatment is referred to as a "step-up in basis." Several rules permit avoidance or deferral of the tax on gain on owner-occupied housing, including a provision allowing deferral of gain until a subsequent house is sold (rollover treatment) and a provision allowing a one- time exclusion of $125,000 of gain for those 55 and over. Finally, there is a maximum tax of 28 percent on capital gains, although ordinary tax rates reach 39.6 percent. The ceiling does not apply to gains that arise from rapid depreciation (the treatment denying special benefits to previous depreciation is termed "recapture.")

In contrast to these provisions that benefit capital gains, capital gains are penalized because many of the gains that are subject to tax arise from inflation and therefore do not reflect real income.

A BRIEF HISTORY

Capital gains were taxed when the income tax (with rates up to seven percent) was imposed in 1913. An alternative flat rate of 12.5 percent was allowed in 1921 (with a 73 percent top rate). Tax rates were cut several times during the 1920s. Capital gain exclusions based on holding period were enacted in 1924 to deal with bunching. Modifications in this treatment were made in 1938. In 1942 a 50 percent exclusion was adopted, with an alternative flat rate of 25 percent. Over the years, the top tax rate on ordinary income varied, rising during the depression and up to 94 percent in the mid-1940s, then dropping to 70 percent after 1964. In 1969 a new minimum tax increased the tax on capital gains for some; the 25 percent alternative tax was repealed.

In 1978, the capital gains tax was criticized as being too high; the minimum tax on capital gains was repealed and the exclusion increased to 60 percent with a maximum rate of 28 percent (0.4 times 0.7). The top rate on ordinary income was reduced to 50 percent in 1981, reducing the capital gains rate to 20 percent (0.4 times 0.5). The Tax Reform Act of 1986 reduced tax rates further, but, in order to maintain distributional neutrality, eliminated some tax preferences, including the exclusion for capital gains. This treatment brought the rate for high income individuals in line with the rate on ordinary income -- 28 percent.

During the Bush Administration, there were proposals to reduce the capital gains tax. In 1989, President Bush proposed a top tax rate of 15 percent, halving top rates. In the Ways and Means Committee, two proposals were considered: Chairman Rostenkowski proposed to index capital gains, and Representatives Ed Jenkins, Ronnie Flippo, and Bill Archer proposed a 30 percent capital gains exclusion through 1991 followed by inflation indexation. This latter measure was approved by the Committee, but was not enacted.

In 1990, the President proposed a 30 percent exclusion, setting the rate at 19.6 percent for high income individuals. The House also passed a 50 percent exclusion with a lifetime maximum ceiling and a $1,000 annual exclusion, but this provision was not enacted into law. When rates on high income individuals were set at 31 percent, however, the capital gains rate was capped at 28 percent.

In 1991, the President again proposed a 30 percent exclusion, but no action was taken. In 1992, the President proposed a 45 percent exclusion. The House adopted a proposal for indexation for inflation for newly acquired assets: the Senate passed a separate set of graduated rates on capital gains that tended to benefit more moderate income individuals. This latter provision was included in a bill (H.R. 4210) containing many other tax provisions that was vetoed by the President.

No changes were proposed by President Clinton or adopted in 1993 and 1994 with the exception of a narrowly targeted benefit for small business stock adopted in 1993. The value of the tax cap was increased, however, in 1993 when new brackets of 36 percent and 39.6 percent were added for ordinary income.

In 1994, the "Contract With America" proposed a 50 percent exclusion for capital gains, and indexing the basis for all subsequent inflation. These provisions would substitute for the current 28 percent cap. The Ways and Means version restricts inflation to newly acquired assets (individuals can "mark to market" -- pay tax on the difference between fair market value and basis as if the property were sold to qualify for indexation), does not allow indexation to create losses, and limits the exclusion and indexing to individuals, allowing corporations an alternative 25 percent tax rate.

REVENUE EFFECTS

Over the past several years, a debate has ensued regarding the revenue cost of cutting capital gains taxes. For example, in 1990 when the President proposed a 30 percent exclusion, estimates from the U.S. Treasury Department (which assumed a slightly larger realizations response) indicated that the proposal would raise $12 billion in revenue over the first five years, and the Joint Committee on Taxation found a revenue loss of approximately equal size.

Although the estimates appeared to be quite different, they both incorporated significant expected increases in the amount of gains realized as a result of the tax cut. For example, the Treasury would have estimated a revenue loss of $80 billion over five years with no behavioral response, and the Joint Tax Committee a loss of $100 billion. (The gap between these static estimates arose from differences in projections of expected capital gains, a volatile series that is quite difficult to estimate). In fact, given the range of empirical estimates of the realizations response, their assumptions were quite close together.

Empirical evidence on capital gains realizations does not clearly point to a specific response and revenue cost. Recent research suggests long run responses may be more modest than that suggested by the economics literature during the 1990 debate, but the short run response is still difficult to ascertain. ¹

It is important also to note that any revenue feedback effect that exists will be smaller the larger the tax reduction. When the tax reduction is large, although there will be a larger response, any induced revenues will be taxed at the new lower rates. Thus, a 50 percent exclusion will not have as large a feedback effect relative to the static estimate as a 30 percent exclusion. (In the extreme, when the tax rate is cut to zero, there will be no feedback effect). The Joint Committee on Taxation estimates the capital gains tax cut in the Contract with America to cost $56 billion over five years. (This estimate includes the effects of the fifty percent exclusion, which is not a fifty percent reduction in average marginal tax rates because there is a current 28 percent cap on the rate which will be removed. This estimate also includes the effects of indexation of newly acquired assets, which is small in the first few years.) The revisions in the Ways and Means version reduce that loss estimate to $32 billion.

The revenue loss in the long run is likely to be larger (even at constant income levels) than that in the next few years. First, the long run realizations response is likely to be smaller than in the short run. Second, in the case of the indexation proposal, the revenue loss will be much larger in the future than it is in the budget horizon because indexation is restricted to newly purchased assets. These latter revenue costs grow rapidly. The Treasury Department, which has done ten year estimates, projects a loss of $28 billion in the first five years, but $53 billion in the second five years.

Arguments have also been made that a capital gains tax cut will induce additional savings which will also result in a feedback effect as taxes are imposed on new income. This effect is uncertain, as it is not clear whether an increase in the rate of return will decrease or increase savings (savings can decrease if the income effect is more powerful than the substitution effect) and what the magnitude of the response might be. Regardless of these empirical uncertainties, any effect of savings on taxable income in the short run is likely to be quite small due to the slow rate of capital accumulation. (Net savings are typically only about two to three percent of the capital stock, so that even a ten percent increase in the savings rate would result in only a 2/10 to 3/10 of a percent increase in the capital stock in the first year.) A related argument is that the tax cut will increase asset values; such an effect is only temporary, however, and will, if it occurs, only shift revenues from the future to the present. ²

IMPACT ON EFFECTIVE TAX BURDENS

The tax burden on an investment is influenced by both the tax rate and any benefits allowed or penalties imposed. One way to measure this tax burden is to calculate a marginal effective tax rate. Basically, the marginal effective tax rate measure is a way of capturing in a single number all of the factors that affect tax burden; it is the percentage difference between the before- and after-tax return to investment. Another way of looking at it is as the a [sic] number that indicates what statutory rate would be applied to economic income to give the taxpayer the same burden as the combination of all tax benefits and penalties.

The effective tax rate on capital gains can be either higher or lower than the statutory rate, depending on the inflation rate relative to the real appreciation rate (which raises the effective tax rate), and the period of time the tax is deferred (which lowers the effective tax rate). Also, assets held until death are not subject to tax. For example, assuming a 28 percent statutory tax rate, the gain on a growth stock (paying no dividends) with a real appreciation rate of 7 percent and an inflation rate of 3 percent would be subject to an effective tax rate of 39 percent if held for one year, of 31 percent if held for seven years, of 20 percent if held for 20 years, and of zero if held until death. At a 5 percent inflation rate, these tax rates are respectively 46, 35, 21, and zero percent. Since less than half of gains that are accrued are realized, the effective tax rate is probably lower than the statutory tax rate. These benefits for capital gains are even larger for individuals who fall in the higher tax brackets (31, 36, and 39.6 percent) because the capital gains tax rate is capped at 28 percent.

With a 50 percent exclusion and no separate cap and a 3 percent inflation rate, an investor in the 28 percent bracket would pay respectively tax rates of 19, 15, 9, and zero percent; if indexing for inflation is added, the rates will be 14, 11, 8, and zero percent. These rates will be higher if the taxpayer is in a higher bracket. For example, if the statutory tax rate is 31 percent, the rates with an exclusion and indexing would be 15, 13, 9, and zero percent.

ISSUES: EFFICIENCY, GROWTH, DISTRIBUTION, AND COMPLEXITY

One of the reasons that economists may argue in favor of reducing the capital gains tax is the effect of lock-in. If there is a large behavioral effect on realizations, this effect implies that the tax introduces significant distortions in behavior with relatively little revenue gain. An alternative way to reduce lock-in is to adopt accrual taxation (i.e. tax gains on a current basis as accrued), but this approach is only feasible when assets can be easily valued (e.g. in the case of publicly traded corporate stock). Another way to reduce lock-in is to tax gains passed on at death. These solutions may face a variety of technical problems and taxation of gains at death has been unpopular.

A case might be made for cutting capital gains taxes on corporate stock because corporate equity capital is subject to heavy taxation. This heavy taxation encourages corporations to take on too much debt and directs too much capital to the noncorporate sector. On the other hand, reducing the capital gains tax would increase the relative penalty that applies to dividends and introduce tax distortions in the decisions of the firm to retain earnings.

Arguments have also been made that cutting gains taxes will increase economic growth and entrepreneurship. While evidence on the effect of tax cuts on savings rates and, thus, economic growth is difficult to obtain, most evidence does not indicate a large response of savings to an increase in the rate of return. Indeed, not all studies find a positive response. ³ Because of the income effect, it is possible for savings to fall when the return rises (i.e., individuals can attain a larger future sum with a smaller savings when the rate of interest goes up). It might be that a more effective route to increasing savings is to take revenues that might otherwise finance a tax cut and devote them to deficit reduction.

Although arguments are made that lower gains taxes stimulate innovation and entrepreneurship, there is little evidence in history to connect periods of technical advance with lower taxes or even high rates of return. The extent to which entrepreneurs take tax considerations into account is unclear; however, there is some reason to doubt that capital gains taxes are important in obtaining large amounts of venture capital, since much of this capital is supplied by those not subject to the capital gains tax (i.e., pension funds, foreign investors). ⁴

A major complaint made by some about a capital gains tax cut is that it will primarily benefit very high income individuals. Capital gains are concentrated among higher income individuals both because these individuals tend to own capital and because they are especially likely to own capital that generates capital gains. For example, the Treasury indicated in 1990 that 54 percent of the proposed capital gains tax cut would go to individuals with incomes over $200,000 and 74 percent would go to individuals with incomes over $100,000 (using a five year average expanded income definition to classify taxpayers). Individuals with $200,000 of income account for about one percent of taxpayers and individuals with incomes over $100,000 account for less than five percent.

Critics of reducing capital gains taxes cite the contribution of preferential capital gains treatment to tax sheltering activities. For example, individuals may borrow (while deducting interest in full) to make investments that are eligible for lower capital gains tax rates, thereby earning high rates of return. These effects are, however, constrained in some cases (i.e., a passive loss restriction limits the deductions allowed in real estate ventures).

Capital gains differentials complicate the tax law, especially as applied to depreciable assets where capital gains treatment can create incentives for churning assets unless complex recapture provisions are adopted. Indexation of capital gains for inflation is more complicated than a simple exclusion, since different basis adjustments must apply to different vintages of assets.

² For a discussion of these issues of savings and asset valuations, see testimony of Jane G. Gravelle, Congressional Research Service before the Senate Finance Committee (February 15, 1995) and the House Small Business Committee (February 25, 1995).

³ See Gravelle, op cit., pp. 24-28 for a survey.

⁴ See James M. Poterba, Venture Capital and Capital Gains Taxation, in Tax Policy and the Economy 3, Cambridge: MIT Press, 1989, pp. 47-68.