CRS REPORT ANALYZES BUSH CAPITAL GAINS PROPOSAL.

CRS REPORT FOR CONGRESS

Donald W. Kiefer

Senior Specialist in Economic Policy

June 2, 1989

SUMMARY

In his fiscal year 1990 budget proposals, President Bush proposed a decrease in the tax rate on capital gains to a maximum rate of 15 percent. Certain taxpayers would be allowed a capital gains exclusion as an alternative to the 15 percent rate. Gain on "collectibles," depreciable or depletable property, and special section 1231 assets used in a trade or business would not qualify for the special treatment.

Two factors combine to elevate the significance of the revenue effect of the capital gains tax proposal. First, because of the ongoing effort to reduce the Federal budget deficit, any policy change that would decrease tax receipts faces greater than normal obstacles. Second, the Administration has estimated that the tax cut would increase tax receipts rather than reduce them. The revenue estimates are, however, very controversial. In fact, the Joint Committee on Taxation has issued revenue estimates indicating that the proposal would lose revenue beginning the second fiscal year after enactment.

The benefits of a capital gains tax cut would be concentrated in the highest income brackets. On average, capital gains represent a relatively trivial source of income for taxpayers below the $75,000 income level, but are a major source of income for high-income taxpayers. Taxpayers with adjusted gross income (AGI) above $1 million, for example, have only 2.5 percent of total gross AGI but receive 23.3 percent of gross capital gains.

Some people argue that it would be a violation of the compromises made in the Tax Reform Act of 1986 to reduce the capital gains tax rate. These people maintain that if the capital gains tax rate is cut, income tax rates in the upper income brackets should be raised to offset the distributional effects, in a manner consistent with the spirit of the Tax Reform Act.

The Administration stated three broad policy goals in advancing the capital gains tax proposal. The first is to encourage saving, entrepreneurship, and risk-taking investments. While it would have this effect, a capital gains tax cut would be less effective in stimulating saving, investment, and high-risk, high-growth firms than may be commonly believed. The second policy goal was to promote long- term, rather than short-term, investment. The net effect of the proposal on the holding period of capital assets, however, is not clear; if the effect is to lengthen the average holding period, it probably would do so by only a small amount. The third policy goal was to provide a rough adjustment for inflation in the measurement of capital gains. It is well known, however, that a preferential tax rate provides a poor approximation for the effects of inflation on capital income.

A proposal to cut the capital gains tax raises a number of issues regarding economic efficiency. While these are very important issues, they are only briefly summarized in this report because they have been treated at greater length elsewhere.

                              CONTENTS

THE BUSH CAPITAL GAINS TAX PROPOSAL

In his fiscal year 1990 budget proposals, President Bush proposed a decrease in the tax rate on capital gains to a maximum rate of 15 percent. ¹ Under current law, capital gains are taxed the same as other income, at tax rates of 15, 28, or 33 percent, depending on the tax bracket of the taxpayer. Throughout most of the history of income taxation in the U.S., capital gains have received preferential tax treatment. This special treatment was ended in the Tax Reform Act of 1986 as one element in a combination of tax revisions that had the effect of broadening the tax base and lowering tax rates. ²

This report summarizes and analyzes the President's capital gains tax proposal. Section I of the report provides a brief summary of the proposal and the goals the Administration stated for it. Given the current Federal budget deficit and the Administration's claim that the capital gains tax cut will increase, rather than reduce, tax receipts, one of the most controversial aspects of the proposal is its revenue effects. For this reason section II discusses the revenue effects in detail. Section III discusses the distributional effects, always a controversial aspect of changes in the tax treatment of capital gains. Because of the many compromises made in putting together the Tax Reform Act of 1986, reducing the capital gains tax rate has implications for the stability of tax reform. This issue is discussed in section IV. Section V discusses the consistency of the proposal with its stated policy goals. Finally, section VI provides a brief overview of economic efficiency issues.

I. SUMMARY OF THE PROPOSAL

The capital gains tax proposal has three principal elements: the special tax treatment, the assets that would qualify for the treatment, and the holding period requirement. ³

SPECIAL TAX TREATMENT: For individual taxpayers the maximum tax rate on capital gains on qualified assets would be 15 percent. ⁴ Taxpayers would be allowed an exclusion of 45 percent of qualified capital gains as an alternative to the 15 percent rate. The exclusion would be advantageous to taxpayers subject to the 15 percent marginal tax rate on ordinary income; it would result in a tax rate of 8.25 percent on capital gains. ⁵ A 100 percent exclusion of qualified capital gains would be provided to married taxpayers filing jointly and heads of households with adjusted gross income (calculated using the 45 percent exclusion) less than $20,000; for single taxpayers and married taxpayers filing separately the income cutoff for the 100 percent exclusion would be $10,000. Taxpayers subject to the minimum tax (calculated using the 45 percent exclusion) would not be eligible for the 100 percent exclusion. The special tax treatment would not apply to capital gains received by corporations. The rules regarding treatment of capital losses would remain unchanged except that each dollar of long-term capital loss in excess of long-term capital gain could offset only 50 cents of ordinary income. ⁶

QUALIFIED ASSETS: The special tax treatment would apply to capital gains realized on the sale or other disposition of capital assets meeting the holding period requirements, with certain exceptions. Gain on depreciable or depletable property and special section 1231 assets used in a trade or business would not qualify for the special treatment. Special section 1231 assets include interests in timber, coal, iron ore, livestock, and unharvested crops. Gains realized on the disposition of "collectibles" (as defined in the IRA rules) also would not be eligible for the special tax treatment.

HOLDING PERIOD REQUIREMENT: Only capital gains realized on the sale or other disposition of assets held for a minimum holding period would qualify for the special tax treatment. The required holding period would be 1 year for gains realized on or after July 1, 1989 (the special tax treatment would not be available before that date), 2 years for gains realized on or after January 1, 1993, and 3 years for gains realized on or after January 1, 1995.

The Administration stated three broad policy goals in advancing the proposal: first, to encourage saving, entrepreneurship, and risk- taking investments; second, to promote long-term, rather than short- term, investment; and third, to provide a rough adjustment for inflation in the measurement of capital gains.

II. REVENUE EFFECTS OF THE PROPOSAL

Under normal circumstances the revenue effects of a tax proposal would not be among the most important and controversial issues involved in its consideration. Two factors, however, combine to elevate the significance of the revenue effect of the capital gains tax proposal. First, because of the ongoing effort to reduce the Federal budget deficit, any policy change that would decrease tax receipts faces greater than normal obstacles. In particular, for several years the tax committees have imposed the rule that any proposed tax change which would decrease revenues must be accompanied by a proposal for replacing the lost revenue.

The second factor that heightens the significance of the revenue effect of the capital gains tax proposal is that the Administration has estimated that the tax cut would increase tax receipts rather than reduce them. While it may seem counterintuitive that a tax cut could increase tax receipts, it is not impossible conceptually. The revenue estimates are, however, very controversial. In fact, the Joint Committee on Taxation has issued revenue estimates indicating that the proposal would lose revenue beginning the second fiscal year after enactment.

The revenue estimates by the Administration and the Joint Committee on Taxation (JCT) are shown in table I.

The Administration estimates that the tax cut would raise revenue until 1994; losses would be sustained for three years beginning that year. The losses are due to the effects of the phase in of the longer holding period (discussed further below). Beginning in 1997, the Administration estimates once again show positive revenue effects.

The JCT estimates, on the other hand, indicate revenue losses beginning in 1991 and continuing thereafter. The JCT estimates also show the effects of the phase in of the longer holding period during fiscal years 1994 to 1996; during this period the estimated revenue losses are larger than the trend in the other years.

Both the Administration and the JCT provide more detail than usual for their revenue estimates, breaking the revenue effect down into several components (the tables showing the complete revenue estimates are reproduced in the appendix). The aspects of the proposal that raise revenue are the "feedback effect" of higher capital gains realizations in response to the tax cut, exclusion of depreciable assets and collectibles, ⁷ and the phased in holding period (in some years). These elements of the revenue estimates plus the effects of the shift of ordinary income to capital gains and the exclusion for low-income taxpayers, which reduce revenue, are discussed below. The implications of the revenue estimates for legislative action are also discussed.

                                TABLE I

A. THE FEEDBACK EFFECT

While the Treasury and JCT revenue estimates differ regarding all aspects of the proposal, the feedback effect is the largest and most controversial element of the estimates.

Because the capital gains tax is paid only when gains are "realized," that is, when an asset is sold or otherwise disposed of, the tax is, to some extent, voluntary. Taxpayers can avoid paying the tax by not selling or disposing of their assets. In this sense, the tax imposes a penalty on asset sales. If an individual wants to sell a capital asset to finance consumption or the purchase of another investment, he must pay a tax on the transaction (assuming there is a gain on the asset). For this reason, the tax discourages realizations of capital gains; asset owners are said to be "locked- in" to their investments. Hence, when the tax is reduced, capital gains realizations increase.

For this reason, a 50 percent cut in the tax rate on capital gains, for example, would not result in a 50 percent decrease in capital gains tax receipts. Because of higher realizations, some of the "static" revenue loss (that is, the revenue loss estimated ignoring any change in realizations) is offset. In fact, if the increase in realizations is sufficiently large, the lower tax rate could actually raise more revenue (raising more revenue with a 50 percent tax rate cut would require gains realizations to increase more than twofold). The net revenue effect depends critically on the degree of responsiveness of capital gains realizations to changes in the tax rate.

There have been numerous attempts to estimate the responsiveness of capital gains realizations to changes in the tax rate. For a variety of technical reasons it is very difficult to estimate, and a consensus has not emerged. The earlier studies used cross-section analysis, a statistical technique that uses data regarding a large number of taxpayers in the same year. These studies tended to find evidence of a fairly high degree of responsiveness. More recent studies rely on time-series analysis, a statistical technique that uses aggregate data over a lengthy time period. The time-series studies tend to result in lower estimates of responsiveness to the capital gains tax rate. ⁸

There are reasons to believe that the time-series estimates are superior because of known deficiencies in the cross-section approach to this problem, as stated by Henderson:

"Early studies typically were of the cross-section variety; that is, these regressions were estimated for households with different income levels during a given year. These studies have shortcomings as a method of determining revenue effects of tax law changes. Households may differ in ways that are difficult to control for in such a regression analysis. Contrary to the premise behind cross-section regressions, household A with a 28 percent capital gains rate may not take on the behavior of household B with a 20 percent rate when A's rate is lowered to 20 percent. Also, the cross-section studies provide no evidence on the time pattern of a reaction to a change in tax rates; they cannot be used to distinguish temporary from permanent responses." ⁹

The time-series study that has recently received the most attention was done by the Congressional Budget Office (CBO). ¹⁰ This study used a variety of equation forms, but the tax rate relationship in the basic equation given the most emphasis in the study can be summarized as follows:

      1) log(gains) = a + c x MTR

      2) gains(sub 2)    = e(to the c x (MTR(sub 2) - MTR(sub 1) power)

The implications of the CBO estimate of capital gains responsiveness can be illustrated in simple calculations assuming that the average and marginal tax rates on capital gains equal the statutory tax rate in the upper income brackets. Based on this assumption and the CBO estimate of the coefficient c, equation 2 implies that a drop in the marginal tax rate on capital gains from 28 percent to 15 percent would result in a 49.6 percent increase in capital gains realizations.

Since the CBO study, two other analyses have re-estimated the relationship and derived slightly different estimates of the coefficient c. One study by the Office of Economic Policy (OEP) of the Treasury criticized the CBO study for underestimating the revenue effect of a capital gains tax cut, but derived a smaller estimate for c, -0.025, which implies a smaller capital gains response. ¹⁶ This estimate implies that a tax rate cut from 28 percent to 15 percent would increase gains realizations by 38.4 percent. A second study by Auerbach estimated a version of the CBO equation revised to address some statistical problems and derived a tax rate coefficient of -0.0427. ¹⁷ This estimate implies a 74.2 percent rise in capital gains realizations in response to a rate cut from 28 to 15 percent. ¹⁸

None of these response estimates implies increased revenue from the capital gains tax cut. Using 1991 for illustration, the Treasury estimates that taxable capital gains realizations under current tax law will be $183 billion. Assuming that marginal and average tax rates are equal, a tax cut from a 28 percent rate to a 15 percent rate would decrease tax revenues by $23.8 billion if there were no feedback effect. Using the CBO estimate of capital gains responsiveness would yield a feedback estimate of $13.6 billion, hence the tax cut would lose $10.2 billion. Using the OEP estimate, the feedback estimate would be $10.5 billion, for a revenue loss of $13.3 billion. Auerbach's estimate yields feedback of $20.4 billion, for a revenue loss of $3.4 billion.

These calculations are only illustrative. They provide examples of how estimates of the capital gains response are derived, and they suggest some of the uncertainty involved. They are not, however, derived in the same manner as the actual revenue estimates for the Bush proposal. Revenue estimates must take into account the specific features of the proposal -- for example, the 45 percent exclusion and the 100 percent exclusion for lower income taxpayers -- rather than making simplifying assumptions, such as the flat tax rate assumed in the above calculations.

Even though this framework is simpler than the methods used to develop actual revenue estimates, it may be instructive to examine the Treasury and JCT revenue estimates within this framework. The year 1991 will again be used for illustration. The Treasury assumed capital gains realizations of $183 billion in 1991 under current law and $349 billion under the tax cut proposal, an increase of 90.7 percent (it has been argued that the proposal would have to result in more than a doubling of capital gains realizations to increase tax receipts, ¹⁹ but, in fact. the Treasury revenue estimates assume a long-run increase in realizations of 87 percent ²⁰).

Based on these realizations figures and the static and feedback revenue estimates for the proposal published by the Treasury, it appears that the Treasury used average effective tax rates of 22.75 percent for current law and 13.1 percent for the proposal. ²¹ Thus, even though the statutory tax rate on capital gains in the upper income brackets would drop from 28 percent to 15 percent under the proposal, a drop of 13 percentage points, the Treasury is assuming that the effective tax rate on capital gains would drop by only 9.6 percentage points.

This tax rate decrease of 9.6 percentage points and the assumed increase in capital gains realizations of 90.7 percent can be inserted into equation 2 above to derive the coefficient c that would be required within this estimation model to be consistent with these results. The required coefficient is -0.06713. While there is a great deal of uncertainty associated with the estimates of capital gains responsiveness, this value for the coefficient is outside the range of a 95 percent confidence interval for the estimate derived by CBO. ²² The Treasury, however, did not rely on time-series estimates to derive their capital gains response estimate for the Administration proposal. Instead, they essentially averaged the time-series and cross-section response estimates derived in the earlier Treasury capital gains tax analysis. /23/, ²⁴

The JCT did not publish their estimates of capital gains realizations under current law and the proposal, but they did provide a graph from which interpolations may be drawn. ²⁵ From the graph it appears that JCT estimates capital gains realizations under current law in 1991 at between $180 billion and $190 billion; since the level seems to be very close to the $183 billion figure used by Treasury, this figure will be used as the JCT estimate as well. The JCT assumption regarding gains realizations in 1991 under the proposal appears in the graph to be about $325 billion. These figures imply an assumed increase in capital gains realizations of $142 billion, or 77.6 percent, under the proposal.

Using these figures for realizations and the static and feedback revenue effect estimates released by JCT, it appears that JCT is assuming an effective capital gains tax rate of 24.9 percent under current law and 12.1 percent under the proposal. These rates, in turn, imply that JCT estimates that the proposal would reduce the average capital gains tax rate by 12.8 percentage points (compared to 9.6 percentage points used by the Treasury). ²⁶

From equation 2, a 12.8 percentage point tax rate decrease and 77.6 percent increase in gains realizations would require an assumed value for the coefficient c of -0.0449. This value represents greater responsiveness than the value estimated by CBO, but is well within the 95 percent confidence interval for the coefficient.

Thus, the difference in estimates by the Treasury and the Joint Committee on Taxation of the revenue effects of the Bush capital gains tax proposal appears to be attributable to at least two factors: 1) the Treasury assumes a larger feedback effect from the capital gains tax cut (the factor that has received all of the attention), and 2) the Treasury assumes that the proposal entails a smaller cut in effective capital gains tax rates. The second factor is largely responsible for the significant difference in static revenue loss estimates: $17.6 billion in 1991 in the Treasury estimate versus $23.4 billion in the JCT estimate. ²⁷

Absent recent tax return data, it is difficult to evaluate the effective tax rate assumptions. Given the current tax rate structure and the high concentration of capital gains in the upper income brackets (see the discussion in section III below), however, the 22.75 percent current law effective tax rate that appears to have been used by the Treasury seems low.

Finally it could be noted that in the Treasury's testimony before the Finance Committee, the estimate was offered that annual capital gains accruals (excluding personal residences) amount to $350 billion. ²⁸ The Treasury estimates that capital gains realizations under the proposal would be $349 billion in 1991. Hence, the Treasury's estimates imply that virtually all capital gains accruals would be realized and taxed under the proposal. While this is possible during the transition from one steady state to another, it is highly unlikely as a long-term relationship. Even if the tax rate on capital gains were zero, after a transition period all accrued capital gains would not be realized; a significant amount of assets with unrealized capital gains would still pass through estates, for example, and some would probably still be donated to charities. Furthermore if stock market values are growing a fraction of annual accruals must remain unrealized in a long-term steady-state relationship. ²⁹

B. THE SHIFT OF ORDINARY INCOME TO CAPITAL GAINS

The Treasury revenue estimates for the capital gains proposal report a separate line item for the revenue loss resulting from the shift of ordinary income to capital gains income once the capital gains tax rate has been reduced. This income shift would actually increase capital gains tax receipts, but the tax revenue lost from taxing the ordinary income converted to capital gains would be greater.

This item plays a key role in the Treasury's explanation of how its revenue estimates for the Tax Reform Act of 1986, which showed a $21.8 billion revenue increase over a five-year period for INCREASING the capital gains tax rate, ³⁰ are consistent with those for the new proposal, which show a revenue increase for REDUCING the tax rate. The explanation of the revenue estimates for the proposal states:

"The capital gains estimate for the 1986 Act included a large revenue gain from stopping the conversion of ordinary income to capital gain income by elimination of the differential. In fact, most of the revenue gain from reduced income shifting resulted from the drop in the top ordinary income tax rate from 50 percent to 28 percent." ³¹

Curiously, however, eliminating the differential in tax rates between capital gains and ordinary income in the 1986 Act would raise no revenue at all as a result of income shifting. It is true that eliminating the preferential treatment of capital gains would result in less reported capital gains income and more reported other income. Since these two types of income would be subject to the same tax rate, however, the income shift would have no effect on tax revenues.

The quoted paragraph seems to imply that the revenue estimate for the 1986 Act was done in two stages. First, the effect of reducing the top tax rate on ordinary income to 28 percent was calculated. This change by itself would lose substantial revenue. The revenue loss would be offset to some extent, however, by a shift of capital gains income to ordinary income because of the smaller tax rate differential. Given the 60 percent exclusion of long-term capital gains under prior law, a decrease in the top tax rate to 28 percent would reduce the top capital gains tax rate to 11.2 percent. The difference between the top tax rate on ordinary income and the top rate on capital gains would therefore decrease from 30 percent (50 percent minus 20 percent) to 16.8 percent (28 percent minus 11.2 percent). This reduction in the tax rate differential would cause some shift of capital gains income to ordinary income and an increase in tax receipts (compared to an estimate assuming no shift).

The second stage of the calculation apparently was to calculate the effect of raising the capital gains tax rate to 28 percent. This would completely eliminate the tax rate differential, inducing a further income shift from capital gains to ordinary income. Since the increase in the capital gains tax rate (in this stage of the calculation) would have a bigger effect on the tax rate differential than the decrease in the tax rate on ordinary income (in the first stage of the calculation), it would seem that the larger share of the income shift should be associated with the second stage of the calculation. This income shift, however, would have no revenue consequences because of the equal tax rates.

While there would be no revenue gain resulting from the income shift, raising the tax rate to 28 percent would yield an estimated static revenue gain and a feedback effect from lower capital gains realizations. According to the Treasury, this second stage of the revenue estimating process yielded only a small revenue gain in the 1986 estimates, so cutting the capital gains tax rate under the current proposal would yield only a small estimated revenue loss. ³²

It is not clear how the revenue effect attributable to shifting income was estimated either for the current proposal or for the 1986 Act. None of the published studies of effects of capital gains tax changes include variables representing the tax rate differential between capital gains and ordinary income.

The Joint Committee on Taxation does not separately report the effects of income shifting in its revenue estimates for the proposal.

C. THE EXCLUSION OF DEPRECIABLES AND COLLECTIBLES

Both the Treasury and JCT revenue estimates for the proposal show a small revenue gain for excluding depreciable assets and collectibles. This exclusion provides a revenue gain in the estimates because the estimation of the static and feedback revenue effects is based on procedures that assume all capital gains qualify for the favorable treatment.

Most of the estimates of the responsiveness of capital gains to tax rate changes do not distinguish among types of assets. ³³ The only known study to do so was the 1985 Treasury study in its cross- section analysis. ³⁴ Estimates were provided only for corporate stock, real estate, and other assets. Unsurprisingly, realization of gains on corporate stock appears to be substantially more responsive to changes in the tax rate than gains on the other assets.

The exclusions in the proposal do not focus the benefit exclusively on corporate stock, however. The Treasury estimates the exclusion would increase receipts from the proposal by $1.7 billion in 1991; the JCT estimate is $2.7 billion. These estimates imply that the exclusion would apply to as much as $22 billion of capital gains, or about 6 percent of the gains projected by the Treasury under the proposal in 1991. Since gains on corporate stock constitute about 35 percent of gross realized gains (omitting gains on personal residences), ³⁵ a large amount of gains on assets other than corporate stock would qualify for the lower tax rate under the proposal.

The Administration had several reasons for excluding depreciable assets from the proposed capital gains tax reduction. First, the sale of depreciable assets is less sensitive to the capital gains tax rate; sales are determined primarily by business reasons. Second, the capital gains treatment of depreciable property under prior law was one of the primary ingredients in tax shelters, which the Tax Reform Act of 1986 went a long way toward eliminating. Third, providing capital gains treatment of depreciable assets also necessitates recapture rules, which greatly complicate the tax code. And finally, capital gains treatment for depreciable property was implemented during World War II to reduce the tax on profits from sale of properties taken over by the government to produce war materials. This justification for the special treatment obviously no longer applies, and the treatment is contrary to current tax principles.

It could also be mentioned that the economic inefficiencies resulting from capital gains taxation are smaller with regard to depreciable assets than financial and other assets. This is because the discouraging effect of the capital gains tax on sales of depreciable assets is, to some extent, offset by the ability of the purchaser to step up the basis of the asset to the purchase price and to take depreciation deductions based on the higher basis.

Collectibles were excluded from the proposed capital gains tax reduction because they do not contribute to economic growth or productivity. This decision obviously reflects a value judgment that the contribution of collectibles to economic welfare is less than the contribution of assets that enhance growth and productivity.

B. THE PHASE IN OF THE HOLDING PERIOD

Both the Treasury and the JCT revenue estimates report separately the effects of the phase in of the three-year required holding period. These estimates are highly uncertain, a fact made clear by the differences in the estimates. For fiscal years 1994 through 1997, the years most affected by the phase in, the Treasury estimates a revenue loss of $21.5 billion attributable to the phase in; the JCT estimates a revenue gain of $2.0 billion.

The estimates are so uncertain because there are virtually no estimates of the underlying economic behavior on which to base the revenue estimates. It is clear that the timing of realizations is affected by a holding period. ³⁶ It is also clear that an expected increase in tax rates can dramatically affect realizations; in 1986, the year before capital gains tax rates increased as a result of the changes in the Tax Reform Act of 1986, realizations nearly doubled to $319 billion from $166 billion the prior year (they dropped back to $140 billion in 1987). But there are no studies that have developed estimates of the extent to which taxpayers will shift realizations from one year to another when confronted by changes in tax rates and holding periods.

The holding period requirement in the proposal is initially one year; it would increase to two years on January 1, 1993 and to three years on January 1, 1995. In the several months before each increase in the holding period there would be an incentive for investors to realize gains that qualified as long term at that time but that would not qualify under the longer requirement. For example, an investor who buys a stock on November 1, 1991 could sell it any time in November or December of 1992 and pay the capital gains tax at the reduced long-term rates under the proposal. If the investor holds on to the stock, however, any gain would again become short-term on January 1, 1993. He would have to keep the stock until November 1, 1993 to again qualify for the long-term rates. If he thinks that he may want to sell the stock between January 1 and November 1, 1993, then there is an incentive for him to sell before January 1 to take advantage of the long-term rates.

This shifting recharacterization of gains would affect all capital assets purchased in 1991 and 1993 under the proposal. Gains realizations would be stimulated in 1992 and 1994 and depressed in 1993 and 1995 because of the incentive to shift realizations to take advantage of the temporary long-term characterization of gains. While the direction of these effects is clear, the magnitudes of the effects on realizations and capital gains tax revenues are not.

It is also not clear why the phase in was designed this way. Not only would it shift tax receipts back and forth between years, but it also would confuse and possibly anger taxpayers. It would seem preferable to phase in the longer holding period by fixing the date of the purchase of the qualifying asset rather than fixing the effective date of the longer holding period. For example, during 1993 assets could be regarded as qualifying for long-term treatment if they were purchased before January 1, 1992. On January 1, 1994, the holding period could then be fixed at two years (until the next phase in to the three-year period in 1995). Under this procedure, once an asset held by an investor qualified for long-term treatment it would never be "disqualified" and recharacterized as short-term again.

This alternative phase in procedure also would have a different revenue pattern. There would be no incentive to accelerate sales to take advantage of the long-term tax rates under this procedure. The incentive to defer gains that would otherwise have been realized during 1993 and 1995 to qualify for long-term status, however, would remain. Hence, under this approach, the phase in of the longer holding period would have effects that only reduce, not increase, tax receipts.

The revenue estimates of both the Treasury and the JCT show the longer holding period contributing permanently to higher revenues once the phase in is completed. This higher revenue is due to the fact that assets held for periods between one and three years would be subject to a higher tax rate than they had been prior to the phase in. ³⁷

E. THE EXCLUSION FOR LOW-INCOME TAXPAYERS

The Treasury and JCT revenue estimates for the proposal also include separate estimates for the revenue effect of the exclusion for low-income taxpayers. While the procedure for making such an estimate is fairly straightforward and the estimated revenue loss is relatively small, it nonetheless underscores the uncertainty in making such estimates. By fiscal year 1999, the revenue loss estimated by JCT is three times larger than the loss estimated by Treasury, $0.9 billion versus $0.3 billion.

Two reasons were given by the Administration for providing special capital gains tax benefits to lower income taxpayers. First, economic studies suggest that lower income people are less responsive than higher income people to capital gains tax rate changes, "thus an extra measure of incentive is required to encourage lower-income individuals to make direct capital investment in America's future." ³⁸ Second, on average, larger fractions of capital gains realized by lower income persons represent merely the effects of inflation and not real gains. It might be noted that the first of these goals conflicts with another goal stated by the Administration, that of concentrating the capital gains tax cut where the market response would be the greatest.

The exclusion for low-income taxpayers in the proposal could cause some administrative difficulties because it would create incentives for shifting capital gains assets to children within families.

F. THE IMPLICATIONS OF THE REVENUE ESTIMATES FOR LEGISLATIVE ACTION

Some Members of Congress have stated that the capital gains tax proposal will not be considered so long as the differences in the revenue estimates between the JCT and the Treasury remain. Given the importance of the Federal budget deficit and the difficulty of efforts in Congress to reduce it, any tax change that would increase the deficit raises serious concerns. As a partial response to these concerns, there are reports that the Administration is considering revisions in its proposal that would result in the Treasury and JCT revenue estimates moving closer together.

There is another relevant consideration, however. While the Joint Committee on Taxation is the official source of revenue estimates for tax legislation in Congress, the Office of Management and Budget (OMB) is the office that determines compliance with the deficit targets under the Gramm-Rudman-Hollings (GRH) deficit reduction procedure. ³⁹ OMB would use the Treasury revenue estimates in scoring the capital gains tax proposal under GRH.

The congressional budget resolution for fiscal year 1990 (H. Con. Res. 106) includes $5.3 billion in higher tax revenue, but does not specify where this tax revenue is to come from. The President is arguing that it should come largely from enacting the capital gains tax proposal. Some Members of Congress have said that the proposal should not be enacted if it would lose revenue in the long run because of the difficulty it would create for the deficit reduction process. On the other hand, since the proposal officially would be counted as increasing revenue under GRH, and because raising the revenue from other sources would be politically difficult, the capital gains tax proposal may look increasingly attractive as the time for writing the budget for fiscal year 1990 draws to a close.

One suggestion that is receiving some attention is for a capital gains tax cut, perhaps to a maximum tax rate of 20 percent, that would be effective for only two years. Such a tax cut would probably be estimated to raise revenue during the two years by both the Treasury and the Joint Committee on Taxation, not only because the short-run feedback effects exceed the long-run effects, but also because of the sales that would be accelerated to avoid the tax rate increase after the two-year period of reduced rates (after the two- year period the tax cut would result in lost revenues because of sales that had occurred earlier to take advantage of the lower tax rate). Such a tax cut may not be good tax policy -- it would introduce uncertainty and instability into the financial markets -- but it would almost certainly raise revenue while it was in effect.

III. DISTRIBUTIONAL EFFECTS

The benefits of a capital gains tax cut would be concentrated in the highest income brackets. Table II provides data on the distribution of capital gains on tax returns in 1985. The latest year for which detailed tax return data are available is 1986, but since capital gains realizations in that year were substantially higher because of the pending capital gains tax increase on January 1, 1987, these data would not provide a representative pattern. Hence, 1985 data are shown in the table.

The first column in the table reports the percentage of returns in each income bracket that report capital gains income. Fewer than 10 percent of returns with Adjusted Gross Income (AGI) less than $40,000 report capital gains income. For returns with AGI above $100,000, however, more than half report capital gains. More than 80 percent of returns above $500,000 have capital gains.

The second column reports capital gains in AGI as a percentage of AGI. In 1985, 60 percent of long-term capital gains was excluded from income, so gains in AGI represents only about 40 percent of total gains received by taxpayers. To get a truer picture of the contribution of capital gains to the incomes of taxpayers at the different income levels and to provide data that are consistent with current law, which does not include a capital gains exclusion, requires adding excluded gains back into both gains in AGI and AGI. This has been done in the middle column in table II. ⁴⁰

                               TABLE II

The final two columns in the table report the percentage of total gross AGI and total gross gains in each bracket. ⁴¹ Taxpayers with AGI above $1 million have only 2.5 percent of total gross AGI but receive 23.3 percent of gross capital gains. For taxpayers with incomes over $200,000 the figures are 7.4 percent of gross AGI and 48 percent of gross capital gains. ⁴²

Thus, the benefits of a capital gains tax cut are concentrated very heavily in the highest income brackets. ⁴³ It should be noted that this conclusion is independent of any controversy over the size of the feedback effect generated by the tax cut. Some people argue that because the tax cut would cause taxpayers to realize more capital gains and therefore pay more capital gains taxes, this should be taken into account in assessing the distributional effects of the tax cut. They argue that measures of distributional effects should be based on actual changes in tax payments in each income bracket, taking feedback effects into account, rather than being based on estimated "static" tax changes, which ignore feedback effects. Taken to its logical extreme, this argument combined with belief in a large feedback effect can result in the conclusion that people can be made worse off by cutting their taxes, which is clearly fallacious.

A tax cut, taken by itself, makes a taxpayer better off. If the taxpayer responds by taking action that results in paying higher taxes, the response presumably makes him better off yet (since the response is voluntary). Since the purpose of distributional analysis is to assess the extent to which different taxpayers are made better off or worse off by the tax change, the tax payment changes resulting from the feedback effect should be ignored in the analysis. Hence, the distributional effects of a tax change should be assessed by examining only the static tax change. ⁴⁴

IV. EFFECTS OF THE PROPOSAL ON TAX REFORM

The Tax Reform Act of 1986 is in several ways a very unusual piece of tax legislation. It was not enacted to raise or cut taxes or to increase or decrease the progressivity of the distribution of the tax burden, goals that usually motivate tax legislation. Instead, it was enacted to improve the fairness of the tax system (fairness in this case refers to "horizontal equity," or the degree to which the tax system treats people in roughly equal situations similarly) and to reduce the economic inefficiencies that the tax system causes. Leaving aside the more typical goals of tax legislation and concentrating on fairness and efficiency permitted political factions that normally would be opposed to join together in supporting these more universal objectives. The Act in some ways constitutes a "grand compromise" in which most groups gave something up but got something in return.

The Tax Reform Act substantially reduced tax rates and broadened the tax base, leaving overall revenues and the distribution of taxes roughly unchanged. The appeal of a dramatic reduction in tax rates was a major catalyst that brought the pieces of tax reform together. The marginal tax rate in the top income brackets was reduced from 50 percent to 28 percent by the Act. Such a large cut in the tax rate, however, would have provided very substantial tax decreases in the upper income brackets if not offset by other changes. This tax cut in the upper brackets would have violated the agreement among the major proponents of tax reform to leave the progressivity of the tax system unchanged. Eliminating the 60-percent exclusion for long-term capital gains (which raised the marginal tax rate on gains received by taxpayers in the highest tax brackets from 20 percent under prior law to 28 percent under current law) was one of the changes incorporated in the Act to offset the distributional effects of the tax rate cut at the highest income levels. ⁴⁵

Some people argue that it would be a violation of this compromise to now reduce the capital gains tax rate. These people maintain that if the capital gains tax rate is cut, income tax rates in the upper income brackets should be raised to offset the distributional effects, in a manner consistent with the spirit of the Tax Reform Act. ⁴⁶ Such an offsetting rate increase, however, would appear to be contrary to President Bush's pledge not to raise taxes.

V. CONSISTENCY OF THE PROPOSAL WITH THE STATED POLICY GOALS

The Administration stated three broad policy goals in advancing the capital gains tax proposal. The first is to encourage saving, entrepreneurship, and risk-taking investments. The reason for wanting to encourage saving is presumably to increase investment and economic output. Reducing the capital gains tax rate is however a very indirect method of stimulating investment and is likely to have small effects.

The first reason cutting the capital gains tax would have a small effect on investment is that only about 33 percent of household wealth is held in forms that are subject to the capital gains tax. ⁴⁷ Hence, a capital gains tax cut has a diluted effect in raising the overall rate of return to saving. The second reason is that, for many assets subject to the tax, a capital gains tax cut would have a relatively small effect in raising the after-tax rate of return. For example, for an asset held for 5 years that provides a real after-tax rate of return of 4 percent with half of the return provided by dividends and half by capital gain, assuming 4 percent inflation, a capital gains tax cut from 28 percent to 15 percent (a 46 percent tax cut) would increase the real after-tax return by only 15 percent (from .04 percent to .046 percent).

The third reason that cutting the capital gains tax would have a small effect on investment is that increasing the rate of return on saving may not have much effect on the amount of saving. Theoretically, an increase in the rate of return can either increase or decrease saving. ⁴⁸ While the empirical research is somewhat mixed, the weight of the evidence suggests that, at best, increasing the rate of return on savings increases savings only by a very small amount. ⁴⁹ Finally, with open international financial markets, increasing domestic saving may not have much effect on domestic investment. The higher savings will become part of the worldwide pool of financial capital and seek the highest rate of return wherever that may be obtained. In such an environment, only part of the higher savings would be expected to flow to higher investments in the U.S.

There is also reason to question the degree to which a capital gains tax cut would stimulate entrepreneurship and risk-taking investments. It is true that the current limitations on the deduction of capital losses, while justified on the grounds of preventing large tax revenue losses, reduce the appeal of risky investments and that a capital gains tax reduction would tend to offset this distortion. It is also true that a capital gains tax cut may increase the incentives for potential entrepreneurs to establish new companies, since much of their return is usually taken in the form of capital gains rather than as wage income. Nonetheless, a capital gains tax cut may have a smaller effect than is commonly believed in stimulating the financing of high-risk investments.

The 1985 Treasury study focused on high-growth, high-technology firms and concluded that, on average, they do not rely more heavily on equity capital than other types of firms or industries. The study also examined venture capital as a source of funds to such firms and concluded that, "between 3 and 12 percent of the external funds flowing to small, technological firms in recent years represented capital supplied by venture capitalists who are directly sensitive to the personal tax treatment of capital gains." ⁵⁰ The rest of the equity funds used by these firms comes largely from tax-exempt sources (pensions and insurance companies), foreign investors, and corporations. ⁵¹ Hence, a capital gains tax cut would have a smaller effect than may be commonly believed in stimulating saving, investment, and high-risk, high-growth firms.

The second broad policy goal stated by the Administration in advancing the capital gains tax proposal was to promote long-term, rather than short-term, investment. With regard to the holding period of capital assets, however, the proposal would have two opposing effects. For those investments that would otherwise be sold after a period shorter than the required holding period, the proposal would create an incentive to hold the asset longer to qualify for the lower capital gains tax rate. For assets currently held for long periods due to the lock-in effect of the present capital gains tax rate, however, the proposal would SHORTEN the average holding period (this is the source of the feedback effect on tax revenues). ⁵² The net effect of these two opposing changes in average holding periods is not clear; if the effect is to lengthen the average holding period, it probably would be by only a small amount.

Furthermore, while the goal of discouraging short-term investment is currently popular in political circles, it has not been rigorously established that this would improve the efficiency of the economy or of financial markets. In fact, it has traditionally been believed that financial markets were made more efficient by reducing transaction costs and encouraging trades whenever investors thought that a higher rate of return could be obtained on an alternative investment. This was part of the logic behind the deregulation of brokerage commissions in the mid-1970s.

Recently, it has been alleged by some observers that investors have a tendency to focus too much on short-term financial results or expectations in making investment decisions, thereby creating market inefficiencies and instability. If so, a tax structured to encourage longer-term investment could improve efficiency; otherwise, such a tax would reduce efficiency. These claims have been debated at length in the economic and financial literature and are quite controversial. At this point, the argument that short-term investment reduces efficiency must be regarded as unproved. ⁵³

The third broad policy goal the Administration stated for the proposal was to provide a rough adjustment for inflation in the measurement of capital gains. It is well known, however, that a preferential tax rate (or its equivalent, an exclusion) provides a poor approximation for the effects of inflation on capital income. In fact, a fairly thorough indictment of the approach was included in the Treasury's 1984 tax reform proposals, which included eliminating the 60 percent exclusion of long-term capital gains in prior law and implementing inflation indexation. In support of this proposal, the Treasury stated:

"The current preferential tax rate for capital gains has often been justified as an allowance for the overstatement of capital gains caused by inflation. The preferential rate actually serves this purpose only sporadically. The effects of inflation accumulate over time, yet the preferential tax rate does not vary with the holding period of an asset (beyond the minimum 6 months or one year) or with the actual rates of inflation during such period. As a result, the preferential rate undertaxes real income at low rates of inflation and overtaxes capital gains at higher rates of inflation; for any inflation rate, the longer an asset is held the greater is the undertaxation of real income. Moreover, the preferential rate does not prevent taxation of inflation-caused nominal gains in circumstances where the taxpayer has in fact suffered an economic loss". ⁵⁴

The inaccuracy of a preferential tax rate on capital gains as an inflation adjustment can be demonstrated easily using stock market data. Table III reports the results of comparing the effective exclusion that would exist under a 15 percent capital gains tax rate (the exclusion is based on the 15 percent rate compared to the 28 percent rate, or effectively a 46.43 percent exclusion) with the exclusion that would exist under indexation for all possible holding periods of stocks (in 1-year increments) over the period 1950 through 1988. That is, the calculations are based on holding periods of 1950 to 1951, 1950 to 1952, . . . 1950 to 1988, 1951 to 1952, 1951 to 1953, . . . 1951 to 1988, 1952 to 1953, etc. There are 741 such holding periods within this time period. The calculations are based on the S&P 500 stock index and the Consumer Price Index.

If the 15 percent capital gains tax rate accurately corrected for the effects of inflation, the ratio reported in the table would equal 1. Of the 741 comparisons, however, only 26, or 3.5 percent, are within 5 percent of being correct (a ratio between 0.95 and 1.05). Indeed, in many cases the 15 percent tax rate would not even come close to the correct adjustment for inflation; in 14.3 percent of the holding periods the adjustment would be more than 3 times too large, ⁵⁵ and in 12.6 percent of the periods the adjustment would be less than one-tenth of the appropriate amount. ⁵⁶

The only way to accurately adjust for the effects of inflation in the measurement of capital gains is to index the basis of assets for inflation.

VI. EFFICIENCY ISSUES

A proposal to cut the capital gains tax raises a number of issues regarding economic efficiency. While these are very important issues, they will be only briefly summarized here because they have been dealt with at greater length elsewhere. ⁵⁷

The "lock-in" of capital assets caused by the capital gains tax (discussed above) is an efficiency issue. The tax distorts the efficient operation of the economy by preventing sales of capital assets that would otherwise occur. This problem is greatest for nondepreciable assets, since their stepped-up basis provides no immediate tax benefit after a sale to partially offset the lock-in effect.

                               TABLE III

An inefficiency caused by a lower capital gains tax rate is that it favors investment in assets that provide returns in the form of gains. It favors investment in land, for example, and favors "growth" stocks over "income" stocks, but there is no well-established economic justification for doing so. It also favors a policy of corporations to retain earnings (which gives rise to capital gains) rather than paying dividends (which results in receipt of ordinary income by shareholders). Not only does this reduce market efficiency, but it may also magnify existing inefficiencies if corporate management has a bias toward "empire building."

By reducing the tax burden on corporate stock, however, a reduced capital gains tax decreases the double taxation of corporate equity, one of the major inefficiencies in the current tax system. This would have two effects. First, it would reduce the tax disadvantage of operating a business in the corporate form. Second, it would decrease the bias in the tax code that favors use of debt finance by corporations rather than equity. This bias may be partially responsible for the increasing corporate debt/equity ratios in recent years. ⁵⁸

In addition, the proposal creates some efficiency issues of its own. For example, land would qualify for the reduced capital gains tax rate but depreciable property used in a trade or business would not. This distinction would create incentives for sellers to allocate a higher portion of the total value of a real estate sale to the land rather than to buildings or equipment. The buyer's interest in allocating value to assets that can be depreciated may partially offset this incentive. The proposal also would create incentives to put depreciable assets and collectibles (which would not qualify for the lower capital gains tax rate) into corporations and then trade the corporate stock (which would qualify). These aspects of the proposal would necessitate regulations and enforcement, which may bring their own inefficiencies.

² For a brier history of capital gains tax treatment, see: U.S. Library of Congress, Congressional Research Service, Capital Gains Tax Issues, Report No. 88-80 E, by Jane G. Gravelle, January 8, 1988. 15 p.

³ The information in this section is derived largely from, Department of the Treasury, General Explanations of the President's Budget Proposals Affecting Receipts, February 1989, 55 p.

⁴ The special treatment of capital gain would not be a tax preference under the minimum tax, so the 15 percent tax rate would be the maximum rate including the effects of the minimum tax.

⁵ The 15 percent maximum tax rate on capital gains would be equivalent to a 46.4 percent exclusion for taxpayers in the 28 percent tax bracket and a 54.5 percent exclusion for taxpayers subject to the 33 percent marginal tax rate.

⁶ See Statement of Dennis E. Ross, Acting Assistant Secretary (Tax Policy), Department of the Treasury, Before the Committee on Finance, U.S. Senate, March 14, 1989, p. 4.

⁷ The revenue estimates are generated by estimating the effect if gains on all capital assets received the favorable treatment, and then subtracting the effects of excluding certain assets. In this context, the exclusion results in a smaller revenue loss, or a revenue gain, compared to a broader proposal.

⁸ For reviews of this research see: U.S Library of Congress, Congressional Research Service, A Proposal for Raising Revenue by Reducing Capital Gains Taxes?, Report No. 87-562E, by Jane G. Gravelle, June 30, 1987, 10 p; and U.S. Congressional Budget Office, How Capital Gains Tax Rates Affect Revenues: The Historical Experience, March 1988, especially chapter II and appendix B.

⁹ Henderson, Yolanda K., Capital Gains Rates and Revenues, New England Economic Review, Federal Reserve Bank of Boston, Jan./Feb. 1989, p. 4.

¹⁰ CBO, How Capital Gains Tax Rates Affect Revenues (cited in footnote 8).

¹¹ The cited estimate is in table A-3, equation Al2 of the CBO study, How Capital Gains Tax Rates Affect Revenues (cited in footnote 8).

¹² The marginal tax rate on capital gains is the tax rate that applies to the next dollar of capital gains income received.

¹³ The average tax rate on capital gains is the total tax paid on capital gains divided by the total amount of capital gains income.

¹⁴ See the discussions in: Office of the Assistant Secretary for Economic Policy, U.S Department of the Treasury, The Direct Revenue Effects of Capital Gains Taxation: A Reconsideration of the Time-Series Evidence, by Michael R. Darby, Robert Gillingham, and John S. Greenlees, June 1, 1988, 9 p.; Minarik, Joseph J., The New Treasury Capital Gains Study: What is in the Black Box?, Tax Notes, June 20, 1988, p. 1465-1471; Darby, Michael R., Robert Gillingham, and John Greenlees, The Black Box Revealed: Reply to Minarik, Tax Notes, July 25, 1988, p. 413-416; Minarik, Joseph J., Capital Gains Tax Cuts and Marginal and Average Rates: Minarik Explores the Black Box, Tax Notes, September 26, 1988, p. 1431-1432, and U.S Congressional Budget Office, Simulating the Revenue Effects of Changes in the Taxation of Capital Gains, Staff Working Paper, March 1989, 32 p.

¹⁵ The average marginal tax rate is the average of the marginal tax rates faced by all taxpayers.

¹⁶ OEP, The Direct Revenue Effects of Capital Gains Taxation (cited in footnote 13). The cited estimate is in table 3, equation 1. Part of the reason for the smaller estimated coefficient is that OEP used a different tax rate series than CBO.

¹⁷ Auerbach, Alan J., Capital Gains Taxation in the United States: Realizations, Revenue, and Rhetoric, Brookings Papers on Economic Activity, 2/1988, p. 595-631. The cited estimate is in table 2, equation 3.

¹⁸ Much of the discussion of the issue of the responsiveness of capital gains realizations to tax rate changes has been in terms of the "elasticity" of the response. Elasticity is a measure of the percentage change in one variable (e.g., gains realizations) in response to a one-percent change in another variable (e.g., the tax rate). In the capital gains discussion, however, elasticity is not very useful because most of the equations used to estimate the responsiveness have not been of the constant-elasticity form. In equation 1 in the text, for example, the elasticity of realizations with respect to the tax rate is c x MTR. Using the CBO estimate of c, the elasticity would be -0.868 at a tax rate of 28 percent, but it would be -0.465 at a tax rate of 15 percent.

¹⁹ See: Statement of Ronald A. Pearlman, Chief of Stan, Joint Committee on Taxation, Before the Senate Committee on Finance, March 14, 1989, p. 5.

²⁰ See: Statement of Dennis E. Ross (cited in footnote 6).

²¹ The feedback revenue effect divided by the increase in realizations provides the tax rate under the proposal. The static revenue effect divided by current-law realizations provides the decrease in tax rates from current law to the proposal.

²² A 95 percent confidence interval for the estimate of the coefficient c derived by CBO extends from -0.006 to -0.056, see CBO, How Capital Gains Tax Rates Affect Revenues (cited in footnote 8), table 14, p. 60.

²³ Office of Tax Analysis, Office of the Secretary of the Treasury, Report to the Congress on the Capital Gains Tax Reductions of 1978, September 1985, 199 p.

²⁴ As this report was in final preparation, the Treasury released three new reports claiming to show higher degrees of responsiveness of capital gains to tax rate changes than previous research. These studies have not yet been evaluated by other researchers. See: Jones, Jonathon D., An Analysis of Aggregate Time Series Capital Gains Equations, OTA Paper 65, U.S Department of the Treasury, May 1989, 20 p.; Gillingham, Robert, John S. Greenless, and Kimberly D. Zeischang, New Estimates of Capital Gains Realization Behavior: Evidence from Pooled Cross-Section Data, OTA Paper 66, May 1989, 31 p.; and Auten, Gerald E., Leonard E. Burman, and William C. Randolph, Estimation and Interpretation of Capital Gains Realization Behavior: Evidence From Panel Data, OTA Paper 67, May 1989, 28 p.

²⁵ See: Statement of Ronald A. Pearlman (cited in footnote 19), figure 1.

²⁶ The effective tax rate could, to some extent, be a function of the level of capital gains realizations. If so, this would partially explain the difference in the results obtained by Treasury compared to the JCT. This complication is ignored in the calculations in the text.

²⁷ Some difference in these estimates may also be attributable to differences in assumed capital gains realizations under current law not discernable from the JCT graph.

²⁸ Statement of Dennis E. Ross (cited in footnote 4), p. 11.

²⁹ If accrued but unrealized gains equal 30 percent of the total value of stocks in the market, for example, then in a long-run steady-state relationship 30 percent of the annual accruals multiplied by the growth rate of the value of stocks must remain unrealized to preserve the long-run relationship.

³⁰ Department of the Treasury, Comparison of Treasury Department and Congressional Budget Office Revenue Estimates of the Tax Reform Act of 1986, January 8, 1987.

³¹ Department of the Treasury, General Explanations (cited in footnote 3), p. 12.

³² The combination of the static and feedback effects of the proposed tax rate cut and the shift of ordinary income to capital gains income yields a small revenue loss in the Treasury estimates. The exclusion or certain assets from the lower capital gains tax rate and the longer holding period convert the revenue loss to a revenue gain.

³³ Some of the studies, however, do focus on a single type of asset; see, for example, Feldstein, Martin, Joel Slemrod, and Shlomo Yitzhaki, The Effects of Taxation on the Selling of Corporate Stock and the Realization of Capital Gains, Quarterly Journal of Economics, June 1980, p. 777-791.

³⁴ Office of the Secretary of the Treasury, Report to the Congress (cited in footnote 23), p. 165.

³⁵ See: Clark, Bobby and David Paris, Sales of Capital Assets, 1981 and 1982, SOI Bulletin, Winter 1985-86, p. 65-89.

³⁶ See, for example: Fredland. J. Eric, John A. Gray, and Emil M. Sunley, Jr., The Six Month Holding Period for Capital Gains: An Empirical Analysis of its Effect on the Timing of Gains, National Tax Journal, December 1968, p. 467-478; and Kaplan, Steven, The Holding Period Distinction of the Capital Gains Tax, NBER Working Paper Series, No. 762, September 1981, 29 p.

³⁷ This effect could be partially offset by a higher level of accrued gains remaining unrealized during investors' lifetimes to take advantage of the step-up in basis at death due to the higher overall taxation of capital gains resulting from the longer holding period.

³⁸ Department of the Treasury, General Explanations (cited in footnote 3), p. 4.

³⁹ See: U.S. Library of Congress, Congressional Research Service, Sequestration Actions for FY90 Under the Gramm-Rudman- Hollings Act, Issue Brief IB89017, by Robert Keith, Updated Regularly.

⁴⁰ This is not the way such adjustments are normally shown in distribution tables. Adding excluded gains back into AGI changes the income concept. Hence, strictly speaking, returns should be reclassified into brackets according to gross AGI levels for comparison. The general pattern of the distributions shown in the table would not be altered dramatically by such a rebracketing.

⁴¹ The data in table II omit returns with AGI less than zero. These returns are predominated by returns of wealthy taxpayers who have losses or other offsets that result in negative AGI for the year. They also report a substantial amount of capital gains. If returns with negative AGI are included in the totals, they have 6.8 percent of total gross capital gains.

⁴² Using a more inclusive income definition than AGI, the Joint Committee on Taxation estimated that 60 percent of the total tax decrease from the Bush capital gains proposal would be received by taxpayers with incomes over $200,000. Under their income definition, a larger percentage of taxpayers is in this bracket than when AGI is used as the classifier. See: Joint Committee on Taxation, Tax Treatment of Capital Gains and Losses, March 11, 1989, table 2, p. 27.

⁴³ Some proponents have argued that data such as those in table II give a misleading impression of the distribution of capital gains because of the effect of non-recurring gains in pushing taxpayers into higher income brackets. This argument was recently disputed by CBO. See: Letter from Congressional Budget Office Director Robert Reischauer to Rep. Willis Gradison (R-Ohio) on Effect of Capital Gains Tax Break on Non-Wealthy Taxpayers, Daily Tax Report, May 31, 1989, p. Ll-L2.

⁴⁴ For further elaboration and explanation of this point, see: U.S. Library of Congress, Congressional Research Service, "Feedback" Effects of Tax Policy: Distributional Implications Report No. 89-94 RCO, by Donald W. Kiefer, February 10, 1989, 12 p.

⁴⁵ The other changes playing this role were the passive loss restrictions and, to some extent, the elimination of the deductibility of State sales taxes.

⁴⁶ The reverse constraint may also apply. If, at some point in the future, income tax rates in the upper income brackets are increased to raise revenue to help reduce the budget deficit, this may be regarded as violating a compromise in the 1986 tax reform. Some people may demand that a capital gains tax cut accompany any income tax rate increase in the upper brackets.

⁴⁷ See: Office of the Secretary of the Treasury, Report to Congress (cited in footnote 23), p. 98-103

⁴⁸ A higher rate of return makes it more beneficial to save, but it also reduces the amount of savings necessary to have a given sum of money at a specified time in the future.

⁴⁹ See: Hall, Robert E., Intertemporal Substitution in Consumption, Journal of Political Economy, April 1988, p. 339-357, Friend, Irwin and Joel Hasbrouck, Saving and After-Tax Rates of Return, Review of Economics and Statistics, November 1983, p. 537- 543; and Evans, Owen J., Tax Policy, the Interest Elasticity of Saving, and Capital Accumulation: Numerical Analysis of Theoretical Models, American Economic Review:, June 1983, p. 398-410.

⁵⁰ Office of the Secretary of the Treasury, Report to the Congress (cited in footnote 23), p. 144.

⁵¹ For another analysis reaching similar conclusions, see: Poterba, James M., Venture Capital and Capital Gains Taxation, in: Summers, Lawrence H., Editor, Tax Policy and the Economy, NBER, MIT Press, Cambridge, 1989, p 47-67.

⁵² It would also shorten the holding period for loss stocks that would otherwise be held longer than the holding period.

⁵³ For a more detailed discussion of this issue, see: U.S. Library of Congress, Congressional Research Service, Should Short- Term Trading in the Stock Market be Discouraged?, Report No. 87-51 S, by Donald W. Kiefer, September 28, 1987, 25 p.

⁵⁴ U.S. Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth. volume 2, November 1984, p 180.

⁵⁵ The calculations can be illustrated by using as an example the holding period 1959 to 1961. At the end of 1959 the S&P 500 index was 59.06, at the end of 1961 it was 71.74, for a 21.5 percent gain At the end of 1959 the CPI was 29.1; at the end of 1961 it was 29.9, a 2.7 percent gain. To index for inflation over this holding period, the basis of the stock should be increased by 2.7 percent. This would exclude from taxation 12.8 percent of the gain on the stock over this period. The 15 percent tax rate, however, effectively excludes 46.43 percent of the gain from taxation, or 3.6 times more than required to adjust for the effect of inflation.

⁵⁶ The calculations reported in the table take into account only the adjustment in the basis of the stock for inflation. They do not consider the effects of deferral of taxation due to realization of capital gain only upon sale of the stock.

⁵⁷ See: Gravelle, Jane G and Lawrence B. Lindsey, Capital Gains, Tax Notes, January 25, 1988, p 397-405, and Office of the Secretary of the Treasury, Report to the Congress (cited in footnote 23).

⁵⁸ How a change in the capital gains tax would affect the economics of issuing debt to repurchase equity, however, is somewhat ambiguous; see: U.S. Library of Congress, Congressional Research Service, Tax Aspects of Leveraged Buyouts, Report No. 89-142 RCO, by Jane G. Gravelle, March 29, 1989, 11 p.

                               APPENDIX

NOTE: Totals may not add due to rounding.

¹ The official CBO baseline extends only through fiscal year 1994. Estimates for fiscal years 1995 through 1999 assume that the CBO baseline assumption for realizations continues to grow at the average rate of growth of the period 1990 through 1994.

² Item 1 has three subparts. The third is the net revenue effect which would result from a 45 percent exclusion, with a maximum 15 percent tax rate, for capital gains regardless of asset type assuming a one-year holding period and an effective date of sales on or after January 1, 1989. The first subpart shows the 'static' revenue effect, that is the revenue effect assuming no taxpayer behavioral response. The second subpart, 'induced realizations,' shows the effect on revenues of new realizations undertaken and conversion of ordinary income to capital gain by taxpayers in response to the preferential rate. Item II presents the estimated revenue effect resulting from moving the effective date of the proposal to July 1, 1989. Item III presents the estimated revenue effect resulting from excluding collectibles and depreciable property. Item IV presents the revenue effect of the lengthening, on a phased-in basis, of the holding period. Item V presents the effect of providing a 100-percent exclusion to those eligible taxpayers with adjusted gross income less than $20,000.

                                TABLE 3