Capital Gains Taxation and U.S. Economic Growth
Testimony Before the Standing Committee on Banking, Trade and Commerce of the Senate of Canada
1. Overview. I am honored to be invited to address this committee on the U.S. experience with capital gains taxation and to outline the ACCF’s goals for future pro-capital formation tax changes. The ACCF’s research shows the positive impact of capital gains tax reductions on capital costs, saving, investment, and entrepreneurial activity.
2. Tax Policy and Economic Growth. To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, capital gains (and other forms of saving) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.
3.Macroeconomic Impact of Capital Gains Tax Reductions.
- Enhance Economic Growth. New research by Dr. David Wyss, chief economist of Standard & Poor’s DRI and a top public finance expert, finds that the Taxpayer Relief Act of 1997, enacted by the U.S. Congress, which reduced the long-term individual capital gains tax rate from a top rate of 28 percent to 20 percent, has had several favorable impacts on the American economy in the intervening two years.
- Encourage Entrepreneurship. Capital gains taxation has a particularly powerful impact on the nation’s entrepreneurs, a major, driving force for technological breakthroughs, new start-up companies, and the creation of high-paying jobs. Starting new businesses involves not only entrepreneurs but also informal investors, venture capital pools, and a healthy public market.
- Benefit Middle-Income Taxpayers. Investments in capital assets are widely held by the middle class. A new study by Leonard E. Burman, deputy assistant secretary for tax analysis at the U.S. Department of the Treasury, states that in 1992 about three-quarters of all families in the United States owned stocks, bonds, business property, real estate, or houses.Middle- and low-income taxpayers also hold a significant share of the total dollar value of capital assets, even when personal residences are excluded. Dr. Burman’s study shows that 30 percent of the dollar value of such assets was held by families with incomes of $50,000 or less in 1992.
4. International Comparison of Capital Gains Tax Rates. Both short- and long-term individual capital gains on equities are taxed at higher rates in the United States than in most of the other 23 countries surveyed. Short-term gains are taxed at 39.6 percent in the United States compared to an average of 18.4 percent for the sample as a whole. Long-term individual gains face a tax rate of 20 percent in the United States versus an average of 14.8 percent for all the countries in the survey.
5.Economic Impact of Further Capital Gains Tax Reductions. A preliminary analysis of the capital gains tax reductions included in the “Taxpayer Refund and Relief Act of 1999″ (H.R. 2488) by Dr. Allen Sinai, chief global economist, Primark Decision Economics, shows that reducing the individual long-term rates from 20/10 percent to 18/8 percent would have a significant, positive impact. (H.R. 2488 was vetoed by President Clinton in September, 1999.)
6.Conclusion. Recent 1997 and 1998 individual capital gains tax reductions and shortening of the holding period have had a positive impact on the U.S. economy. Further capital gains tax reductions could significantly enhance economic growth.
My name is Margo Thorning. I am Senior Vice President and Chief Economist of the American Council for Capital Formation. I am honored to be invited to address this committee on the U.S. experience with capital gains taxation and outline the ACCF’s goals for future pro-capital formation tax changes.
The ACCF represents a broad cross-section of the American business community, including the manufacturing and financial sectors, Fortune 500 companies and smaller firms, investors, and associations from all sectors of the economy. Our distinguished board of directors includes cabinet members of prior Republican and Democratic administrations, former members of Congress, prominent business leaders, and public finance experts.
The American Council for Capital Formation has led the private-sector Capital Gains Coalition since 1978, when the first major post-World War II capital gains tax cut was enacted. The Coalition brings together in support of capital gains tax relief diverse participants from all sectors of the business community-venture capital, growth companies, timber, farmers, ranchers, small business, real estate, securities firms, and the banking and insurance industries.
Recent Evidence on the Impact of Tax Policy on Economic Growth
To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, saving (including capital gains) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.
This is primarily because the income tax hits saving more than once-first when income is earned, and again when interest and dividends on the investment financed by saving are received, or when capital gains from the investment are realized. The playing field is tilted away from saving and investment because the individual or company that saves and invests pays more taxes over time than if all income were consumed and no saving took place. Taxes on income that is saved raise the capital cost of new productive investment for both individuals and corporations, thus dampening such investment. As a result, future growth in output and living standards is impaired.
Several recent analyses by academic scholars and government policy experts such as Professors Alan Auerbach of the University of California and Laurence J. Kotlikoff of Boston University, and others whose studies are cited in a 1997 study by the Joint Committee on Taxation of the U.S. Congress, suggest that substituting a broad-based consumption tax for the current federal income tax could have a positive impact on economic growth and living standards. The macroeconomic models used by the scholars in the studies described below incorporate feedback and dynamic effects in simulating the impact of adopting either a broad-based consumption tax or “pure” income tax.
The “pure” income tax eliminates all personal exemptions and deductions, and taxes labor and capital income at a single rate. The “pure” consumption tax differs from the pure income tax by permitting expensing of new investment (meaning that the total cost of the investment is deducted in the first year). This tax is implemented as a tax on wages with all saving (including capital gains) exempt from tax at the household level, and as a cash-flow tax on businesses.
The effects of the consumption tax proposals on GDP are generally positive over the medium and long terms, although the magnitude of these effects varies widely (see Table 1). For example, the Jorgenson-Wilcoxen model predicts that under a consumption tax, real GDP would be 3.3 percent higher each year in the long run compared to 1.3 percent higher under a unified income tax. The Auerbach, Kotlikoff, Smetters, and Walliser model predicts even greater gains in the long run (7.5 percent) under a consumption tax and losses (-3.0 percent of GDP) under a unified income tax. Similarly, the Engen-Gale analysis shows that the capital stock would be 9.8 percent higher in the long run under a consumption tax but 1.6 percent lower under a unified income tax compared to current law. The consensus seems to be that the economy would fare better under a “pure” consumption tax than under a “pure” income tax or under current law.
|Table 1||Impact of Tax Reform on GDP and Capital Stock Growth
Percent differences from current tax code baseline
|Consumption Tax||Unified Income Tax|
|Summary variables||2005||2010||Long run||2005||2010||Long run|
Smetters, & Walliser
|Coopers & Lybrand||1.2||-||-||1.1||-||-|
Smetters, & Walliser
|Coopers & Lybrand||1.5||-||-||1.1||-||-|
|1. Assumes leisure-consumption (intratemporal) and intertemporal elasticities both are 0.15.
2. Assumes leisure-consumption (intratemporal) and intertemporal elasticities both are 0.50.
Source: Adapted from Joint Committee on Taxation, “Tax Modeling Project and 1997 Tax Symposium Papers,” November 20, 1997.
Thus, in the ACCF’s view, the long-run goal of U.S. federal tax policy should be to shift toward a broad-based consumption tax under which all income that is saved, including that from capital gains, is exempt from tax.
Trends in U.S. Capital Gains Tax Policy
Historical Perspective During the last half of the century, the U.S. Congress has acted several times to increase or decrease individual and corporate capital gains tax rates and to raise or lower the holding period requirement for capital gains treatment (see Table 2). The top marginal federal statutory rate on individual capital gains has ranged from as high as 35 percent to the current low of 20 percent. Corporate capital gains tax rates have ranged from 25 percent to the current-law 35 percent. Holding period requirements have varied from 6 months to as long as 18 months; currently the holding period is one year.
|Table 2||History of U.S. Federal Capital Gains Tax Rates|
|Top Income Tax Rate (%)||Top Capital Gains Tax Rate (%)a||Capital Gains Differential (%)b||Top Income Tax Rate (%)||Top Capital Gains Tax Rate (%)a||Capital Gains Differential (%)b|
|a. Maximum capital gains tax rate.
b. Differential between marginal income tax rate and capital gains rate.
c. Interplay of minimum tax and maximum tax on earned income results in a marginal rate of 49.125 percent.
d. Statutory maximum of 28 percent but “phase-out” notch increases rate to 33 percent.
e. Interplay of all “phaseouts” can increase marginal rate to 49.5 percent.
f. The Budget Act of 1990 increased the statutory rate to 31.0 percent, and capped the marginal rate on capital gains at 28.0 percent. Until 1996, however, some taxpayers will face effective marginal rates of more than 34.0 percent due to the phase-out of personal exemptions and itemized deductions.
g. Includes a 10 percent surcharge.
h. The IRS Restructuring and Reform Act of 1998 reduced the holding period required to qualify for the 20 percent long-term capital gains rate from 18 months to 12 months for gains properly taken into account on or after January 1, 1998.Prepared by the ACCF Center for Policy Research, Washington, D.C.
Current U.S. Capital Gains Tax Provisions
Individual Capital Gains Tax Rates
The Taxpayer Relief Act of 1997 reduced the top individual capital gains tax rate to 20 percent (10 percent for individuals in the 15 percent bracket). A special lower rate of 18 percent (8 percent for individuals in a 15 percent tax bracket) applies to transactions after December 31, 2000, when the asset was held more than five years.
Corporate Capital Gains Tax Rates
Corporate capital gains are taxed at a rate of 35 percent (the same as the top tax rate on ordinary corporate income).
Netting of Gains and Losses
Gain or loss from the sale or exchange of a capital asset is characterized as either short term or long term depending on how long the asset was held by the taxpayer. If a taxpayer has both long-term and short-term transactions during the year, each type is reported separately and gains and losses from each type are netted separately. The net long-term capital gain or loss for the year is then combined with the net short-term capital gain or loss for the year to arrive at an overall (net) capital gain or loss. If capital gains exceed capital losses, the overall gain is included with the taxpayer’s other income but is generally subject to a maximum tax rate of 20 percent for sales of long-term capital assets and 35 percent for corporations. If capital losses exceed capital gains, the overall losses are subject to deduction limitations ($3,000 per year for individuals). A corporation can use capital losses for a tax year only to offset capital gains in that year.
The Impact of Capital Gains Tax Reductions on the U.S. Economy
Searching for methods of stimulating saving, investment, and economic growth, policymakers enacted a significant capital gains tax reductions for individuals in 1997 (described above).
Lower capital gains taxes not only treat savers more fairly but also help hold down capital costs. Public finance economists refer to the tax on capital gains as a tax on retained income. It is retained income that funds a large part of business investment. The higher the capital gains tax, the more difficult it is for management to retain earnings (rather than pay out dividends) for real investment in productive projects.
Although the short-term outlook for the U.S. economy is favorable, worries about the future appear to be multiplying. For example, many public finance experts such as Stanford University’s Professor John Shoven conclude that this country’s long-term strength and economic stability depend on increasing saving and investment to ensure that the retirement of the baby boom generation does not sink the economy into a sea of red ink. While the 1997 cut in the top marginal capital gains tax rate from 28 to 20 percent was not an economic panacea, it has helped to encourage saving, maintain the values of capital assets (e.g. real estate and stocks), promote investment by both mature and new businesses, and more fairly tax individual savings.
Macroeconomic Effects of 1997 Capital Gains Tax Cut
Reducing the individual capital gains tax from a top rate of 28 percent to 20 percent in 1997 reduced the net cost of capital for new investment by about 3 percent, according to a new macroeconomic analysis of the economic and revenue impact of the tax cut prepared by Dr. David Wyss, chief economist of Standard & Poor’s DRI and a top public finance expert.
Dr. Wyss’s study shows that reducing capital costs will, other things being equal, raise business investment by 1.5 percent per year. Over a 10-year period, the capital stock will rise by 1.2 percent and productivity and real GDP will increase by 0.4 percent relative to the baseline forecast (see Table 3). This productivity increase allows living standards to rise; for example, U.S. household income will be $309 higher each year and the average worker’s real wage will be $250 higher in 2007 and in each succeeding year (see Figure 1).
|Table 3||Economic Impact of the 1997 Capital Gains Tax Reduction
Compared to the baseline forecast
|Real GDP (% increase by 2009)||0.4|
|Investment (% per year increase)||1.5|
|Capital stock (% difference by 2009)||1.2|
|Productivity (% increase by 2009)||0.4|
|Cost of capital (% difference)||-3.0|
|Total federal tax receipts
(billions of 1997 dollars)
|Source: Capital Gains Taxes and the Economy: A Retrospective Look, June, 1999. Standard & Poor’s DRI, Lexington, Mass.|
Figure 1: 1997 Capital Gains Tax Cut: Impact on U.S. Wages and Household Income in 2007 and Beyond (1999 dollars)
Note: The DRI study shows that productivity increases by 0.4 percent by 2007 due to the 1997 capital gains tax cut. Higher productivity growth permits real wages and household income to increase relative to the baseline (no 1997 capital gains tax cut).
Source: Capital Gains Taxes and the Economy: A Retrospective Look, June, 1999. Standard & Poor’s DRI, Lexington, Mass.
In addition, a significant share of the increase in stock prices since 1997 (about 25 percent) is due to lower taxes on individual capital gains realizations (see Figure 2). Lower capital gains taxes increase the after-tax rate of return on equities, thus stock prices must rise to re-equilibrate the risk-adjusted after-tax return with the rate available on other assets, such as bonds.
Figure 2: 1997 Capital Gains Tax Cut: Impact on Stock Prices From 1997 to 1999 (S&P index of 500 common stocks)
Source: Capital Gains Taxes and the Economy: A Retrospective Look, June, 1999. Standard & Poor’s DRI, Lexington, Mass.
Finally, a dynamic rather than static analysis of the impact of the cut on federal revenues shows that the stronger growth in the economy adds to federal revenues over the long run.
Impact on Entrepreneurship and Venture Capital
Capital gains taxation has a particularly powerful impact on entrepreneurs. These individuals are a major driving force for technological breakthroughs, new start-up companies, and the creation of high-paying jobs. Starting new businesses involves not only entrepreneurs but also informal investors, venture capital pools, and a healthy public market. All taxable participants are sensitive to after-tax rates of return, which is why the level of capital gains taxation is so important.
Foremost is the entrepreneur. If the tax on potential capital gains is a higher rate, either the pool of qualified entrepreneurs will decline or taxable investors will have to accept a lower rate of return. In either case, the implications for the economy are clearly negative. To be successful, the entrepreneur needs capital. Fledgling start-ups depend heavily upon equity financing from family, friends, and other informal sources. Professors William Wetzel and John Freear of the University of New Hampshire, in a survey of 284 new companies undertaken in the late 1980s, found taxable individuals to be the major sources of funds for those raising $500,000 or less at a time. The point to be stressed is that individuals providing start-up capital for these new companies pay capital gains taxes and are sensitive to the capital gains tax rate.
The important role of taxable “angels” in providing “seed money” for startups is also documented in a new report by Dr. Stephen Prowse of the Federal Reserve Board of Dallas presented at a 1998 conference sponsored by the Federal Reserve Bank of Kansas City. Dr. Prowse notes that the angel capital market appears to be growing in importance, although it operates in almost total obscurity. He points out that there are wide-ranging estimates of its size-from as little as $3 billion per year invested to as much as $20 billion. Whatever its actual size, the market appears to be an essential source of funds for entrepreneurs in many different industries. In one study of high-tech start-up companies, for instance, Dr. Prowse found that more than half the companies sampled had used angel investors as a source for at least part of their capital base, and a fifth had relied exclusively on angels. Small businesses and entrepreneurs face higher capital costs than Fortune 500 companies. For them, a significant capital gains tax differential can make a big difference in their decisions affecting jobs and growth.
According to DRI’s Dr. Wyss, there are two primary reasons for encouraging venture investment: First, it is critical to the economy since innovation and job creation come disproportionately from new start-ups; and second, the private market will tend to under-invest. Thus, start-ups need to be encouraged. Innovation and new company formation are inherently risky; only about one in three new start-ups succeed; individual investors are risk averse, and since they cannot invest in every start-up, must balance the high risk by the hope of high returns. Society should not be risk averse, since on an actuarial basis it knows start-ups will be winners; the success of the one will more than offset the failure of the two losers. Since society effectively “invests” in every start-up, it should not be averse to the risks. Every stop should be pulled out to encourage more new business, because these new ventures are so high-risk, and return such a high reward, they need to be pushed even harder by society, Dr. Wyss concludes.
Impact on Middle-Income Taxpayers
Investments in capital assets are widely held by middle-income taxpayers. A new study by Leonard E. Burman, deputy assistant secretary for tax analysis at the U.S. Department of the Treasury, states that in 1992 about three-quarters of all families in the United States owned stocks, bonds, business property, real estate, or houses.
Middle- and low-income taxpayers also hold a significant share of the total dollar value of capital assets, even when personal residences are excluded. Dr. Burman’s study shows that 30 percent of the dollar value of such assets was held by families with incomes of $50,000 or less in 1992.
In addition, a 1999 survey by the Investment Company Institute and the Securities Industry Association shows that almost half of all U.S. households own equities.
U.S. Capital Gains Tax Policy: Strategies to Enhance U.S. Economic Growth
The individual capital gains tax rate reductions in the Taxpayer Relief Act of 1997 and the shortening of the holding period in the IRS Restructuring and Reform Act of 1998 were positive steps that reduced U.S. capital costs, increased investment, real income, productivity growth, and federal budget receipts. However, many public finance experts suggest that additional capital gains rate reductions would have a positive impact on the U.S. economic growth, job creation, and entrepreneurship.
International Comparison of Capital Gains Tax Rates
U.S. capital gains tax rates, which affect the cost of capital and therefore investment and economic growth, are still high compared to those of other countries. In fact, most industrial and developing countries tax individual and corporate capital gains more lightly than does the United States, according to a survey of 24 industrialized and developing countries that the ACCF Center for Policy Research commissioned from Arthur Andersen LLP.
Both short- and long-term individual capital gains on equities are taxed at higher rates in the United States than in most of the other 23 countries surveyed (see Table 4). Short-term gains are taxed at 39.6 percent in the United States compared to an average of 18.4 percent for the sample as a whole. Long-term individual gains face a tax rate of 20 percent in the United States versus an average of 14.8 percent for all the countries in the survey. Thus, U.S. taxpayers face tax rates on long-term gains that are 35 percent higher than those paid by the average investor in other countries. In addition, the United States is one of only five countries surveyed with a holding period requirement in order for the investment to qualify as a capital asset.