Capital Gains Taxes and U.S. Economic Growth: A Retrospective Look


Policymakers concerned about the economic welfare of future generations of Americans, as well as this nation’s ability to maintain superpower status and world leadership, need to constantly reassess current tax policy in terms of its long-run impact on U.S. saving, investment, and international competitiveness. The ACCF Center for Policy Research offers this Special Report summarizing two recent ACCF analyses to help policymakers evaluate the economic impact of the 1997 capital gains tax rate reduction in the Taxpayer Relief Act of 1997 as well as assess how U.S. capital gains tax rates compare to those of other countries.

Macroeconomic Effects of
1997 Capital Gains Tax Cut

First, reducing the 1997 individual capital gains tax from a top rate of 28 percent to 20 percent 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 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 the capital cost reduction 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 1). 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 1 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. Prepared by Standard & Poor’s DRI, Lexington, Mass., for the American Council for Capital Formation.


[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, & Poor’s DRI, Lexington, Mass., for the American Council for Capital Formation.

Second, 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. Prepared by Standard & Poor’s DRI, Lexington, Mass., for the American Council for Capital Formation.

Third, a dynamic rather than a 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 tax rates are important in rewarding entrepreneurs and early-stage investors for the risk they bear when starting a new venture. Dr. Wyss states that 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 is 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.

Competitors Tax Gains Less Than
United States

Another ACCF study, “An International Comparison of Capital Gains Tax Rates,” which surveyed 24 industrial and developing countries, shows that most countries tax individual and corporate capital gains more lightly than does the United States. The study, prepared by Arthur Andersen LLP, shows that short-term individual gains are taxed at 39.6 percent in the United States compared to an average of 19.4 for the sample as a whole. Long-term gains face a tax rate of 20 percent in the United States versus an average of 15.9 for all the countries in the survey. Thus, U.S. individual taxpayers face tax rates on long-term gains that are 26 percent higher than those paid by the average investor in other countries.

The ACCF study also shows that corporate capital gains are taxed at higher rates in the United States than elsewhere. Both short- and long-term gains are taxed at a rate of 35 percent in the United States, compared to an average of 22.8 percent for short-term gains and 19.6 percent for long-term gains in the sample as a whole. In other words, U.S. corporations face long-term capital gains tax rates almost 80 percent higher than those of their competitors in other countries.


Persistently low U.S. saving rates, and investment that in recent decades has lagged behind our industrial competitors despite continued economic growth and low unemployment, underline the need for pro-growth tax policies as a substantial part of any tax bill approved by this Congress. Given the projected budget surplus and the desire of many in Congress to enact a major tax cut for Americans, there is clearly an opportunity to move the U.S. tax system in a pro-growth direction.