Hatch-Lieberman Capital Gains Tax Reductions, U.S. Investment, and Economic Growth

Report Summary
The Hatch-Lieberman Capital Formation Act of 1995 (S. 959) parallels the major capital gains tax reduction provisions passed by the House, including: (1) the 50 percent exclusion for individual capital gains resulting in a top rate of 19.8 percent; (2) a corporate capital gains rate of 25 percent; and (3) capital loss treatment on the sale of a taxpayer’s principal residence. S. 959 does not include indexing for inflation. Furthermore, S. 959 provides for a 75 percent exclusion for qualified small business stock held for five years and 100 percent deferral if the gain is rolled over into another qualified small business investment within 60 days. The ACCF Center for Policy Research prepared this Special Report to present a new DRI/McGraw-Hill analysis to encourage informed debate on the capital gains tax reductions. Other recent ACCF Center for Policy Research analyses and publications pertaining to capital gains include: testimony by Mark Bloomfield and Margo Thorning presented before the Senate Finance Committee on February 15, 1995, entitled “The Impact of Capital Gains Taxation on U.S. Investment and Economic Growth” and “Update: Questions and Answers on Capital Gains” (September 1995).

Summary of Findings
New research by the prominent economic analysis firm DRI/McGraw-Hill concludes that the capital gains tax cut in S. 959 would, over the 1996-2005 period:

  • Increase fixed investment by a total of 5.1 percent;
  • Raise GDP by a total of 1.4 percent;
  • Expand the capital stock by 4.1 percent;
  • Increase labor productivity by 1.2 percent;
  • Reduce the cost of capital by 8 percent; and
  • Increase federal tax revenues by almost $12 billion.

Also, an average of 150,000 additional jobs per year would be created during the 1997-2000 period.

Background on Capital Gains
Those who favor stimulating economic growth, creating new and better jobs, and leveling the playing field for individuals and businesses to save and invest believe 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.

Their primary argument is that saving is unfairly taxed more than once, first by the income tax 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 because the individual or company that saves and invests pays more taxes over time than if all income is consumed and no saving takes 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 productivity and living standards is impaired.

Low 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, which 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.

Favorable tax treatment of capital gains is especially important in encouraging the start-up of new but risky enterprises, which provide significant dynamism and growth to the U.S. economy. Much of that start-up money comes from friends and relatives of the entrepreneur. Their return will be in appreciated stock and thus low capital gains taxes make them more willing to risk their savings.

The unfairness of taxing capital gains is significantly increased in those cases in which gains are phantom earnings brought on by inflation. Indexation of capital gains taxes would obviate this.

Under current law, gains on the sale of capital assets held for more than a year are limited to a maximum tax rate of 28 percent under the federal individual income tax, even though rates on ordinary income go up to 39.6 percent (or even higher in some cases). Net capital losses in excess of $3,000 are carried over to later taxable years. This constraint limits the ability of investors to time the realization of gains and losses so as to minimize taxes.

Corporate capital gains are taxed at a rate of 35 percent, the rate applied to ordinary corporate income.

A new study by the prominent economic analysis firm DRI/McGraw-Hill (DRI) concludes that the capital gains tax reductions in S. 959 would have a beneficial impact on the U.S. economy because they would reduce the cost of capital (defined as the pretax return required by investors) by almost 8 percent. Lower capital costs induce more investment, faster productivity growth, higher gross domestic product (GDP), and increased employment. The capital gains tax reductions also cause the price of capital assets to increase and the stock market to rise in value. In addition, total federal tax revenues would increase relative to the baseline forecast.

Investment
The DRI study shows that the capital gains tax reductions in S. 959 for individuals and corporations cause real fixed investment to increase by a total of 5.1 percent or a total of $50 billion in inflation-adjusted dollars over the 1996-2005 period compared to the baseline forecast (see Table 1 and Figure 1). Equipment spending rises by a total of 5.9 percent or $45 billion dollars. In addition, the stock of equipment increases by 4.1 percent over the period so that by 2005, the amount of capital being combined with the labor force is $26 billion higher (in real terms) than it would have been under the baseline forecast (see Figure 2).

Productivity
The larger capital stock also increases labor productivity by an average of 0.12 percent per year over the 1996-2005 period for a total of 1.2 percent over 10 years (see Table 1). This is a significant amount because productivity growth has averaged less than 2 percent annually since 1980 and productivity increases permit living standards to rise.

GDP Growth
Capital gains tax reductions in S. 959 cause inflation-adjusted GDP to increase by a total of 1.4 percent or a total of $81 billion over the ten years from 1996-2005 (see Table 1 and Figure 1).

Employment Growth
The DRI study also shows that the capital gains tax rate reductions in S. 959 would increase employment by an average of 150,000 jobs per year during the 1997-2000 period (see Figure 3).

Federal Tax Receipts
Although static analysis of the capital gains rate reductions suggests the federal government loses revenue, DRI’s dynamic analysis shows that the government gains revenue from S. 959’s capital gains tax reductions. Over the 1996-2005 period, federal tax receipts increase by almost $12 billion relative to the baseline (see Table 1).

Conclusion
The DRI study shows that the individual and corporate capital gains tax reductions included in the Hatch-Lieberman Capital Formation Act of 1995 (S. 959) will have a positive impact on U.S. investment, GDP growth, employment, and capital costs. In addition, the increased economic activity resulting from the capital gains tax reductions results in higher federal tax revenues than under current law.