The Case for a Broad-Based Capital Gains Tax Cut

Background and Summary

In its search for methods of stimulating economic growth, the Platform Committees of the Democratic and Republican Parties should give strong consideration to including a plank calling for a significant capital gains tax reduction.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. 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.

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.

Although the economy is expanding, worries about the future appear to be multiplying. A cut in the capital gains tax to a top marginal rate of 15 to 20 percent would by no means act as an economic panacea. However, it would surely give a strong boost to values of capital assets (e.g. real estate and stocks), encourage investment by both mature and new businesses, and constitute fairer taxation of individual savings.

The Case for a Pro-Growth Capital Gains Tax Cut

Substantial reductions in capital gains taxes for individuals and corporations would have important economy-wide consequences.

Increase Jobs and Economic Growth
Dr. Allen Sinai, chief global economist at Lehman Brothers and a highly respected economic forecaster, recently released a report calling for the adoption of pro-growth tax policy by the next administration. Capital gains tax cuts are a major component of his proposal. Dr. Sinai’s tax reform agenda is based on his previous analysis of the capital gains rate reductions included in the Republican Contract With America, which included a 50 percent exclusion and prospective indexing for all individual taxpayers. His analysis shows that when macroeconomic feedback effects as well as unlocking of unrealized capital gains are estimated, capital gains tax reductions would result in stronger economic growth, increased capital formation, a more buoyant stock market, and federal tax revenues that are larger than under current law (see Table 1).
[Table 1: Macroeconomic Effects of Capital Gains Tax Reductions in the House Republican Contract With America ]

FY 1995-1999
Real GNP
(Total change in real $ compared to baseline) 2.3%
(Total change in GNP growth rate) 0.7%
(Total change-millions) 1.4
Business Capital Spending
Total (average annual change) 2.1%
Equipment 1.6%
Structures 3.6%
S&P 500 Stock Index
(average annual change) 1.1
Total Federal Tax Revenues 1
(billions) $9.0-$18.0
1. The revenue impact varies according to the degree of unlocking assumed in response to a reduction in capital gains tax rates.Testimony of Dr. Allen Sinai, chief global economist with Lehman Brothers, before the House Committee on Ways and Means, January 24, 1995.


In addition, a recent study by the prominent economic analysis firm DRI/McGraw-Hill (DRI) concludes that the capital gains tax reductions in the Contract With America Tax Relief Act of 1995 (H.R. 1215) would have a beneficial impact on the U.S. economy because they would reduce the cost of capital (defined as the pre-tax return required by investors) by almost 12 percent (Table 2). Lower capital costs induce more investment, faster productivity growth, higher GDP, and increased employment. Lower capital gains taxes cause the stock market to rise in value and the price of capital assets to increase.

A capital gains tax reduction would also shift the financing of business activity from debt to equity, and induce portfolio allocations by households toward equity to take account of changes in expected after-tax returns on stocks and bonds.

[Tabel 2: Cumulative Impact of Tax Reductions in H.R. 1215 ]

Cumulative Total
Real GDP (% difference) 1.7
Real capital spending (% difference)
Total equipment 8.4
Total fixed investment 7.8
Capital stock (% difference) 6.0
Output per hour (% difference)
(productivity increase)
Cost of capital (% difference)
(pre-tax return required by an investor)
Total federal tax receipts
(billions of current $)
Source: DRI/McGraw-Hill, September 1995


Reduce Capital Costs 

The cost of capital is the pretax return of the new investment needed to cover the purchase price of an asset, the market rate of interest, inflation, taxes, and the return required by the investors. Capital costs are an important factor in determining which investments firms will make and how much investment occurs. High capital costs mean that only those projects with the greatest expected return will be undertaken because only they will yield a return large enough to satisfy investors, resulting in less overall investment and an aversion toward higher risk projects.

Research by Professor John Shoven, Dean of Stanford University’s School of Humanities and Sciences, Professor Patric Hendershott of Ohio State University, and Dr. Allen Sinai of Lehman Brothers indicates that a capital gains tax rate in the range of 15 to 20 percent would reduce the cost of by capital by 4 to 8 percent. DRI’s new study shows that the combined impact of a 50 percent exclusion (maximum rate 19.8 percent) and indexing for individuals as well as reducing the corporate capital gains tax rate from 35 to 25 percent reduces the cost of capital by almost 12 percent.

Benefit Middle Class Taxpayers

Investments in capital assets are widely held by middle and lower-income classes, according to a new Congressional Budget Office (CBO) draft report. According to the CBO report, in 1989, 31 percent of families whose incomes were under $20,000 held capital gains assets (not including personal residences) and 54 percent with income between $20,000 and $50,000 held capital assets.

Middle-income taxpayers also hold a significant share of the total capital assets, even when personal residences are excluded. The CBO study shows that 30 percent of the value of capital assets (excluding housing) was held by families with incomes of $50,000 or less in 1989.

The issue of counting as wealthy the middle-class person who occasionally realizes a capital gain that artificially inflates his income in a given year was also addressed in the CBO report. While it is true that many upper-income people realize large capital gains, they also pay more taxes, making revenue available to finance government programs which benefit lower-income recipients. A panel analysis for the years 1979-1988 found that taxpayers with incomes of $50,000 or under had gains in only three years out of ten. In contrast, people with the highest income reported capital gains in seven years out of ten.

Encourage Entrepreneurship

Capital gains taxation has a particularly powerful impact on the entrepreneurial segment of the U.S. economy, which makes possible new technological breakthroughs, new start-up companies, and new jobs. Starting new businesses involves entrepreneurs, informal investors, venture capital pools, and a healthy public market. All are sensitive to after-tax rates of return, which is why the level of capital gains taxation is important.

Foremost is the entrepreneur. By taxing his potential capital gains at a higher rate, either the pool of qualified entrepreneurs will decline or investors will have to accept a lower rate of return. In either case, the implications for the U.S. economy are clearly negative. To be successful, the entrepreneur needs capital. Fledgling start-ups depend heavily on equity finance 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, found taxable individuals to be the major source 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.

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.

Raise Tax Receipts

Critics of lower capital gains taxes argue that such cuts will reduce federal revenues and thus add to the budget deficit, absorb national saving, and raise interest rates and capital costs. Both economic analysis and experience effectively refute this view.

There is actually little difference between congressional estimates of the revenue impact of capital gains tax cuts and those of the U.S. Treasury. For example, when President Bush proposed a 30 percent exclusion for capital gains in 1989, the Joint Committee on Taxation (JCT) estimated a static loss over 1990-1995 of $100 billion. However, induced realizations-the “unlocking” effect-and depreciation recapture would recoup almost 90 percent of the loss, according to the JCT, and 110 percent as estimated by the Treasury. (This arithmetic accounts for only one behavioral response-the unlocking effect-and the Treasury recoups almost all of the revenue loss. There is no revenue accounting for lower capital costs and increased economic activity. This impact would be substantial, as indicated by the analysis prepared by Dr. Allen Sinai and DRI/McGraw-Hill.)

Experience indicates that lower capital gains taxes have a positive impact on federal revenues. The most impressive evidence involves the period from 1978 to 1985. During those years the top marginal federal tax rate on capital gains was cut by almost 45 percent from 35 percent to 20 percent but total individual capital gains tax receipts nearly tripled from $9.1 billion to $26.5 billion annually.

Research by experts at the prestigious National Bureau of Economic Research indicates that the maximizing capital gains tax rate, i.e., the rate that would bring in the most Treasury revenue, is somewhere between 9 and 21 percent.

Promote U.S. Saving and Investment 

Our international competitors recognize the contribution a capital gains tax differential can make to new risk capital, entrepreneurship, and new job creation. The United States taxes capital gains more harshly than almost any other industrial nation. A survey of twelve industrialized countries shows that the U.S. capital gains tax rate on long-term gains on portfolio securities exceeds that of all countries except Australia and the United Kingdom, and these two countries index the cost basis of an asset (see Table 3). Germany, Japan, and South Korea exempt or tax only lightly capital gains on portfolio stock. Not only do virtually all industrialized countries tax individual capital gains at lower rates than the United States; they also accord more favorable treatment to corporate capital gains.

Most of the countries shown in Table 3 have had higher rates of investment as a percent of GDP over the past two decades. This fact may reflect the encouragement to saving and investment due to their lower capital gains tax rates.

[Table 3: International Comparison of Capital Gains Taxes and Personal Savings Rates ]

Country Capital Gains Maximum Individual Rate1 Personal Saving Rate2
Short-term Long-term 1975-1994
United States 39.6% 28% 6.4%
Japan 1% of sale price or 20% of net gain 1% of sale price or 20% of net gain 17.0%
Australia 48.3% 48.3%; asset cost is indexed 8.4%
Belgium Exempt Exempt 18.0%
Canada 23.8% 23.8% 11.9%
France 18.1% 18.1% 15.3%
Germany 53.0% Exempt 12.6%
Hong Kong Exempt Exempt N/A
Italy 25.0% 25.0% 20.7%
Netherlands Exempt Exempt 2.4%
Sweden 25.0% 25.0% 2.7%
United Kingdom 40%; asset cost is indexed 40%; asset cost is indexed 10.3%
1. Reflects top marginal rates on portfolio securities gains.
2. Organization for Economic Cooperation and Development. Net household saving as a percent of disposable income. OECD Economic Outlook 57, June 1995, Annex Table 26, p. A-29.
Prepared by the ACCF Center for Policy Research.


Ameliorate the Impact of Inflation

Opponents of capital gains tax reductions fail to recognize that capital gains investment are inherently high risk and that realized capital gains include purely inflationary gains that are not income. The willingness to invest is hindered by taxing capital gains, which are phantom earnings brought on by inflation. The combined effect of taxing inflationary gains and limiting the deductibility of capital losses leads to a severe over-taxation of many investments that will earn capital gains.

As the new CBO study observes, on average, the sale price of capital gains assets in 1989 was substantially less than the inflation-adjusted purchase price. Before adjustment for inflation, such assets generated net capital gains of $47.3 billion. In real terms, however, they produced a net loss of $17.4 billion. Taxpayers suffered losses at every income level, but the losses were proportionately bigger at the lower income levels.

The hard fact is that we can no longer afford the luxury of government economic policies that reward consumption, discourage saving and investment, overregulate American business, and penalize economic growth. Enactment of capital gains tax reform provisions would help move the United States toward a tax system that is more neutral toward saving and investment.

Capital gains tax reform should satisfy three criteria. First, it should make economic sense by lowering the excessively high cost of U.S. capital, reducing the bias against high-risk capital, and ameliorating the taxation of inflationary gains. Second, it should be fair to all income groups and sectors of the U.S. economy: Main Street and Wall Street, middle-class investors and farmers, new entrepreneurs and retiring businessmen, and individual investors and businesses. Finally, a capital gains tax reduction should result in stronger economic growth, increased capital formation, and a more buoyant stock market, and, when macroeconomic feedback effects are considered, raise the same amount or possibly more tax revenues as current law.


  • Len Burman and Peter Ricoy, “Who Pays Capital Gains Taxes?,” Congressional Budget Office, unpublished draft, July 19, 1996.
  • DRI/McGraw-Hill, “The Capital Gains Tax, Its Investment Stimulus, and Revenue Feedbacks,” September 1995.
  • John Freer and William Wetzel, “Equity Financing for New Technology-Based Firms,” Babson Entrepreneurship Conference, Calgary, Alberta, May, 1988.
  • Organization for Economic Cooperation and Development, OECD Economic Outlook 57, June 1995, Annex Table 26, p. A-29.
  • Allen Sinai, testimony before the House Committee on Ways and Means, January 24, 1995.

The American Council for Capital Formation submitted recommendations to the Platform Committees of both the Democratic and Republican national conventions for tax policy initiatives to promote saving, investment, and economic growth. What follows is the ACCF’s analysis of the impact on the American economy of substantial reductions in capital gains taxes for individuals and corporations.