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A Capital Gains Tax Cut Op-Ed

Not a Capital Idea

by Brad De Long and David Levine

An edited version of this appeared in the San Francisco Chronicle on December 5, 1995. The edited version is copyright 1995 by the San Francisco Chronicle.

The Legacy of the 1980s

In the 1980s Republicans argued that the tax cuts they proposed would make the economy grow faster. They at least had a theory behind their claim: tax cuts for the rich would make everybody better off because the rich would redirect energy from avoiding taxes to entrepreneurial endeavors.

Unfortunately, the theory was wrong. Even the most optimistic assessment of the supply-side effects from the 1981 Republican tax cuts show economic benefits of the tax cut that
are far lower than the burden of the extra debt that the deficits they generated have produced. (Examine, say, the estimates made by Lawrence Lindsay, now one of President Bush's legacies to the Governors of the Federal Reserve.)

Now the Republicans are again proposing tax cuts for the rich. Today skepticism infects even the core of the Republican coalition. For example, the Wall Street Journal's editors attacked the tax cut as being the kind of tax cut that former Democratic Congressman Rostenkowski might have produced--surely the worst insult they could imagine. Republicans in Congress may
claim that this round of tax cuts will boost economic growth, but Republican economic advisers with principles are silent. For there is no theory under which the Republicans' capital gains tax
cut, child credit, or increase in taxes on low-income families that qualify for the Earned Income Tax Credit (EITC) would boost economic growth.

Incentives for Future Investment, Not Windfalls for Past Saving

Consider the capital gains tax cut. It will not boost economic growth because it provides no incentives to boost investment. No business deciding whether to build a factory, buy
a computer, or engage in research and development changes its calculations of expected profit because of a reduction in capital gains taxes. How then could such a tax reduction boost investment
and growth?

Although the capital gains tax cut is not an investment incentive, some claim it will boost investment and growth indirectly because it is a savings incentive.

The reasoning is that reduced capital gains taxes raise the after-tax returns earned by those who place their savings in stocks and other risky assets. Higher returns on these assets will, in turn, induce
higher savings. Finally, higher savings will drive down interest rates, lower interest rates make business investment more profitable, and higher investment boosts economic growth.

But this roundabout chain of cause and effect falls apart at the first touch. The capital gains tax rate has wandered all over the place in the past generation. Private savings have not shifted significantly in response. Moreover, any increase in private savings must be balanced against the increased government borrowing due to the tax cut. Unfortunately, research shows that
each dollar of tax cuts increase private savings by less than a dollar; the net effect is to lower national savings.

Continued belief that lowering tax rates will boost American savings is the triumph of faith over experience.

In addition, a reduction in capital gains taxes will induce many savers with unrealized capital gains to sell their assets and pay the now-low tax rate before the next turn of the political wheel sends capital gains tax rates back up. A large increase in the number of people selling their shares of stock
may well do what every increase in supply does: push down stock prices. A lower stock market will raise the cost businesses pay to finance investment from new stock issues--hardly the standard prescription for higher investment.

The root of the problem is that his tax cut provides an enormous windfall gain to those who have saved and profited in the past. The top one percent of American families with unrealized gains hold about half of all unrealized capital gains, averaging perhaps a million dollars in unrealized gains per family. While many people have a small amount of capital gains in any given year, these wealthy are the big winners. Good tax policies provide incentives for people to work and and make investments that boost American growth in the future; tax cuts rewarding decisions already made and wealth already accumulated cannot have much effect on future growth.

What is the impact in the long run? Once the first wave of selling in response to lowered tax rates is over, the standard guess is that the capital gains tax cut will cost about $20 billion a year. When the government decides to spend $20 billion a year on a tax incentive, shouldn't it at least choose one that actually affects economic growth?

Equality of Conditions

When you look at the estimates of the impact of Republican tax proposals on the distribution of income, it is hard to escape the impression that the congressional majority is waging a one-sided class war: the cuts in the Earned Income Tax Credit and the details of how the child credit is paid add up to tax increases that total some $2.2 billion a year on families whose annual incomes less than $30,000, and tax decreases of some $2.8 billion--$7,000 or so--on families with incomes of more than $200,000.

Early in the nineteenth century, Alexis de Tocqueville wrote in the introduction to Democracy in America of "equality of conditions as the creative element" that made America great. This substantial "equality of conditions" was under threat once, in the generation of the Gilded Age, and almost turned America into a very different and worse country. This year's tax changes are another in a series of steps that place it under threat again.

Brad DeLong and David Levine teach economics and business at the University of California, Berkeley.