Capital Gains Mythology

By :: April 29th, 2008

Much of the reaction to the April 16 Democratic Presidential debate was directed at the moderators for focusing on character and perception rather than policy. But issues got mangled as well—not only by the candidates, but by moderator Charles Gibson. While questioning Barack Obama about his proposal to raise the capital gains tax, Gibson claimed that when the rate has been cut, government took in more money, but when the tax was increased revenue fell. Although this argument warms the hearts of the Wall Street Journal editorial page, the implication that capital gains tax rate cuts raise revenues is not supported by the evidence.

The relationship between capital gains taxes and revenues has been studied extensively by economists. Although most studies find that higher rates reduce realizations of gains, that does not mean they cut revenues. It is simple math: If revenue is going to fall when capital gains rates are raised, the percentage drop in realizations must exceed the percentage increase in the tax rate. And there is little evidence that happens, especially at today’s maximum 15% rate, but even at the 28% top rate that applied after 1986.

In 1994, TPC’s Len Burman and Bill Randolph (then at Treasury, now at CBO) estimated that a 10 percent permanent increase in the capital gains rate reduces realizations by 2 percent in the long run. The real impact, they found, is in the short run. People take their gains when their tax rate is temporarily low and respond strongly in the year rates change, delaying their gains (or accelerating them) to take advantage of the lower rate.

When I was at CBO in 1988, I co-authored a paper that estimated that the government’s revenues are maximized at a rate of between 25.6 percent and 32.3 percent—far higher than today’s 15 percent maximum.

In 2000, Matthew Eichner and Todd Sinai published a paper in the National Tax Journal that updated our estimates. They found a huge response in 1986, when people sold a lot of stock in advance of a big tax increase they knew was coming in 1987. But, excluding that unusual year, Eichner and Sinai found an even smaller reaction to changes in capital gains rates than CBO had.

In addition to the direct revenue loss of lower capital gains tax rates, a large gap between rates on gains and ordinary income encourages taxpayers to convert their income to capital gains, which reduces ordinary income tax collections. The carried interest arrangement, in which partners in Wall Street hedge funds take compensation as gains instead of bonuses, is a perfect example. A higher capital gains rate would reduce this behavior. That, in turn, would raise revenue not only from higher capital gains taxes, but also from ordinary income.

In his question to Obama, Gibson also claimed that 100 million shareholders would be affected by a hike in the capital gain rate. But most of these shareholders hold assets in 401k plans, which are not subject to capital gains tax. In 2005, less than 14 million taxpayers realized taxable capital gains. And the vast majority of these gains are realized by very wealthy individuals—almost 60 percent by individuals with income over $1,000,000.