The Capital Gains Tax Cut: Economic Panacea or Just Plain Snakeoil?

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Economic panacea or just plain snakeoil?

Should tax rates on income from realized capital gains be set below rates on other income? In a way, the question is academic. They already are, in practice. Although the maximum statutory tax rate on capital gains is 30 percent, more than half of all capital gains are never taxed. Either they are held until the owner dies, after which they are exempt from tax to subsequent owners. Or they accrue to tax-exempt U.S. entities, such as pension funds, or to foreign owners not subject to U.S. tax. In addition, most capital gains are realized several years after they actually accrue, a delay that automatically and significantly reduces effective tax rates. And the longer the delay, the greater the reduction. In actual practice, the tax rate on capital gains is less than 10 percent.

Advocates of reduced statutory rates, however. clearly want more. To make their case, they offer four lines of argument. First, reducing the tax rate on realized capital gains will promote growth. Second, it will mitigate flaws in the tax system. Third, it will increase tax equity. Finally, it either is, or comes very close to being, a perfectly efficient tax cut: it generates benefits but no costs.

None of these arguments, alas, is valid. Each is either demonstrably false or ignores alternative - and better - policies.

Promoting Growth

To understand why a capital gains tax cut will not promote growth, it is important to keep in mind a key economic identity. Domestic investment is exactly equal to private saving less the government budget deficit less U.S. net investment abroad as measured by exports minus imports. That assertion is not a matter of opinion or economic analysis. It is an identity that must exist, given the way we count investment, saving, government spending and revenues, and international transactions. The idea is clear enough. Resources for investment can come from the domestic saving left over after paying for the government deficit and from whatever we invest abroad. (In recent years the United States has been borrowing from foreigners, not investing abroad.) There is nowhere else to get the resources.

Private Saving

If the reduced rate on capital gains is to boost private saving, it must do so by increasing the after-tax rate of return to saving. Economists have debated whether private saving really does increase when the rate of return rises. In theory, the effect could go either way. A higher rate of return lessens the need to save (someone saving, say, to make a down payment on a house five years hence can put aside a little less …