As U.S. financial markets continue to teeter back and forth, it is clear that investors worldwide have little faith in the health of the American economy. In 1993, the performance of the U.S. stock market was 32nd on an index of 35 countries. Americans invested $40 billion more abroad last year than foreigners invested here - thus reversing a $500 billion net surplus of capital flowing into the United States in the 1980s.
There is a fairly simple and certain way for Washington to restore confidence in U.S. financial markets: Cut the capital gains tax.
Remember that issue? As the centerpiece of his economic agenda in 1989, George Bush proposed chopping the capital gains tax rate roughly in half. When the George Mitchells and the Tom Foleys of Congress started retaliating with their mantra of "tax cuts for the rich," frightened Republicans fled en masse from the issue. Recent evidence overwhelmingly confirms that the GOP was right and the Democrats were wrong on that issue; yet Republican leaders seem content to allow it to rest in peace.
When the capital gains rate was raised from 20 percent to 28 percent in 1986, supply-siders protested that the 40 percent increase almost certainly would drag down capital formation and government tax receipts. GOP proposals to cut the tax rate, however, were spurned by experts in Washington. The Congressional Budget Office, or CBO, predicted that 60 percent of the gains would wind up in the wallets of Americans making more than $200,000.
We know now that those predictions were spectacularly wrong. New data on tax returns from the Internal Revenue Service show that the actual effect of the 1986 tax rate increase was a substantial reduction in capital gains tax collections - mainly from wealthy Americans. In response to the 40 percent raise in the capital gains tax rate, investors, business owners, homeowners, farmers and workers became reluctant to sell their assets, thus shrinking the pool of capital gains for the government to tax. That phenomenon is known as the lock-in effect. It is the way Americans keep the value of their appreciating investments safely at arm's length from the tax collector.
The data since 1986 fit a consistent historical pattern: Higher capital gains tax rates mean fewer capital gains to tax. Real, taxable capital gains are now just half of what they were in 1985, even though real GNP is about 25 percent higher and the Dow-Jones has risen by roughly 40 percent. The drop-off has been so severe that in 1990 and 1991, real capital gains were lower than in any year since 1978. Just-released preliminary 1992 capital gains tax numbers from the Internal Revenue Service indicate that capital gains revenues to the Treasury again will be near their anemic 1991 level. …