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 each year the higher the rate of return). But it also makes saving more attractive (bringing within reach, for example, the goal of saving enough to make a down payment on a larger house).

Most economists think that private saving will rise if the rate of return increases, but they are unsure how much. One widely used estimate is that of current Council of Economic Advisers chairman, Michael Boskin, who suggests that a 10 percent increase in the

Say that the average annual rate of return to capital is 10 percent, that one-third of this return accrues in the form of capital gains, and that the effective rate of tax on these capital gains is the maximum statutory rate of 30 percent. If so, reducing the capital gains tax rate by one-half (about what President Bush is seeking for assets held three years or more) would increase the rate of return by 7 percent, which would boost private saving by just under 3 percent. If these crude assumptions are valid, then, given the current U.S. net private saving rate of under 5 percent of gross domestic product, the capital gains tax cut would boost saving by 0.15 percent of GDP. Given standard economic models, such an increase in saving would raise growth of national income no more than 0.02 percent of GDP.

In fact, this estimate grossly exaggerates the effect of a capital gains tax cut on private saving, since, as noted, the effective tax rate on capital gains is actually less than 30 percent. …