Not Such a Capital Idea

        by Brad De Long and David Levine

        Appeared in the San Francisco Chronicle, December 5, 1995, p. A23.


        In the 1980s Republicans argued that the tax cuts they proposed would
make the economy grow faster because the rich would redirect energy from
avoiding taxes to entrepreneurship. Unfortunately, the theory was wrong. The
most optimistic serious assessment of the effects from the 1981 tax cuts (by
supply-sider Larry Lindsay) show supplyside benefits of the tax cut far lower
than the burden of the debt they generated.

        Now Republicans are again proposing tax cuts. Today skepticism infects
even the core of the Republican coalition. The Wall Street Journal's editorial
pages attacked the tax cuts as being the kind that former Democratic
Congressman Rostenkowski might have producedsurely the worst insult they can
imagine. Principled Republican economic advisers are silent. There is not even
a theory under which the Republicans' capital gains tax cut, child credit, and
increase in taxes on families that qualify for the Earned Income Tax Credit
(EITC) could boost growth.

        Start with the capital gains tax cut. It provides no incentives to
boost
investment. No manager deciding whether to build a factory, buy a computer, or
engage in research and development changes his or her calculation of expected
profit because of a reduction in capital gains taxes.

        Some proponents believe the tax cut will boost investment and growth
indirectly by increasing savings. They note that the tax cut raises the
aftertax returns on savings placed in risky assets such as shares of stock.
They then claim higher returns on these assets will, in turn, induce higher
savings. Higher savings will drive down interest rates, which in turn, will
raise business investment and growth.

        But this roundabout chain of cause and effect falls apart at the first
touch. Both the capital gains tax rate and the after-tax return to savings 
have
wandered all over the place in the past generation. Private savings have 
barely
shifted in response. Thus, each dollar of tax cuts increases private savings 
by
less than a dollar. The net effect of the tax cut is to lower the pool of
national savings available to fund investment.  Continued hope that lowering
tax rates will boost American savings and investment is the triumph of faith
over experience.

        The problem is that this tax cut provides an enormous windfall gain to
those who have unrealized capital gains on assets they acquired in the past.
The top one percent of American families with unrealized capital gains hold
about half of these unrealized gains.  While many people realize a small 
amount
of capital gains in any given year, these few families hold trillions of
dollars of unrealized gains. Good tax policies provide incentives for people 
to
work, save, and invest. Bad tax policies reward a wealthy few for decisions
they made in the past.

        A capital gains tax cut may well raise revenue in its first year or
two,
as people liquidate their unrealized gains before the next increase in capital
gains rates. But once the first wave of selling is over, a 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
choose one likely to boost economic growth for everyone? And shouldn't it be
part of a package that avoids further tilting our distribution of income in an
unhealthy direction?

        The overall effect of the Republican tax proposals on the distribution
of income gives the impression that the congressional majority is waging a
onesided class war: the cuts in the Earned Income Tax Credit and the details 
of
how the child credit is paid add up to roughly $2.2 billion a year in tax
increases on families with annual incomes less than $30,000, and tax decreases
of some $2.8 billion$7,000 or so per familyon those 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 step in a series that places it under threat again.
        Brad De Long and David Levine teach economics and business at the
University of California, Berkeley.



Addendum:
        Due to space constraints, the editorial omitted three (sometimes
offsetting) issues concerning how the capital gains tax treats time.  The
capital gains tax over-taxes gains because it taxes nominal gains, including
gains that are due solely to inflation.  Thus, if inflation doubles average
prices over a decade, someone who sells an asset that also doubles in nominal
value will face taxation although the asset's real value was constant.
        The capital gains tax under-taxes gains because the tax on unrealized
gains is not collected until a sale. This delay is like the federal government
lending the value of the uncollected tax at zero interest; at low inflation 
the
under-taxation due to value of this loan is usually larger than the
over-taxation due to the first effect.
        Moreover, if the person dies holding the gain, the tax on unrealized
gains is forgiven -- a somewhat bizarre feature of the tax system.  This 
latter
feature makes the tax ineffective at collecting revenue from the very wealthy,
who merely delay sales of their appreciated assets.
        A better capital gain tax should tax only real gains, should not
forgive
taxes on inherited unrealized gains, and (this is trickier) should try to
minimize the value of lost tax due to holding appreciated assets.


David I. Levine                 Associate professor
Haas School of Business    ph: 510/642-1697
University of California    fax: 510/643-1420
Berkeley CA  94720-1900                            email:
levine@haas.berkeley.edu
http://web.haas.berkeley.edu/www/levine/