SENATE MAJORITY leader George Mitchell performed an important service last week. He told Republicans (and wandering Democrats) that the price of the capital gains tax cut the president has proposed would be an increase from 28 to 33 percent in the top income tax rate. His was a needed warning that the budget summit ought not be used as a pretext for fobbing off regressive policies in the name of deficit reduction.
The capital gains tax cut is a bad idea. In the long run it would cost the government money it doesn't have, and, by reintroducing two classes of income into the code, it would jeopardize tax reform and invite abuse. It would also mainly help the least needy; more than 80 percent of the benefit would go to the top 2 or 3 percent of all taxpayers -- this at the end of an era in which income inequality in the country has gone sharply up while the federal tax and transfer system has become less progressive.
In symbolic if not in substantive terms, the most important tax achievement of the Reagan years was the cut in the top income tax rate, from 70 percent to 28 percent. That is the one that matters most to Republicans. The price of reducing the rate to 28 percent in the reform act of 1986 was to increase the tax on capital gains by removing their preferential status and treating them as ordinary income. In both fiscal and distributional terms this was how the act was made to come out even -- neither losing any revenue, at least as estimated at that time, nor letting the richest taxpayers, who have the bulk of both capital and gains, reduce their share of federal taxes.
Mr. Mitchell, who stopped a gains cut last year but barely, is saying his party is not going to let the wealthiest payers have it both ways -- the lower rate and the preferential gains treatment. In response, and perhaps in embarrassment, some Republican negotiators are now said to be discussing taking both proposals off the table and leaving the treatment of gains and rate structure as they are. If a decision were then made to raise the income taxes of the better-off, another way would have to be found, perhaps by limiting the deductions they can take.
In fact, there has to be a sizable tax increase if the deficit is to be reduced. The fairest way is to sharpen the income tax, whether by raising rates or denying deductions as income rises doesn't matter. There has also been much talk, and not just on the Republican side, of increasing excise taxes on energy, alcohol and tobacco. These would have useful social effects, and a new analysis by the Congressional Budget Office suggests they would be less regressive than commonly thought. Even so, they would require offsets for the poor.
If Congress then still wants to changes the capital gains tax, it should 1) introduce indexation, so that tax would be owed only on real gains and not on inflation, but 2) do that prospectively only, since there is neither need nor money to make the provision retroactive and 3) begin to tax capital gains at death as well -- they now escape taxation. That would rationalize the gains tax without being the giveaway the president proposes. Deficit reduction is urgent, but it is worth repeating: it cannot become the occasion for making the society less fair.