When the House-Senate conference committee meets to reconcile the two versions of the tax reform proposal, the taxation of capital gains will be among the most important issues to be settled. It should be an easy decision. The House and Senate versions differ significantly, and there is little doubt that the House plan is superior. It would generate more revenue, would be better for the economy and would be preferred by everyone who pays a tax on capital gains.
The existing tax system recognizes that gains received from the sale of stock or other investment assets differ from ordinary income. Under current law, individuals exclude from taxable income 60 percent of the increase in the value of the asset if they have held the asset for six months or longer. Since the maximum tax rate is now 50 percent, the maximum tax rate on capital gains after the 60 percent exclusion is now 20 percent.
The tax bill passed by the House would reduce the capital gains exclusion from 60 percent to 42 percent, but it would not alter the underlying principle of capital gains treatment. And since the top individual tax rate would be lowered to 38 percent, the maximum tax on capital gains would be 22 percent, essentially unchanged from the current 20 percent maximum.
The Senate plan is radically different. It would eliminate the capital gains exclusion completely and would tax capital gains like ordinary income. The maximum federal tax rate on capital gains would generally rise from the current 20 percent to 27 percent, almost a third higher than current law. For taxpayers in the income range from $75,000 to $185,000, the phase-out of the first bracket rate and of the personal exemption would push the capital gains tax rate to 32 percent.
If this radical proposal was made to raise revenue, it is bound to fail. Experience has repeatedly shown that increasing the tax rate on capital gains reduces realization, or the selling of assets, by so much that tax revenues actually decline. And symmetrically, when the tax rate on capital gains is reduced, individuals increase the total amount of their sales by so much that tax revenue actually increases. Equally important, the response is not a one-shot burst of additional revenue, but is sustained year after year.
In 1978 a major cut in capital gains tax rates reduced the maximum rate from more than 40 percent to 28 percent. The result was a sustained increase in the amount of taxable capital gains and, therefore, in tax revenue. The increase in realization was relatively greatest among those high-income taxpayers for whom the rate cut had been most significant. And when capital gains rates were cut again in 1981 -- lowering the maximum rate from 28 percent to 20 percent -- there was a new sustained boost in capital gains tax revenue.
There is nothing surprising about the powerful incentive effect of the capital gains rate. Since most of the proceeds from the sale of stocks are reinvested in different stocks and other financial assets, the bite that the tax would take out of the available funds can be a significant deterrent to such switching of assets. Rather than reduce the amount that he has invested, the shareholder keeps his original investment, and the government receives no revenue. In any year the actual value of capital gains realized is typically only a very small fraction of the capital gains that investors have accumulated during the year. Raising the capital gains tax rate would make that fraction even smaller.
The lesson is that the House-Senate conference committee can scale back the exclusion of capital gains from taxation without losing revenue, but should reject the Senate's plan for abolishing the exclusion. The top tax rate on ordinary income that is likely to emerge from the conference committee will be about 28 or 29 percent. If the current distinction between income and capital gains is maintained but the exclusion scaled back to 30 percent, the top tax rate on capital gains will remain at about 20 percent.
The disadvantage of the Senate's plan to eliminate the capital gains exclusion involves more than the loss of tax revenue. The Senate's higher capital gains tax rate would, by deterring asset sales, impede the flow of capital from existing investments to the stock of new companies and growing businesses, where the funds would make a greater contribution to growth and productivity.
In a world where taxable gains often reflect only inflation, the Senate plan is grossly unfair. An investor who put $10,000 in 1970 into the mix of stocks represented by the Dow Jones average would find his investment valued at $24,000 today. But because of inflation in consumer prices over these years, it would now take $28,000 to buy what $10,000 could buy in 1970. The Dow Jones investor would have lost $4,000 of purchasing power, but he would be liable for a tax on a $14,000 gain if he were to sell those stocks now.
The president's original plan would have allowed individuals to pay tax on only the inflation-adjusted rise in the value of their investments. We still like that idea. But if that isn't going to be done, it's especially important to keep the capital gains exclusion and to limit the maximum capital gains tax rate to 20 percent.
Martin Feldstein was chairman of the Council of Economic Advisers. Kathleen Feldstein is an economist.