Capital cuts: the debate over capital-gains tax cuts may finally yield dividends this year

National Review, April 21, 1997 by Alan Reynolds

THE odds seem very good that the 1997 budget battles will include some sort of broad-based cut in the capital-gains tax. The Associated Press reports that "one of Capitol Hill's biggest arguments now is not whether capital-gains taxes should be cut, but by how much and when."

The details matter. Some Democrats favor "targeted" tax relief. But efficient allocation of capital requires that investors make their decisions on the basis of economics, not political favoritism. To use tax policy to bribe investors to hold the wrong investments for too long just impairs the liquidity and mobility of capital. "Short-termism" is a hoax. Managers of firms are not influenced by how long investors hold their shares, but by the value the market places on those shares. And the value of shares does not depend on how many years they are owned by the same person.

The whole notion of targeting capital-gains tax relief is fundamentally misguided. So too is the trendy idea of providing a large exclusion for capital gains on homes, but not on other assets. It would be far better, as Norman Ture suggests, to treat all capital gains the way we now treat gains on housing -- i.e., no tax at all so long as the gains were reinvested.

THE leading Republican proposal, a leftover from the Contract with America, is less than ideal when it comes to the timing of capital gains. By taxing capital gains at half the 1993 tax rates (and thereby capitulating to that system of graduated rates), the Republican plan would create five tax rates ranging from 7.5 per cent to 19.8 per cent. People would have an incentive to realize gains in years when they were in lower tax brackets -- perhaps by postponing gains until retirement, or even taking a year off to qualify for a low capital-gains tax. A 7.5 per cent rate in the lowest bracket is a useless gesture, because anyone with a significant gain would no longer be in that bracket. Any tax on capital gains should in any case depend on the amount of gain, not on your salary during the year the asset is sold. It would be far more efficient to simply adopt a flat 15 per cent rate for gains, or perhaps a 20 per cent maximum with indexing.

Another potential problem is that Republicans might wind up paying a high price for a scaled-back cut in the capital-gains tax. It could easily involve accepting some risky schemes hidden among the Administration's package of 34 tax increases, all aimed at businesses and investors. Or it might involve accepting Mr. Clinton's costly and ill-designed tax deductions and credits for college tuition.

Putting these caveats aside, we are nevertheless likely to see some significant relief from capital-gains taxes, and not just for homeowners. We might even see some protection against future inflation, although that seems less likely because it is scored as a serious revenue loser.

Some journalists have pointed to cuts in the capital-gains tax in 1978 and 1981 as evidence that another reduction in the capital-gains tax would so encourage asset sales that the stock market would drop. But the evidence from that earlier period is tainted by the fact that inflation was roaring at the time --creating bracket creep, overtaxation of illusory capital gains and paper profits, and rising interest rates. In normal times, a lower capital-gains tax encourages buying and holding stock, not just selling, because investors know that they will be able to keep a larger share of any future gains.

This is not to say that timing isn't important. As soon as possible, it should be firmly announced that any capital-gains tax cut will be retroactive to January 1, 1997. Otherwise, the incentive to postpone trading could add unnecessary uncertainty to the markets until the issue was settled, and there could well be a disruptive bunching of sales just after the change was made effective.

Other than such timing concerns, a lower capital-gains tax is unambiguously favorable for asset values -- particularly for those assets that pay off in the form of capital gains rather than interest and dividends. The market value of such assets is determined by the "discounted present value" of future income to investors, after taxes. At any given interest rate, shares in the future earnings of a company are worth more if the tax collector is expected to take a smaller bite.

Even in the case of bonds and high-dividend stocks, the chance of capital gains is part of the motive for keeping funds in them rather than the money market. If nothing else changes (such as inflation or the dollar), then bond prices should rise, and interest rates fall, on news of a lower capital-gains tax. Potential capital-gains on bonds will also become more attractive, after taxes, even though that may not be the primary motive for holding bonds.

THE clearest winners, however, are stocks in young companies that are using all their profits to grow, and therefore offer no regular dividends. Most of these emerging companies are listed on NASDAQ, and include clever service and retailing firms as well as high tech.