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Capital Gains Taxation and U.S. Economic Growth

Testimony Before the Standing Committee on Banking, Trade and Commerce of the Senate of Canada

Published by the American Council for Capital Formation. The Council's mission is to promote economic growth through sound tax, trade, and environmental policies. Contact the Council for reprint permission.

ACCF Senior Vice President and Chief Economist Dr. Margo Thorning testified as an invited witness on December 16, 1999, before the Standing Committee on Banking, Trade and Commerce of the Senate of Canada as the Canadian Parliament considers tax reform proposals including capital gains reductions. The executive summary and full text of the ACCF's testimony are presented here.

1. Overview. I am honored to be invited to address this committee on the U.S. experience with capital gains taxation and to outline the ACCF's goals for future pro-capital formation tax changes. The ACCF's research shows the positive impact of capital gains tax reductions on capital costs, saving, investment, and entrepreneurial activity.

2. Tax Policy and Economic Growth. To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, capital gains (and other forms of saving) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.

3. Macroeconomic Impact of Capital Gains Tax Reductions.

• Enhance Economic Growth. New research by Dr. David Wyss, chief economist of Standard & Poor's DRI and a top public finance expert, finds that the Taxpayer Relief Act of 1997, enacted by the U.S. Congress, which reduced the long-term individual capital gains tax rate from a top rate of 28 percent to 20 percent, has had several favorable impacts on the American economy in the intervening two years.
  
  
• Encourage Entrepreneurship. Capital gains taxation has a particularly powerful impact on the nation's entrepreneurs, a major, driving force for technological breakthroughs, new start-up companies, and the creation of high-paying jobs. Starting new businesses involves not only entrepreneurs but also informal investors, venture capital pools, and a healthy public market.
  
  
• Benefit Middle-Income Taxpayers. Investments in capital assets are widely held by the middle class. A new study by Leonard E. Burman, deputy assistant secretary for tax analysis at the U.S. Department of the Treasury, states that in 1992 about three-quarters of all families in the United States owned stocks, bonds, business property, real estate, or houses.
  
  Middle- and low-income taxpayers also hold a significant share of the total dollar value of capital assets, even when personal residences are excluded. Dr. Burman's study shows that 30 percent of the dollar value of such assets was held by families with incomes of $50,000 or less in 1992.

4. International Comparison of Capital Gains Tax Rates. Both short- and long-term individual capital gains on equities are taxed at higher rates in the United States than in most of the other 23 countries surveyed. Short-term gains are taxed at 39.6 percent in the United States compared to an average of 18.4 percent for the sample as a whole. Long-term individual gains face a tax rate of 20 percent in the United States versus an average of 14.8 percent for all the countries in the survey.

5. Economic Impact of Further Capital Gains Tax Reductions. A preliminary analysis of the capital gains tax reductions included in the "Taxpayer Refund and Relief Act of 1999" (H.R. 2488) by Dr. Allen Sinai, chief global economist, Primark Decision Economics, shows that reducing the individual long-term rates from 20/10 percent to 18/8 percent would have a significant, positive impact. (H.R. 2488 was vetoed by President Clinton in September, 1999.)

6. Conclusion. Recent 1997 and 1998 individual capital gains tax reductions and shortening of the holding period have had a positive impact on the U.S. economy. Further capital gains tax reductions could significantly enhance economic growth. 

ACCF TESTIMONY

My name is Margo Thorning. I am Senior Vice President and Chief Economist of the American Council for Capital Formation. I am honored to be invited to address this committee on the U.S. experience with capital gains taxation and outline the ACCF's goals for future pro-capital formation tax changes.

The ACCF represents a broad cross-section of the American business community, including the manufacturing and financial sectors, Fortune 500 companies and smaller firms, investors, and associations from all sectors of the economy. Our distinguished board of directors includes cabinet members of prior Republican and Democratic administrations, former members of Congress, prominent business leaders, and public finance experts.

The American Council for Capital Formation has led the private-sector Capital Gains Coalition since 1978, when the first major post-World War II capital gains tax cut was enacted. The Coalition brings together in support of capital gains tax relief diverse participants from all sectors of the business community-venture capital, growth companies, timber, farmers, ranchers, small business, real estate, securities firms, and the banking and insurance industries.

Recent Evidence on the Impact of Tax Policy on Economic Growth

To those who favor a truly level playing field over time to encourage individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, saving (including capital gains) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.

This is primarily because the income tax hits saving more than once-first when income is earned, and again when interest and dividends on the investment financed by saving are received, or when capital gains from the investment are realized. The playing field is tilted away from saving and investment because the individual or company that saves and invests pays more taxes over time than if all income were consumed and no saving took place. Taxes on income that is saved raise the capital cost of new productive investment for both individuals and corporations, thus dampening such investment. As a result, future growth in output and living standards is impaired.

Several recent analyses by academic scholars and government policy experts such as Professors Alan Auerbach of the University of California and Laurence J. Kotlikoff of Boston University, and others whose studies are cited in a 1997 study by the Joint Committee on Taxation of the U.S. Congress, suggest that substituting a broad-based consumption tax for the current federal income tax could have a positive impact on economic growth and living standards. The macroeconomic models used by the scholars in the studies described below incorporate feedback and dynamic effects in simulating the impact of adopting either a broad-based consumption tax or "pure" income tax.

The "pure" income tax eliminates all personal exemptions and deductions, and taxes labor and capital income at a single rate. The "pure" consumption tax differs from the pure income tax by permitting expensing of new investment (meaning that the total cost of the investment is deducted in the first year). This tax is implemented as a tax on wages with all saving (including capital gains) exempt from tax at the household level, and as a cash-flow tax on businesses.

The effects of the consumption tax proposals on GDP are generally positive over the medium and long terms, although the magnitude of these effects varies widely (see Table 1). For example, the Jorgenson-Wilcoxen model predicts that under a consumption tax, real GDP would be 3.3 percent higher each year in the long run compared to 1.3 percent higher under a unified income tax. The Auerbach, Kotlikoff, Smetters, and Walliser model predicts even greater gains in the long run (7.5 percent) under a consumption tax and losses (-3.0 percent of GDP) under a unified income tax. Similarly, the Engen-Gale analysis shows that the capital stock would be 9.8 percent higher in the long run under a consumption tax but 1.6 percent lower under a unified income tax compared to current law. The consensus seems to be that the economy would fare better under a "pure" consumption tax than under a "pure" income tax or under current law.

Figure 1	1997 Capital Gains Tax Cut: Impact on U.S. Wages and Household Income in 2007 and Beyond 1999 dollars
Note: The DRI study shows that productivity increases by 0.4 percent by 2007 due to the 1997 capital gains tax cut. Higher productivity growth permits real wages and household income to increase relative to the baseline (no 1997 capital gains tax cut). Source: Capital Gains Taxes and the Economy: A Retrospective Look, June, 1999. Standard & Poor's DRI, Lexington, Mass.

Figure 2	1997 Capital Gains Tax Cut: Impact on Stock Prices From 1997 to 1999 S&P index of 500 common stocks
Source: Capital Gains Taxes and the Economy: A Retrospective Look, June, 1999. Standard & Poor's DRI, Lexington, Mass.