Capital Formation Newsletter
January-February 1997, Vol. 22, No. 1


Capital Gains Tax Debate

Senator Paul Coverdell Speaks to ACCF Forum

ACCF Director Paul E. Tsongas

Capital Gains Tax Debate

In an unexpected move, Ways and Means Committee Chairman Bill Archer (R-TX) paid a quiet visit to the Oval Office for a one-on-one meeting with President Clinton on December 27, followed by a similar session at the Capitol with Treasury Secretary Robert Rubin.

Although the specific conversations are as yet undisclosed, it is known that Mr. Archer advised the President of his strong support for broad-based, deep capital gains tax cuts. The President listened; he recognizes that the odds for his desired multi-year balanced budget package increase if he gives the GOP majority in Congress (and the Chairman of the Ways and Means Committee) a capital gains tax cut. Chairman Archer takes every opportunity to raise the issue. In a recent letter to the President on welfare reform, the Chairman reiterated his commitment to capital gains tax cuts as "the fairest way to help create jobs for people on welfare, and all working Americans."

In one real way, the January 16 Wall Street Journal headline, "Campaign for Cut in Capital-Gains Tax Gets Boost From Key Democratic Senator," is right on point. Senator Tom Daschle (SD), the Democratic Leader in the upper house, is drafting a targeted capital gains tax cut for venture capital, small business, and farmers. The importance of the Daschle initiative is not in the details but as House Majority Leader Richard Armey (R-TX) said, "Once you embrace the concept to say it's good for the folks I represent, it's probably very easy then to move on toother people."

The odds of a capital gains tax cut are greater in 1997 than they were in 1995 when the GOP proposed its Contract With America. Then, congressional advocates underestimated the President's willingness to wield his veto pen. Now, the election results, a political climate which anticipates progress, and the concern of the President about his place in history all suggest that a balanced budget (for the first time in recent history) is a very real possibility. If there is a budget deal, it will include a tax cut component. The Republican majority insists that a cut in capital gains taxes heads the list.

There are only a few approaches to cutting capital gains taxes: eliminate the tax; enact a flat rate; raise the exclusion; index the basis for inflation; provide tax-free rollovers; target cuts to particular assets and taxpayers. Each has its pros and cons. All of these options were presented to Congressman Bill Steiger when he drafted his pathbreaking 1978 capital gains tax cut. When the smoke cleared, an increased exclusion for capital gains was enacted into law.

An additional wrinkle is added this year since the drive for a balanced budget will reduce the amount of revenue available for tax cuts. As a voluntary tax, capital gains tax cuts are unique because of the potential unlocking of revenue to the Treasury. If the tax rate is lowered enough, investors will be more willing to convert unrealized gains, which increases revenue to the government. Conversely, if the rate is too high, gains are locked in and the government forgoes revenues. The classic example was the steep hike in capital gains taxes enacted in 1986 which resulted in a rush to realize capital gains before the higher rate went into effect in 1987. As a result, taxes paid on capital gains nearly doubled from $26.5 billion in 1985 to $49.7 billion in 1986.

If a capital gains tax cut can be constructed this year to result in a revenue increase under the budget scoring rules, chances of a substantial cut will be greatly improved. There are methods of increasing the unlocking potential of a cut, including the option proposed by Jack Kemp for retroactive indexing for inflation, but only for two years to stimulate unlocking. During the presidency of George Bush, the House approved a temporary capital gains tax cut to be followed by an increase in rates, thus resulting in higher revenue estimates from unlocking under the arbitrary budget scoring. The unlocking phenomenon does not take into account the considerable increase in tax revenue which results from the dynamic impact of capital gains tax cuts on economic growth.

What are the criteria for a sensible capital gains tax cut? First, it should be fiscally responsible. Second, it should be fair in the broadest sense. All should benefit from capital gains tax cuts-farmers and high tech entrepreneurs; retirees and yuppie investors; Fortune 500 companies and small businesses; homeowners, individuals, partnerships, and corporations; investors in corporate stock, land, and businesses; Wall Street and Main Street. Third, a capital gains tax cut should make economic sense. It should reduce U.S. capital costs, prevent the taxation of inflationary gains, facilitate the mobility of capital, and foster entrepreneurship.

There are several proposals now on the table:

President Clinton. The president's budget proposes to allow married taxpayers to exclude from capital gains taxes up to $500,000 in gains from selling a home; single taxpayers could exclude up to $250,000. The exclusion will replace both the one-time exclusion of $125,000 now available for taxpayers over 55, and the deferral of capital gains, now available when purchasing a more expensive home.

Ways and Means Chairman Bill Archer. The Chairman, for the time being, has decided not to introduce a specific capital gains tax cut bill. Rest assured, he remains strongly committed to an across-the-board, deep capital gains tax cut. In a recent interview in Fortune, he stressed that only a broad-based capital gains tax cut would suffice.

Senators Orrin Hatch (R-UT), Joe Lieberman (D-CT), Charles E. Grassley (R-IA), and John B. Breaux (D-LA). This proposal is not markedly different from the 1995 Hatch/Lieberman bill that provided for a 50 percent exclusion for individuals, a 25 percent capital gains rate for corporations, a 50 percent exclusion and capital loss treatment on the sale of a taxpayer's principal residence, and an incentive for investment in qualified small business. (S.66)

The GOP Senate Leadership Proposal. It is normal practice for both parties to introduce priority legislation at the beginning of a new Congress. In that context, Finance Committee Chairman William Roth (R-DE) and Majority Leader Trent Lott (R-MS) introduced the capital gains provisions included in the Balanced Budget Act of 1995 which was vetoed by President Clinton. This proposal provides a 50 percent exclusion for individuals and a 28 percent rate for corporations, indexes for inflation on the gain upon the sale of certain assets, modifies the current law exclusion for gains from small business stock, and provides a 50 percent exclusion and a capital loss deduction on the sale or exchange of a principal residence. (S. 2)

Senator Tom Daschle. The Senate Democratic Leader's bill provides the same $500,000 exclusion for married taxpayers on the gain from the sale of a principal residence ($250,000 for single taxpayer) as the Administration's proposal, relief from capital gains taxes for investment in certain small businesses, and special estate tax treatment for family businesses and farms. (S. 20)
Senator Wendell Ford (D-KY). This bill provides a sliding scale for individuals resulting in lower tax rates the longer an asset is held. The 28 percent rate is reduced by two percentage points for each year an asset is held. For assets held more than eight years, the rate is 14 percent. (S. 306)

Representatives David Dreier (R-CA), Karen McCarthy (D-MO), Ralph Hall (D-TX), James Moran (D-VA), and Phil English (R-PA). This bill reduces the top individual capital gains rate from 28 percent to 14 percent and the lower individual tax rate from 15 percent to 7.5 percent. It provides a 28 percent rate for corporations, and prospective indexing for inflation of the basis value of assets held at least three years by individual taxpayers. (H.R. 14)

Representatives Bob Matsui (D-CA) and Phil English (R-PA). Their bill creates a targeted capital gains tax cut for investment in companies with capitalization under $100 million. (H.R. 420)

A fair, growth-promoting capital gains tax cut can be enacted in 1997. The challenge is to ensure that what is doable is worth doing.

Senator Paul Coverdell Speaks to ACCF Forum

Speaking to a February 6 Capital Formation Forum, Senator Paul Coverdell (R-GA) told ACCF supporters that the level of government intrusion in the lives of Americans must be sharply reduced. "When the new majority came to Washington two years ago with the idea of reducing government encroachment, they succeeded in some measure but the task ahead is still great. I remain hopeful that progress can be made and believe that enactment of the Balanced Budget Amendment would take us in the right direction," he observed. Georgia's new senior senator noted that the Administration's promise that "the era of big government is over" is simply a slogan, not a goal, adding that the State of the Union message delivered by President Clinton on February 4 contained 36 initiatives which would expand, not cut, the role of government. "If the government keeps 55 percent of what average Georgia families earn, then the government has more to say about how those families live their lives than they do. We must turn in another direction. Working families should be able to keep at least 66 percent of what they earn," Senator Coverdell stressed. He added that we shouldn't be surprised that with taxes so high, the typical American family has little savings. Senator Coverdell was elected Republican Conference Secretary in December 1996, one of the five Senate party leadership positions. Looking to the year ahead, he said that he is optimistic that progress can be made. "A modest change in the management of our financial affairs can help turn things quickly in the right direction."

ACCF Director Paul E. Tsongas

The ACCF is saddened to note the passing of former United States senator and presidential candidate Paul E. Tsongas, a member of ACCF's board of directors since 1992. Paul Tsongas' political career began in 1968 when he ran successfully for a seat on the Lowell, Massachusetts city council. In 1974, he was elected to serve the Massachusetts Fifth District in the U.S. House of Representatives and, in 1978, he won election to the U.S. Senate. Mr. Tsongas ran for President in 1992, bringing to the country a new awareness of the need for deficit reduction. Later that year, he became co-founder of the Concord Coalition, a citizens group dedicated to educating the public and policymakers about the need to eliminate the federal budget deficit.