Questions and Answers on IRAs: September 1995 Update

American Council for Capital Formation
September 1995

Q. Does the United States Need a Capital Gains Tax Cut?

A. Yes. Those who favor stimulating economic growth, creating new and better jobs, and leveling the playing field for individuals and businesses to save and invest believe 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.

Their primary argument is that saving is unfairly taxed more than once, first by the income tax 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 because the individual or company that saves and invests pays more taxes over time than if all income is consumed and no saving takes 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 productivity and living standards is impaired.

Low capital gains taxes not only treat savers more fairly but also help hold down capital costs. Public finance economists refer to the tax on capital gains as a tax on retained income, which funds a large part of business investment. The higher the capital gains tax, the more difficult it is for management to retain earnings (rather than pay out dividends) for real investment in productive projects.

Favorable tax treatment of capital gains is especially important in encouraging the start-up of new but risky enterprises, which provide significant dynamism and growth to the U.S. economy. Much of that start-up money comes from friends and relatives of the entrepreneur. Their return will be in appreciated stock and thus low capital gains taxes make them more willing to risk their savings.

The unfairness of taxing capital gains is significantly increased in those cases in which gains are "phantom earnings" brought on by inflation. Indexation of capital gains taxes would obviate this. Although the economy is expanding, worries about the future appear to be multiplying. A cut in the capital gains tax to a top marginal rate of 15 to 20 percent would by no means act as an economic panacea. However, it would surely give a strong boost to values of capital assets (e.g. real estate and stocks), encourage investment by both mature and new businesses, and constitute fairer taxation of individual savings.

Q. Will Capital Gains Tax Cuts Increase U.S. Job Growth and Economic Growth?

A. Yes. Dr. Allen Sinai, chief global economist at Lehman Brothers and a highly respected economic forecaster, stated in testimony before the House Committee on Ways and Means that when macro­p;economic "feedback" effects as well as unlocking of unrealized capital gains are estimated, the capital gains tax reductions in the House Republican Contract With America would result in stronger economic growth, increased capital formation, a more buoyant stock market, and federal tax revenues that are larger than under current law (see Table 1).


In addition, a new study by the prominent economic analysis firm DRI/McGraw-Hill (DRI) concludes that the capital gains tax reductions in the Contract With America Tax Relief Act of 1995 (H.R. 1215) would have a beneficial impact on the U.S. economy because they would reduce the cost of capital (defined as the pre-tax return required by investors) by almost 12 percent (Table 2). Lower capital costs induce more investment, faster productivity growth, higher GDP, and increased employment. Lower capital gains taxes cause the stock market to rise in value and the price of capital assets to increase.

A capital gains tax reduction would also shift the financing of business activity from debt to equity, and induce portfolio allocations by households toward equity to take account of changes in expected after-tax returns on stocks and bonds.

Q. How Do Capital Gains Affect Capital Costs?

A. The cost of capital is the pretax return of the new investment needed to cover the purchase price of an asset, the market rate of interest, inflation, taxes, and the return required by the investors. Capital costs are an important factor in determining which investments firms will make and how much investment occurs. High capital costs mean that only those projects with the greatest expected return will be undertaken because only they will yield a return large enough to satisfy investors, resulting in less overall investment and an aversion toward higher risk projects.

Research by Professor John Shoven, Stanford's Dean of the College of Arts and Sciences, Professor Patric Hendershott of Ohio State, and Dr. Allen Sinai of Lehman Brothers indicates that a capital gains tax rate in the range of 15 to 20 percent would reduce the cost of capital by 4 to 8 percent. DRI's new study shows that the combined impact of a 50 percent exclusion (maximum rate 19.8 percent) and indexing for individuals as well as reducing the corporate capital gains tax rate from 35 to 25 percent reduces the cost of capital by almost 12 percent.

Q. Aren't Cuts in Capital Gains Tax Rates Simply Another Version of "Trickle-Down" Economics That Won't Help Working Americans?

A. No. The econometric studies of Dr. Allen Sinai and DRI/McGraw-Hill demonstrate that a cut in capital gains tax rates will begin quickly to promote jobs, growth, and investment. This is because the tax cut would lower business capital costs, increase start-ups of new companies, and raise the value of equities and real estate. This is precisely the sort of economic environment in which working Americans prosper.

Perhaps the best anecdotal answer to those who argue that high taxes on capital gains hurt working Americans comes from a New Jersey painting contractor who (as quoted in the Washington Post) was "trying to scare up some work..."

"...you're looking at a poor man who thinks the capital gains tax [cut] is the best thing that could happen to this country because that's when the work will come back. People say capital gains is for the rich, but I've never been hired by a poor man."

Q. Isn't it True that Most of the Direct Benefits of a Capital Gains Tax Cut Go to the Rich?

A. No. The facts are that many middle-class taxpayers realize a capital gain every once in a while but are counted as permanently rich under IRS statistics. When those taxpayer returns are adjusted to exclude their temporary capital gains and include only their wage and salary income, it becomes clear that middle-class taxpayers are major beneficiaries of lower capital gains tax rates.

A special U.S. Treasury study covering 1985 showed that nearly one-half of all capital gains were realized by taxpayers with wage and salary income of less than $50,000. In addition, three-fourths of all returns with capital gains were reported by taxpayers with wage and salary income of less than $50,000. An update of the Treasury study by the Barents Group, a subsidiary of the public accounting firm of KPMG Peat Marwick, estimates that for 1995, middle-income wage and salary earners making $50,000 or less in inflation-adjusted dollars will continue to receive almost half of all capital gains. As in the earlier Treasury study, three-fourths of all returns with capital gains in 1995 are estimated to be reported by taxpayers with wage and salary income of $50,000 or less.

The issue of counting as wealthy the middle-class person who occasionally realizes a capital gain that artificially inflates his income in a given year has been studied by the Joint Committee on Taxation (JCT). A panel analysis for the years 1979-1983 by the JCT found that 44 percent of taxpayers reporting capital gains realized a gain in only one of every five years.

It is true that many upper-income people realize large capital gains. They also pay more taxes, making revenue available to finance government programs which benefit lower-income recipients.

Q. How Do Capital Gains Rates Affect "Start-Up" Companies?

A. Capital gains taxation has a particularly powerful impact on the entrepreneurial segment of the U.S. economy, which makes possible new technological breakthroughs, new start-up companies, and new jobs. Starting new businesses involves entrepreneurs, informal investors, venture capital pools, and a healthy public market. All are sensitive to after-tax rates of return, which is why the level of capital gains taxation is important.

Foremost is the entrepreneur. By taxing his potential capital gains at a higher rate, either the pool of qualified entrepreneurs will decline or investors will have to accept a lower rate of return. In either case, the implications for the U.S. economy are clearly negative. To be successful, the entrepreneur needs capital. Fledgling start-ups depend heavily on equity finance from family, friends, and other informal sources. Professors William Wetzel and John Freear of the University of New Hampshire, in a survey of 284 new companies, found taxable individuals to be the major source of funds for those raising $500,000 or less at a time. The point to be stressed is that individuals providing start-up capital for these new companies pay capital gains taxes and are sensitive to the capital gains tax rate.

Small businesses and entrepreneurs face higher capital costs than Fortune 500 companies. For them, a significant capital gains tax differential can make a big difference.

Q. Can We "Afford" a Capital Gains Tax Cut?

A. Yes. Critics of lower capital gains taxes argue that such cuts will reduce federal revenues and thus add to the budget deficit, absorb national saving, and raise interest rates and capital costs. Both economic analysis and experience effectively refute this view.

There is actually little difference between congressional estimates of capital gains tax cuts and those of the U.S. Treasury. For example, when President Bush proposed a 30 percent exclusion for capital gains in 1989, the JCT estimated a "static" loss over 1990-1995 of $100 billion. However, induced realizations-the "unlocking" effect-and depreciation recapture would have recouped almost 90 percent of the loss, according to the JCT, and 110 percent as estimated by the Treasury. (This arithmetic accounts for only one behavioral response-the "unlocking" effect-and the Treasury recoups almost all of the revenue loss. There is no revenue accounting for lower capital costs and increased economic activity. This impact would be substantial, as indicated by the analyses prepared by Dr. Allen Sinai and DRI/McGraw Hill.)

Experience indicates that lower capital gains taxes have a positive impact on federal revenues. The most impressive evidence involves the period from 1978 to 1985. During those years the top marginal federal tax rate on capital gains was cut by almost 45 percent from 35 percent to 20 percent-but total individual capital gains tax receipts nearly tripled from $9.1 billion to $26.5 billion annually.

Research by experts at the prestigious National Bureau of Economic Research indicates that the "maximizing" capital gains tax rate-i.e., the rate that would bring in the most Treasury revenue-is somewhere between 9 and 21 percent.

Q. How Do Our International Competitors Treat Capital Gains?

A. Our international competitors recognize the contribution a capital gains tax differential can make to new risk capital, entrepreneurship, and new job creation.

The United States taxes capital gains more harshly than almost any other industrial nation. A survey of twelve industrialized countries shows that the U.S. capital gains tax rate on long-term gains on portfolio securities exceeds that of all countries except Australia and the United Kingdom, and these two countries index the cost basis of an asset (see Table 3). Germany, Japan, and South Korea exempt or tax only lightly capital gains on portfolio stock.

Not only do virtually all industrialized countries tax individual capital gains at lower rates than the United States; they also accord more favorable treatment to corporate capital gains.

Q. What Should a Sensible Capital Gains Tax Cut Look Like?

A. Capital gains tax reform should satisfy three criteria. First, it should make economic sense by lowering the excessively high cost of U.S. capital, reducing the bias against high-risk capital, and ameliorating the taxation of inflationary gains.

Second, it should be fair to all income groups and sectors of the U.S. economy: Main Street and Wall Street, middle-class investors and farmers, new entrepreneurs and retiring businessmen, and individual investors and businesses.

Finally, a capital gains tax reduction should result in stronger economic growth, increased capital formation, and a more buoyant stock market, and, when macroeconomic "feedback" effects are considered, raise the same amount or possibly more tax revenues as current law.

Q. Isn't Indexing the Best Way to Lower the Capital Gains Taxes?

A. Indexing for inflation alone does not unleash the full economic potential that a broader capital gains reduction triggers because it will only have a minimal impact on unlocking unrealized capital gains, a voluntary action on the part of investors.

Indexing for inflation will not offset much of the negative effects on the cost of capital caused by the very high capital gains taxes resulting from the Tax Reform Act of 1986.

Q. What Is the House Capital Gains Tax Proposal?

A. The Contract With America Tax Relief Act of 1995 (H.R. 1215) which was approved by the House of Representatives on April 5, 1995, includes: (1) a 50 percent exclusion for capital gains of individuals (a maximum rate of 19.8 percent); (2) a 25 percent capital gains tax rate for corporations; (3) indexing for inflation for assets acquired on or after January 1, 1995, by individuals; and (4) capital loss treatment for personal residences.


Q. What Major Capital Gains Tax Changes are Being Considered in the Senate?

A. The Hatch-Lieberman Capital Formation Act of 1995 (S. 959) parallels the provisions passed by the House, including the 50 percent exclusion for individual capital gains resulting in a top rate of 19.8 percent; a corporate capital gains rate of 25 percent; and capital loss treatment on the sale of a taxpayer's principal residence. The bill does not include indexing for inflation. Furthermore, S. 959 provides for a 75 percent exclusion for qualified small business stock held for five years and 100 percent deferral if the gain is rolled over into another qualified small business investment within 60 days.

Q. What Is a Capital Gain?

A. A capital gain or loss is the difference between the selling price of an asset and its basis (cost). The basis is the purchase price of the asset, including any brokerage fee. For example, if corporate stock is purchased for $2,000 and later sold for $2,500 (net of broker commissions), the capital gain is the difference between the $2,000 purchase price and the $2,500 received from the sale, or $500. If the asset purchased is a physical asset, such as a building, and the owner had made improvements, then the tax basis is the purchase price plus the cost of the improvements. If the asset depreciates over time, the basis is the original sale price reduced by the decline in value from depreciation.

The distinction between capital assets and other forms of property is the most important concept in the law relating to the taxation of capital gain. Under the Code, any property is a "capital asset" unless it is covered by one of numerous exceptions. The theme running through the exceptions is that capital gains treatment is appropriate only for income resulting from the appreciation in value of investment property or property used in a trade or business. Thus, there are exceptions that deny capital gain treatment for income from personal efforts, income from property not attributable to appreciation (such as interest, dividends, royalties, and rent), and the ordinary profits of business operations.

The primary assets that typically yield capital gains are corporate stock and business and rental real estate, according to a recent report by the Senate Budget Committee. Corporate stock accounts for 20 to 50 percent of total realized gains, depending on the state of the economy and the stock market. There are also gains from assets such as bonds, partnership interests, owner-occupied housing, timber, and collectibles, but all of these are relatively small as a share of total capital gains.

Q. What Is the Current Federal Capital Gains Tax Rate?

A. Gains on the sale of capital assets held for more than a year are limited to a maximum tax rate of 28 percent under the federal individual income tax, even though rates on ordinary income go up to 39.6 percent (or even higher in some cases). Also, gain on the sale of property used in a trade or business is treated as a long-term capital gain if all gains for the year on such property exceed all losses for the year. Qualifying property used in a trade or business generally is depreciable property or real estate that is held more than a year, but not inventory.

Benefits of the 28 percent maximum tax rate are limited to individuals with tax rates above 28 percent-that is, those in the 31 percent bracket, the 36 percent bracket, or the 39.6 percent bracket. For 1994, a taxpayer filing a joint return would have to have taxable income of $91,850 before the 31 percent tax rate applied (single taxpayers would have to have $53,500). Joint taxable income would have to be $140,000 before the 36 percent rate applied, and $250,000 before the 39.6 percent rate applied.

Under current law, capital gains net of capital losses realized by an individual are taxed at a top marginal federal tax rate of 28 percent in taxable income. Net losses are included up to a maximum of $3,000. Net capital losses in excess of $3,000 are carried over to later taxable years. This constraint limits the ability of investors to time the realization of gains and losses so as to minimize taxes.

Corporate capital gains are taxed at a rate of 35 percent, the rate applied to ordinary corporate income.

Q. What Is the History of Capital Gains Taxes in the United States?

A. Although the original 1913 Income Tax Act taxed capital gains at ordinary rates, legislation in 1921 provided for an alternative flat-rate tax for individuals of 12.5 percent for gain on property acquired for profit or investment. This treatment was to minimize the influence of the high progressive rates on market transactions. Over the years, many revisions in this treatment have been made. In 1934, a sliding-scale treatment was adopted (where lower rates applied the longer the asset was held). This system was revised in 1938. In 1942, the sliding-scale approach was replaced by a 50 percent exclusion for all but short-term gains (held for less than six months), with an elective alternative tax rate of 25 percent (see Table 4). The alternative tax affected only individuals in tax brackets above 50 percent.

In 1978, a 60 percent exclusion for individuals was introduced and the alternative rate for corporations was lowered to 28 percent. In 1981, the maximum tax rate on capital gains was reduced to 20 percent; the corporate gains tax remained at 28 percent.

The Tax Reform Act of 1986 (TRA), which lowered overall tax rates and included only two tax rate brackets (15 percent and 28 percent), provided that capital gains would be taxed at the same rate as ordinary income.

In 1990, a 31 percent rate was added to the rate structure for ordinary income. There had been, however, considerable debate over proposals to reduce capital gains taxes. Since the new rate structure would have increased capital gains tax rates for many taxpayers from 28 percent to 31 percent, a separate capital gains rate cap of 28 percent was maintained. The 28 percent cap was continued when the 1993 Omnibus Budget Reconciliation Act added a top rate of 36 percent and a 10 percent surcharge on very high incomes, producing a maximum rate of 39.6 percent on ordinary income.

Q. Do States Also Tax Capital Gains?

A. Yes. Of the 42 states which tax capital gains, the majority apply this tax to the gain reported on the federal tax return. TRA, which eliminated the 60 percent exclusion for capital gains income, dramatically increased state capital gains taxes. As noted in a recent op-ed in the Washington Times:

...State capital gains taxes add another layer of impediment to investment and entrepreneurship, thereby further hampering economic growth and job creation...

Even though a state capital gains tax rate of 4.5 percent, for example, as levied in Connecticut, is less than the national state average of 5.4 percent, it can turn out to be much more daunting after inflation is factored into the equation. For example, if one considers inflation on a venture capital investment of $50,000 made in 1987 and sold for $70,000 in 1993, Connecticut's real capital gains tax rate jumps to 11 percent.

In a state with a much higher capital gains tax rate, such as New York, where the top rate is 7.875 percent, the real rate on such an investment jumps to over 19 percent.

The combined burden of federal and state taxes on capital gains makes it more difficult to raise capital for the start-up and entrepreneurial companies which are the source of much economic vibrancy, innovation, and job creation.

Q. Is Capital Gains a Partisan Issue?

A. No. A reduction in capital gains taxation has not been a partisan issue in the past and should not be a partisan issue now. Capital gains tax reductions enjoyed bipartisan support from the tax-writing committees in all the major debates on this issue for nearly two decades. The real issues are economic: U.S. productivity growth, competitiveness, and job creation. As to fairness, past capital gains cuts have benefited the public generally by strengthening the U.S. economy. In fact, capital gains tax reductions in the Contract With America Tax Relief Act of 1995 (H.R. 1215) and the Hatch-Lieberman Capital Formation Act of 1995 (S. 959) are among the most progressive measures to be considered by Congress in many years.