The Impact of Capital Gains Tax Reductions On the U.S. Economy

March 1997

ACCF President Mark Bloomfield, accompanied by ACCF Senior Vice President and Chief Economist Dr. Margo Thorning, testified as a committee-invited witness on March 19, 1997 before the Committee on Ways and Means of the U.S. House of Representatives. Mr. Bloomfield also testified on March 13, 1997, before the Committee on Finance of the United States Senate. The executive summary and full text of the ACCF's testimony are presented here.

Executive Summary

1. Overview. We commend the emphasis Chairman Archer has placed on the impact of capital gains taxation on the cost of capital, saving and investment, and economic growth. A capital gains tax cut will help reduce the burden on capital formation imposed by current U.S. tax policy.

2. Trends in U.S. Capital Formation. Slow growth in the United States over the past two decades can be partly attributed to low levels of investment. A recent international comparison by the World Bank suggests that countries with high levels of investment grow faster than countries with relatively low levels of investment.

3. 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 by many mainstream economists today.

4. Macroeconomic Impact of Capital Gains Tax Reductions.

• Increase Jobs and Economic Growth. New analyses by mainstream economic forecaster Allen Sinai, president and chief global economist of Primark Decision Economics, and by David Wyss, director of research of DRI/McGraw-Hill, show that a broad-based and carefully crafted capital gains tax cut for individuals and corporations reduces the cost of capital and increases investment, GDP, productivity growth, and employment. In addition, such a cut would essentially be revenue neutral, when unlocking and macroeconomic consequences are included.
  
  
• Benefit Middle-Class Taxpayers. A 1996 Congressional Budget Office draft report documents the widespread ownership of capital assets among middle-income taxpayers. According to the CBO report, in 1989, 31 percent of families with incomes under $20,000 held capital assets (not including personal residences) and 54 percent with income between $20,000 and $50,000 held capital assets.
  
  
• 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.
  
  
• Promote U.S. Saving and Investment. The United States taxes capital gains more harshly that almost any other industrial nation, according to an OECD survey of twelve industrialized countries. Most of these countries also had higher rates of investment as a percent of GDP than the United States over the past two decades.

5. Conclusion. A soundly structured, broad-based cut in tax rates on capital gains would significantly benefit all Americans. By reducing the cost of capital, it would promote the type of productive business investment that fosters growth in output and high-paying jobs. By increasing the mobility of capital, it would help assure that scarce saving is used in the most productive manner. By raising capital values, it would help support values in capital asset markets in general and the stock market in particular. By increasing the availability and lowering the cost of capital, it would aid entrepreneurs in their vital efforts to keep the United States ahead in technological advances and translate those advances into products and services that people need and want. By reducing taxes on their savings, it would treat fairly those thrifty Americans who must bear a heavier tax burden than the profligate. And, because of the combined impacts of unlocking and macroeconomic feedback, a broad-based capital gains tax cut is likely to increase federal revenues.

ACCF Statement

Introduction

My name is Mark Bloomfield. I am president of the American Council for Capital Formation (ACCF). I am accompanied by Dr. Margo Thorning, our senior vice president and chief economist.

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.

This testimony begins with a discussion of trends in U.S. capital formation and productivity growth, and the impact of tax policy on economic growth. Then we specifically address the macroeconomic effects of capital gains tax reductions. We conclude our testimony by setting forth three criteria that a good capital gains tax cut should meet: it should make economic sense; it should be fair; and it should be fiscally responsible.

We commend the emphasis that Chairman Archer has placed on the impact of capital gains taxation on the cost of capital, saving and investment, and economic growth. A capital gains tax cut will help reduce the burden on capital formation imposed by current U.S. tax policy. That tax policy must be revised if real wages for U.S. workers are to increase, living standards are to advance at a faster pace, and the United States is to maintain the economic strength necessary to sustain its leading role in world affairs.

Trends in U.S. Capital Formation, Productivity Increases, and Economic Growth

Slow growth in the United States over the past twenty years can be partly attributed to low levels of investment. A recent international comparison by the World Bank suggests that countries with high levels of investment experience faster growth than countries with relatively low levels of investment. This relationship is clearly demonstrated in Table 1 and Figure 1.

Table 1	Investment and Saving as a Percent of GNP and Real GNP Growth, 1974-1993
Country	Gross Domestic Saving	Gross Domestic Investment	Average Annual Real GNP Growth
South Korea	30.7	32.0	11.4
Singapore	40.0	41.8	7.6
Thailand	27.3	31.2	7.5
Hong Kong	30.4	28.6	7.3
Malaysia	34.9	31.7	6.8
Japan	32.3	30.9	3.6
Norway	30.0	27.7	3.5
Switzerland	24.9	24.0	3.1
Australia	23.2	24.3	2.7
Canada	23.5	22.7	2.7
Germany	23.7	21.0	2.6
United States	17.5	18.8	2.3
France	22.1	22.0	2.0
United Kingdom	17.4	18.1	1.6
Denmark	20.7	19.5	1.6
Source: The World Bank, World Tables 1995 (Baltimore: The Johns Hopkins University Press).

Figure 1	Investment and Saving as a Percent of GNP and Real GNP Growth, 1974-1993
Source: The World Bank, World Tables 1995 (Baltimore: The Johns Hopkins University Press).

International comparisons aside, even more disturbing is the fact that net annual business investment in this country has in recent years fallen to only half the level of the 1960s and 1970s. As shown in Table 2, that rate dropped from an average of 8.9 percent of GDP in the 1960s and 1970s to 4.8 percent in the 1990s.

Table 2	Flow of U.S. Net Saving and Investment (percent of GDP in current $; national account basis)
	Average 1960-1980	Average 1981-1985	Average 1986-1990	Average 1991-1996***
Net Private Domestic Saving	8.1%	7.3%	5.3%	5.3%
State and Local Government Surpluses	2.1%	1.9%	1.8%	1.4%
Subtotal of Private and State Saving	10.2%	9.2%	7.1%	6.7%
Less: Federal Budget Deficit	-0.8%	-3.8%	-2.8%	-3.1%
Net Domestic Saving Available for Private Investment	9.3%	5.4%	4.3%	3.6%
Net Inflow of Foreign Saving*	-0.4%	1.2%	2.4%	1.3%
Net Private Domestic Investment	8.9%	6.7%	6.7%	4.8%
Gross Private Domestic Investment	16.0%	16.9%	15.4%	13.7%
Nonresidential Fixed Investment	10.4%	12.2%	10.5%	9.6%
Producers' Durable Equipment	6.6%	7.4%	6.9%	6.8%
Industrial Equipment	1.9%	1.8%	1.6%	1.6%
Producers' Durable Equipment Less Info. Processing and Related Equipment	5.2%	5.0%	4.6%	4.5%
Personal Saving	5.4%	5.7%	3.8%	3.6%
Net Business Saving**	2.7%	1.6%	1.5%	1.7%
*In the 1960-1980 period the United States sent more capital abroad than it received; thus net inflow was negative during this period. **Net Business Saving = gross private saving - personal saving - corporate and noncorporate capital consumption allowance. ***Includes only first, second, and third quarter figures for 1996. Source: Department of Commerce Bureau of Economic Analysis, National Income Accounts. Update prepared by American Council for Capital Formation Center for Policy Research, February 1997.

Harvard Professor Dale W. Jorgenson, one of the nation's foremost public finance economists, emphasizes the overwhelming importance of investment in plant and equipment for economic growth in his recent volume, Productivity-Postwar U.S. Economic Growth. Professor Jorgenson's study analyzes economic growth between peaks in the business cycle over the 1948-79 period. Allocating increases in output to three sources-growth in the capital stock, labor supply, and multifactor productivity-he found that increases in the capital stock had the strongest impact on growth in output.

Studies by University of California Professor J. Bradford De Long and Deputy Secretary of the Treasury Lawrence H. Summers also conclude that investment in equipment is perhaps the single most important factor in economic growth and development. Their research provides strong evidence that, for a broad cross section of nations, every one percent of GDP invested in equipment is associated with an increase in the GDP growth rate itself of one-third of one percent, a very substantial social rate of return.

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.

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.

A consumption-based tax system, under which all saving and investment would be exempt from tax, would be more favorable toward capital formation and economic growth than is our current income tax system, according to analyses by top public finance scholars over the past decade and a half. Studies by Stanford University's John Shoven and Lawrence Goulder, Harvard's Dale Jorgenson, the University of Texas' Don Fullerton, and Joel Prakken of Macroeconomic Advisers have used macroeconomic models that incorporate feedback and dynamic effects in simulating the impact of adopting a consumption tax as a full or partial replacement for the income tax. These studies, which use different types of general equilibrium models, conclude that U.S. economic growth would be enhanced if we relied more on consumption taxes, or replaced the income tax with a fundamental tax restructuring plan similar to those proposed by several prominent members of the U.S. Senate and House of Representatives in recent years.

In addition, at a recent forum on dynamic revenue estimating sponsored by the Joint Committee on Taxation, the majority of the economic modelers concluded that if the United States switched from the existing income tax to a broad-based consumption tax, the rate of economic growth would increase significantly.

Macroeconomic Impact of Capital Gains Tax Reductions

In their search for methods of stimulating saving, investment, and economic growth, policymakers should give strong consideration to lightening the tax burden on investment through a significant capital gains tax reduction.

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. It is retained income that 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.

Although the short-term outlook for the U.S. economy is favorable, worries about the future appear to be multiplying. For example, many public finance experts such as Professor John Shoven conclude that this country's long-term strength and economic stability depend on increasing saving and investment to ensure that the retirement of the baby boom generation does not sink the economy into a sea of red ink. 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 help encourage saving, help maintain the values of capital assets (e.g. real estate and stocks), promote investment by both mature and new businesses, and more fairly tax individual savings.

Substantial reductions in capital gains taxes for individuals and corporations would have important economy-wide consequences:

• Increase Jobs and Economic Growth
  
  A new study by Dr. Allen Sinai, president and chief global economist of Primark Decision Economics and a highly respected economic forecaster, concludes that a well-crafted, broad-based capital gains tax rate reduction would have significant benefits for the U.S. economy.
  
  Dr. Sinai analyzed the impact of two capital gains tax reduction proposals: S. 66, a broad-based capital gains proposal introduced by Senators Hatch, Lieberman, Grassley, and Breaux, which provides for a 50 percent exclusion for individuals and a 25 percent corporate capital gains tax rate; and H.R. 14, introduced by Representatives Dreier, Hall, McCarthy, English, and Moran, which provides for a 14 percent marginal rate for individuals and a 28 percent rate for corporations among other provisions. Dr. Sinai concluded that both proposals reduce the cost of capital (defined as the pretax return required by investors). For example, S. 66 reduces capital costs by 4.3 percent, while H.R. 14 reduces capital costs by 7.1 percent. Reduced capital costs lower the hurdle rate for new business investment and induce increases in the rate of growth of capital formation, investment, productivity, GDP, and employment (see Table 3). Lower capital gains taxes support the value of equities as well as other capital assets.

• Benefit Middle-Class Taxpayers
  
  Investments in capital assets are widely held by the middle class. According to data compiled by the Investment Company Institute, almost 60 percent of households with income of $50,000 or less own mutual funds. A 1996 Congressional Budget Office (CBO) draft report also documents the widespread ownership of capital assets among middle-income taxpayers. According to the CBO report, in 1989, 31 percent of families whose incomes were under $20,000 held capital assets (not including personal residences) and 54 percent with income between $20,000 and $50,000 held capital assets.
  
  Middle- and low-income taxpayers also hold a significant share of the total dollar value of capital assets, even when personal residences are excluded. The CBO study shows that 30 percent of the dollar value of such assets (excluding housing) was held by families with incomes of $50,000 or less in 1989.
  
  
• Encourage Entrepreneurship
  
  Capital gains taxation has a particularly powerful impact on this nation's entrepreneurs. These individuals are 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. All taxable participants are sensitive to after-tax rates of return, which is why the level of capital gains taxation is so important.
  
  Foremost is the entrepreneur. If the tax on potential capital gains is a higher rate, either the pool of qualified entrepreneurs will decline or taxable 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 financing 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 undertaken in the late 1980s, 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 in their decisions affecting jobs and growth.
  
  
• Raise Tax Receipts
  
  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.
  
  Scholars have researched and debated two elements affecting capital gains tax revenues: the unlocking of unrealized gains and the macroeconomic impact of a low tax on capital gains.
  
  Revenue estimates used in congressional and Treasury Department analyses ignore macroeconomic impacts but do incorporate an unlocking or behavioral response on the part of taxpayers to changes in capital gains tax rates. Estimates of unlocking are extremely sensitive to assumptions about the elasticity of taxpayer response. Very minor differences in assumptions can result in large differences in expected revenues.
  
  In the late 1980s, experts at the prestigious National Bureau of Economic Research (NBER) examined the question of the revenue-maximizing capital gains tax rate: At what point is there sufficient unlocking to compensate for the static revenue loss resulting from a reduction in the tax? The NBER study by former Harvard Professor Lawrence Lindsey (a recently retired member of the Board of Governors of the Federal Reserve), which was based on academic models of the responsiveness of taxpayers to changes in the capital gains tax rates, found that the revenue-maximizing rate ranged between 9 and 21 percent. The NBER study did not take into account the additional revenue stemming from the positive macro consequences of increased employment and growth which result from a significant reduction in capital gains tax rates.
  
  Although government revenue estimates do not factor in the macroeconomic consequences of lower capital gains tax rates on U.S. capital costs, investment, and economic growth, previous research indicates these effects can have a favorable impact on overall tax revenues. In addition, the new dynamic analysis by Dr. Sinai shows that the government could gain revenue from a capital gains tax reduction (see Table 3).
  
  Actual experience also 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 almost in half-from 35 percent to 20 percent—but total individual capital gains tax receipts nearly tripled, from $9.1 billion to $26.5 billion annually.
  
  
• Promote U.S. Saving and Investment
  
  Our international competitors recognize the contribution a lower capital gains tax rate can make in promoting capital formation, entrepreneurship, and new job creation. The United States, on the other hand, taxes capital gains more harshly than almost any other industrial nation. A survey by the OECD 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 5). Germany, Japan, and others exempt or tax only lightly capital gains on portfolio stock. Not only do virtually all industrialized as well as developing countries tax individual capital gains at lower rates than the United States, they also accord more favorable treatment to corporate capital gains (see Figure 2).

Figure 2	Corporate Capital Gains Tax Rates, 1996

It is important to note that most of the countries shown in Table 1 have had higher rates of investment as a percentage of GDP than the United States over the past two decades. This fact may in part reflect the encouragement of saving and investment due to their lower capital gains tax rates.

Conclusion

A soundly structured, broad-based cut in tax rates on capital gains would significantly benefit all Americans. By reducing the cost of capital, it would promote the type of productive business investment that fosters growth in output and high-paying jobs. By increasing the mobility of capital, it would help assure that scarce saving is used in the most productive manner. By raising capital values, it would help support values in capital asset markets in general and the stock market in particular. By increasing the availability and lowering the cost of capital, it would aid entrepreneurs in their vital efforts to keep the United States ahead in technological advances and translate these technological advances into products and services that people need and want. By reducing taxes on their savings, it would treat fairly those thrifty Americans who must bear a heavier tax burden than the profligate. And, because of the combined impacts of unlocking and macroeconomic feedback, a broad-based capital gains tax cut is likely to increase federal revenues.

Mr. Chairman, the case for an early broad-based cut in capital gains tax rates is exceedingly strong. We urge this Committee and both Houses of Congress to enact such legislation at the earliest feasible time.