Order Code 96-769 E
Updated July 15, 2003
CRS Report for Congress
Received through the CRS Web
Capital Gains Taxes: An Overview
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
1997 tax legislation reduced capital gains taxes on several types of assets, imposing
a 20 maximum tax rate on long-term gains, a rate temporarily reduced to 15% for 2003-
2008. There is also an exclusion of $500,000 ($250,000 for single returns) for gains tax
on home sales. The capital gains tax has been a tax cut target since the 1986 Tax
Reform Act treated capital gains as ordinary income. An argument for lower capital
gains taxes is reduction of the lock-in effect. Some also believe that lower capital gains
taxes will cost little compared to the benefits they bring and that lower taxes induce
additional economic growth, although the magnitude of these potential effects is in some
dispute. Others criticize lower capital gains taxes as benefitting higher income
individuals and express concerns about the budget effects, particularly in future years.
Another criticism of lower rates is the possible role of a larger capital gains tax
differential in encouraging tax sheltering activities and adding complexity to the tax law.
What Are Capital Gains and How Are They Taxed?
Capital gain arises when an asset is sold and is the difference between the basis
(normally the acquisition price) and the sales price. Corporate stock accounts for 20% to
80% of taxable gains, depending on stock market performance. Real estate is the
remaining major source of capital gains, although gain arises from other assets (e.g.,
timber sales and collectibles). The appreciation in value can be real or reflect inflation.
Corporate stock appreciates both because the firm’s assets increase with reinvested
earnings and because general price levels are rising. Appreciation in the value of property
may simply reflect inflation. For depreciable assets, some of the gain may reflect the
possibility that the property was depreciated too quickly.
If the return to capital gains were to be effectively taxed at the statutory tax rate in
the manner of other income, real gains would have to be taxed in the year they accrue.
Current practice departs from this approach. Gains are not taxed until realized,
benefitting from the deferral of taxes. (Taxes on interest income are due as the interest
is accrued). Gains on an asset held until death may be passed on to heirs with the tax
forgiven; if the asset is then sold, the gain is sales price less market value at the time of
death, a treatment referred to as a “step-up in basis.”
Congressional Research Service ˜ The Library of Congress
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Under current law, there is a maximum tax of 20% on capital gains held for a year
(temporarily reduced to 15% for 2003-2008), although the ordinary income tax rates
reach as high as 39.6% (temporarily reduced to 35%). Where ordinary tax rates are 15%
or below, the capital gains tax is 10% (temporarily at 5% for 2003-2007 and 0% for
2008). Assuming the temporary provisions expire, gain from assets held 5 years and
acquired after 2000 will be subject to a maximum rate of 18%. For gains in the 15%
bracket and below, an 8 % rate will apply to any gain on assets held for 5 years and sold
after 2000, with no required acquisition date. Gain arising from prior depreciation
deductions is taxed at ordinary rates, but there is a 25% ceiling rate on the gain from
attributable to prior straight-line depreciation on real property.
Under law prior to 1997, several rules permitted avoidance or deferral of the tax on
gain on owner-occupied housing, including a provision allowing deferral of gain until a
subsequent house is sold (rollover treatment) and a provision allowing a one-time
exclusion of $125,000 of gain for those 55 and over. These provisions were replaced with
a general $500,000 exclusion ($250,000 for a single individual), which cost only slightly
more in revenue.
In contrast to these provisions that benefit capital gains, capital gains are penalized
because many of the gains that are subject to tax arise from inflation and therefore do not
reflect real income.
A Brief History
Capital gains were taxed when the income tax (with rates up to 7%) was imposed in
1913. An alternative rate of 12.5% was allowed in 1921 (the regular top rate was 73%).
Tax rates were cut several times during the 1920s. Capital gain exclusions based on
holding period were enacted in 1924, and modified in 1938, to deal with bunching of
gains in one year. In 1942 a 50% exclusion was adopted, with an alternative rate of 25%.
Over time, the top rate on ordinary income varied, rising to 94% in the mid-1940s, then
dropping to 70% after 1964. In 1969 a new minimum tax increased the gains tax for
some; the 25% alternative tax was repealed.
In 1978 the minimum tax on capital gains was repealed and the exclusion increased
to 60% with a maximum rate of 28% (0.4 times 0.7). The top rate on ordinary income
was reduced to 50% in 1981, reducing the capital gains rate to 20% (0.4 times 0.5). The
Tax Reform Act of 1986 reduced tax rates further, but, in order to maintain distributional
neutrality, eliminated some tax preferences, including the exclusion for capital gains.
This treatment brought the rate for high income individuals in line with the rate on
ordinary income — 28%.
In 1989, President Bush proposed a top rate of 15%, halving top rates. The Ways
and Means Committee considered two proposals: Chairman Rostenkowski proposed to
index capital gains, and Representatives Jenkins, Flippo, and Archer proposed a 30%
capital gains exclusion through 1991 followed by inflation indexation. This latter
measure was approved by the Committee, but was not enacted.
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In 1990, the President proposed a 30% exclusion, setting the rate at 19.6% for high
income individuals. The House also passed a 50% exclusion with a lifetime maximum
ceiling and a $1,000 annual exclusion, but this provision was not enacted into law. When
rates on high income individuals were set at 31%, however, the capital gains rate was
capped at 28%.
In 1991, the President again proposed a 30% exclusion, but no action was taken. In
1992, the President proposed a 45% exclusion. The House adopted a proposal for
indexation for inflation for newly acquired assets: the Senate passed a separate set of
graduated rates on capital gains that tended to benefit more moderate income individuals.
This latter provision was included in a bill (H.R. 4210) containing many other tax
provisions that was vetoed by the President.
No changes were proposed by President Clinton or adopted in 1993 and 1994 with
the exception of a narrowly targeted benefit for small business stock adopted in 1993.
The value of the tax cap was increased, however, in 1993 when new brackets of 36% and
39.6% were added for ordinary income.
In 1994, the “Contract With America” proposed a 50% exclusion for capital gains,
and indexing the basis for all subsequent inflation, while eliminating the 28% cap; this
exclusion would be about a 40% reduction on average from current rates. The Ways and
Means Committee reported out H.R. 1215 which restricted inflation indexing to newly
acquired assets (individuals could “mark to market” — pay tax on the difference between
fair market value and basis as if the property were sold to qualify for indexation), did not
allow indexation to create losses and provided a flat 25% tax rate for corporations). The
1995 reconciliation bill (H.R. 2491) that was vetoed by the President, included these
revisions but delayed the indexation provision until 2002. During the 1996 presidential
election, Mr. Dole proposed a slightly larger capital gains cut, and both candidates
supported elimination of capital gains taxes on virtually all gains from home sales.
In 1997, the President and Congress agreed to a tax cut as part of the reconciliation.
The Administration tax cut proposal included the change in tax treatment of owner
occupied housing. The House bill included a reduction in the 15% and 28% rates to 10%
and 20%, about a 30% cut. Capital gains would also be indexed for assets acquired after
2000 and held for 3 years; mark-to-market would also be allowed. The Senate and the
final bill did not include indexing. The capital gains issue was briefly revisited in 1998,
when the holding period for long term gains was moved back from the 18 months set in
1997 to the one year period that has typically applied. The 1999 House bill would have
cut the rates to 15% and 10%: the conference version cut rates to 18% and 8% and
proposed indexing of future gains, but the bill was vetoed. Capital gains were discussed
during the consideration of the economic stimulus bill at the end of 2002, but not included
in any legislative proposal (and no proposal was adopted). The temporary provisions for
lower rates of 15% for 2003-2008 for those in the higher brackets and to 5% in 2003-2007
and 0% in 2003 for taxpayers in the 15% bracket or lower were adopted in 2003.
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Revenue Effects
Over the past several years, a debate has ensued regarding the revenue cost of cutting
capital gains taxes (see CRS Report 97-559 ,The Revenue Cost of Cutting Capital Gains
Tax Rates, for further discussion). For example, in 1990 when the President proposed a
30% exclusion, Treasury estimates showed a $12 billion gain in revenue over the first 5
years, while the Joint Committee on Taxation found a revenue loss of approximately
equal size.
Although the estimates seemed quite different, they both incorporated significant
expected increases in the amount of gains realized as a result of the tax cut. For example,
the Treasury would have estimated a revenue loss of $80 billion over 5 years with no
behavioral response, and the Joint Tax Committee a loss of $100 billion. (The gap
between these static estimates arose from differences in projections of expected capital
gains, a volatile series that is quite difficult to estimate.)
Empirical evidence on capital gains realizations does not clearly point to a specific
response and revenue cost. Recent research suggests long-run responses may be more
modest than those suggested by the economics literature during the 1990 debate, but the
short-run response is still difficult to ascertain. (For a survey of this literature, see Jane
G. Gravelle, The Economic Effects of Taxing Capital Income, Cambridge, MA.: MIT
Press, 1984, pp. 143-151; see also Leonard Burman, The Labyrinth of Capital Gains Tax
Policy, Washington, DC: The Brookings Institution, 1999 for a discussion of this issue
and many others.)
Any revenue feedback effect will be smaller the larger the tax reduction. When the
tax reduction is large, although there will be a larger response, any induced revenues will
be taxed at the new lower rates. Thus, a 50% exclusion will not have as large a feedback
effect relative to the static estimate as a 30% exclusion. Moreover, allowing a prospective
tax cut that depends on selling and acquiring a new asset to qualify (or marking to market)
as is the case for the reduction from 20% to 18% for 5-year property causes a gain in the
short run as well.
Arguments have also been made that a capital gains tax cut will induce additional
savings, also resulting in a feedback effect as taxes are imposed on new income. This
effect is uncertain, as it is not clear that an increase in the rate of return will increase
savings (savings can decrease if the income effect is more powerful than the substitution
effect) and what the magnitude of the response might be. (See Congressional Budget
Office Memorandum, An Analysis of the Potential Macroeconomic Effects of the
Economic Growth Act of 1998). There is also a debate about the effect of the capital gains
tax on growth through its effect on innovation. Regardless of these empirical
uncertainties, any effect of savings on taxable income in the short run is likely to be quite
small due to the slow rate of capital accumulation. (Net savings are typically only about
2% to 3% of the capital stock, so that even a 10% increase in the savings rate would result
in only a 2/10 to 3/10 of a percent first-year increase in the capital stock.) A related
argument is that the tax cut will increase asset values; such an effect is only temporary,
however, and will, if it occurs, only shift revenues from the future to the present. (For a
discussion of savings and asset valuations, see testimony of Jane G. Gravelle,
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Congressional Research Service before the Senate Finance Committee, February 15, 1995
and the House Ways and Means Committee, March 19, 1997.)
Impact on Effective Tax Burdens
The tax burden on an investment is influenced by both the tax rate and any benefits
allowed or penalties imposed. One way to measure this tax burden is to calculate a
marginal effective tax rate that captures in a single number all of the factors that affect tax
burden. It is the percentage difference between the before- and after-tax return to
investment, or the estimated statutory rate that would be applied to economic income to
give the taxpayer the same burden as the combination of tax benefits and penalties.
The effective tax rate on capital gains can be either higher or lower than the statutory
rate, depending on the inflation rate relative to the real appreciation rate and the holding
period. Also, assets held until death are not subject to tax. For example, under prior law,
assuming a 20% statutory tax rate, the gain on a growth stock (paying no dividends) with
a real appreciation rate of 7% and an inflation rate of 3% would, if held for one year, 7
years, 20 years, and until death, be subject respectively to tax rates of 27%, 22%, 14%,
and 0%. The rate on 7- and 20-year assets would be 18%, for effective tax rates of 19%
and 12%). (With no inflation and a 20% rate, the rates would be 19%, 16%, 12% and 0%;
inflation penalizes assets held a shorter period more heavily than assets held for a longer
period). Since less than half of gains that are accrued are realized, the effective tax rate
is probably lower than the statutory tax rate. These benefits are larger for individuals who
in the highest tax brackets (31%, 36%, and 39.6%) because the capital gains tax rate is
capped at 20%. The rates would be lowered proportionally with a 15% tax rate.
Issues: Efficiency, Growth, Distribution, and
Complexity
One argument in favor of reducing the capital gains tax is the lock-in effect. If this
effect is large, the tax introduces significant distortions in behavior with relatively little
revenue gain. Another way to reduce lock-in is accrual taxation (i.e., tax gains on a
current basis as accrued), but this approach is only feasible when assets can be easily
valued (e.g., publicly traded corporate stock). Another way to reduce lock-in is to tax
gains passed on at death. These solutions may face technical problems and taxation of
gains at death has been unpopular.
For owner-occupied housing, although there were many ways to avoid the tax under
current law, the rules may have resulted in individuals remaining in houses that are too
large if economic circumstances have declined (for example, through job loss), retirement
has brought a preference for a smaller home, or there is relocation to a lower-cost area.
A case might be made for lower capital gains taxes on corporate stock because
corporate equity capital is subject to heavy taxation. This heavy taxation encourages
corporations to take on too much debt and directs too much capital to the noncorporate
sector. On the other hand, lower capital gains taxes increase the relative penalty that
applies to dividends and introduce tax distortions in the decisions of the firm to retain
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earnings. However, this latter effect does not occur under the temporary tax cuts that
benefit dividends as well as capital gains.
Arguments have also been made that lower gains taxes will increase economic
growth and entrepreneurship. While evidence on the effect of tax cuts on savings rates
and, thus, economic growth is difficult to obtain, most evidence does not indicate a large
response of savings to an increase in the rate of return. Indeed, not all studies find a
positive response, because a higher rate of return may allow individuals to save less while
reaching their desired goal. (See Gravelle, The Economics of Taxing Capital Income,
MIT Press, pp. 24-28, for a survey.) A more effective route to increasing savings may be
to take revenues that might otherwise finance a tax cut and reduce the debt.
Although arguments are made that lower gains taxes stimulate innovation and
entrepreneurship, there is little evidence in history to connect periods of technical
advance with lower taxes or even high rates of return. The extent to which entrepreneurs
take tax considerations into account is unclear; however, there is some reason to doubt
that capital gains taxes are important in obtaining large amounts of venture capital, in part
because much of this capital is supplied by those not subject to the capital gains tax (i.e.,
pension funds, foreign investors). (See CRS Report RL30040, Capital Gains Taxes:
Innovation and Growth, for a further discussion of capital gains taxes and venture
capital.) Moreover, there is no evidence that longer corporate stock holding periods lead
to more investments in long-term assets, including R&D, a rationale for lowering rates
for assets with longer holding periods. (Note that indexing, initially proposed, and then
dropped, favors assets with shorter holding periods.)
A major complaint made by some about lower gains rates cut is that they primarily
benefit very high income individuals. Capital gains are concentrated among higher
income individuals because these individuals tend to own capital and because they are
likely to own capital that generates capital gains. For example, the Treasury indicated in
1990 that 54% of the proposed capital gains tax cut would go to individuals with incomes
over $200,000 and 74% would go to individuals with incomes over $100,000 (using a 5-
year average expanded income definition to classify taxpayers). Individuals with
$200,000 of income account for about 1% of taxpayers and individuals with incomes over
$100,000 account for less than 5%. The distributional effects of the capital gains relief
for homes is somewhat less concentrated at the higher end (although lower income
individuals are much less likely to own homes). The revisions may also enhance
horizontal equity by treating taxpayer in different circumstances more evenly.
Critics of lower capital gains taxes cite the contribution of preferential capital gains
treatment to tax sheltering activities and complexity. For example, individuals may
borrow (while deducting interest in full) to make investments that are eligible for lower
capital gains tax rates, thereby earning high rates of return. These effects are, however,
constrained in some cases (i.e., a passive loss restriction limits the deductions allowed in
real estate ventures). Capital gains differentials complicate the tax law, especially as
applied to depreciable assets where capital gains treatment can create incentives for
churning assets unless recapture provisions are adopted. Indexation of capital gains for
inflation is more complicated than a simple exclusion, since different basis adjustments
must apply to different vintages of assets and proper indexation of gains on depreciable
property is especially difficult. Thus, foregoing indexing probably kept the tax law
simpler.