Economic and Revenue Effects of Permanent and Temporary Capital Gains Tax Cuts

Economic and Revenue Effects of Permanent and Temporary Capital Gains Tax Cuts

Order Code RS21014
Updated January 29, 2003
CRS Report for Congress
Received through the CRS Web
Economic and Revenue Effects of Permanent
and Temporary Capital Gains Tax Cuts
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
During the 107th Congress proposals were made to enact either a temporary or a
permanent capital gains tax cut. The former would probably gain revenue in the first 2
years but lose that revenue and more, most likely within the following 3 years. H.R.
3090, passed by the House, would lower the top tax rate from 20% to 18% for assets
held at least a year. The Senate Finance Committee version of H.R. 3090, did not
reduce capital gains taxes. President Bush’s current dividend relief proposal contains
some capital gains relief as well. A capital gains tax cut appears the least likely of any
permanent tax cut to stimulate the economy in the short run; a temporary capital gains
tax cut is unlikely to provide any stimulus. Permanently lower capital gains taxes can
contribute to economic efficiency in some ways and detract from it in others. Capital
gains tax cuts would favor high income individuals, with about 80% of the benefit going
to the top 2% of taxpayers. This report will be updated to reflect legislative
developments.
Introduction
Recent proposals have been made to enact a capital gains tax cut, and some
arguments have been made that such tax cuts are needed to stimulate the economy.
Proposals include both temporary cuts in capital gains taxes rates for 2 years as well as
permanently lower rates. Interest in a tax stimulus package has increased following the
terrorist attack of September 11, and a capital gains tax cut is one of a number of tax cuts
being discussed. H.R. 3090, passed by the House on October 24, in a 216-214 vote,
would lower the top tax rate to 18% for assets held a year. The Senate Finance
Committee version of H.R. 3090, which was approved by the Committee on November
8, does not contain a capital gains tax cut.
President Bush’s dividend relief proposal effectively contains prospective capital
gains relief for corporate stock because it would increase basis attributable to retained
Congressional Research Service ˜ The Library of Congress

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earnings that had been taxed. Eventually this adjustment should eliminate much of capital
gains on corporate stock.
Under tax law prior to 2001, individuals were taxed on ordinary incomes at rates of
15%, 28%, 31%, 36% and 39.6%. A new 10% bracket will be added for 2002, and the
top rates (28% and higher) began to drop in 2001; eventually the 28% bracket will
become 25%. Capitals gains on assets held for a year or more, however, are (and will
continue to be absent legislative changes), taxed at special rates. The capital gains tax
rate for individuals in the 28% or higher normal tax rate bracket is 20%. Assets acquired
after 2000 and held for 5 years will then be subject to a tax rate of 18%. Individuals in
the 15% rate bracket are taxed at 10%, or 8% for assets held for 5 years (regardless of
when acquired). Proposals have been made to reduce the 20% rate to 15%, and the 10%
rate to 7.5%. One proposal would make this change permanent; another would provide
a temporary rate cut for 2 years. H.R. 3090, reported out of the Ways and Means
Committee on October 12, would lower the 20% and 20% rates to 18% and 8%.
The vast majority of capital gains tax revenue is collected from individuals in the
28% regular income bracket or above. This report focuses on the likely revenue effects
and effects on the economy of such tax changes, focusing on the proposed 15% rate,
although other issues are addressed as well.1
Revenue Effects
Permanent Tax Cuts
There is a significant difference between the revenue effects of a permanent and a
temporary capital gains tax cut. Past capital gains tax cuts (such as the reduction in rates
from 28% to 20% in 1997) have been estimated to gain revenue in the first 2 calendar
years (which may extend over 3 fiscal years) and lose revenue thereafter. This initial
effect occurs because of realizations responses–increases in realizations induced by the
reduction in the tax rate. These responses occur because of an unlocking effect.
Individuals who might wish to sell their assets and invest in some preferred alternative
(either because they expect the rate of return to be higher or because the alternative asset
has a more desirable risk-return trade-off) are locked in by the capital gains tax. To shift
to the new asset causes taxes to be paid earlier (or, in cases where assets were intended
to be held indefinitely, causes taxes to be paid at all). Lowering the rate allows an
unlocking, which tends to be more pronounced initially. These induced realizations, and
the tax collected on them, offset the static revenue loss. However, as the tax rate falls, the
induced response offset declines, for two reasons. First, the responsiveness is estimated
to be smaller at lower rates than at higher ones. Second, the induced realizations are taxed
at lower rates.
To illuminate these points, in 1999, H.R. 2488, the Financial Freedom Act, passed
the House with a similar provision, to cut the capital gains tax rate to 15%. The
provision, which became effective in mid-year, was projected by the Joint Committee on
1 For a description, history and overview of capital gains taxes see CRS Report 96-769E, Capital
Gains Taxes: An Overview, by Jane G. Gravelle.

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Taxation to lose revenue of $0.7 billion in FY2000 and $3.8 billion in FY2001. The
revenue loss then rose to $5.8 billion per annum, and cumulated to $51 billion over a 10-
year period. This revenue pattern can be contrasted with the effects of a larger tax cut in
1997 (from 28% to 20%), which was estimated to gain revenue in the first 3 fiscal years,
and was estimated at that time to cost $21 billion over 10 years. While some increase in
projected gains had occurred, the difference between the initial year patterns, and the
cumulative total indicates that a capital gains tax cut will be expected to cost considerably
more for a given amount of stimulus because of the lower starting point. This provision
is estimated to cost $10 billion over the next 10 years.
Temporary Tax Cut
A temporary tax cut has additional nuances. First, the temporary tax cut may gain
revenue in the initial years. The unlocking response will be somewhat larger for certain
types of assets because the slightly lower tax has made the tradeoff for currently taxing
income more favorable (that is, there is a larger incentive to realize gain today than with
a permanent tax cut because the tradeoff is between different rates as well as between
rates of return and tax deferral). This effect is somewhat offset because of complications
with the 18% rate, as described below.
Secondly, the lower rate can create an incentive for individuals to sell even if they
would not otherwise desire to do so in the absence of tax considerations. This effect
occurs when the asset is expected to be sold relatively soon in any case (otherwise,
without a higher expected rate of return or other inducement, the benefit of the lower rate
is swamped by the loss of tax deferral). A similar event occurred when the 1986 tax
reform act was passed and a higher 28% capital gains tax rate effective the next year
became known in advance. There was a significant rise in capital gains realizations.
Capital gains realizations rose from 4.22% of GDP in 1985 to 7.60% in 1986, and then
fell to 3.2% in 1987, and continued to fall. While it is hard to control for the different
forces affecting capital gains, it is clear that there was a significant response.
While the prospect of higher rates caused a jump in realizations, this type of
magnitude is not likely to be repeated for this proposed tax cut. This effect occurs not
only because the differences between old and new rates are much smaller today than they
were in 1986, but also because of the 18% rate. Any asset acquired after 2000 and held
for 5 years becomes eligible for an 18% tax rate. Suppose the lower rate is adopted
effective Jan 1, 2002. The arbitrage will be most successful if the asset sales are delayed
until the end of the second year. Any assets held in 2003 will be potentially eligible for
the 18% tax rate if they were acquired after 2000, that is, any assets held for less than 3
years (assuming sale on the last day of 2003). If any of these assets are sold, however,
they will have to restart the 5-year holding period. For that reason, we calculate that all
of the advantages for these assets would be for cases where there was an existing plan to
sell before 5 years. Thus any shifting of taxes would occur in most cases within 5 years:
in less than 4 years for assets already held for a year, within 3 years for assets already held
for 2 years, and within 2 years for assets already held for 3 years. If plans were to hold
the asset for longer than those times, realizing gains now would restart the clock on the
5-year holding period, and require such a longer time to wait to qualify that the deferral
period would offset the advantage of the lower 15% tax bracket.

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It is possible to have longer periods for assets that were acquired before 2000 which
are not eligible for the 20% rate (as was the case for assets in 1986). But these individuals
also did not take advantage of a previous arbitrage opportunity (selling assets at the
beginning of 2001 to take advantage of the 18% rate cut), which makes it less likely that
they would do so in this case.
Effects on the Economy
Permanent Tax Cuts
A fiscal policy can stimulate the economy in the short run only if it increases
aggregate spending. There are reasons to expect that capital gains tax cuts would have the
smallest stimulative effect on the economy of virtually any fiscal stimulus option. While
a fiscal stimulus delivered through direct spending has a relatively straightforward effect,
a fiscal stimulus delivered via a personal tax cut tends to have a more muted effect on the
economy, because only part of it will be spent. The smaller the share spent, the smaller
the stimulus, although for most types of tax cuts, the presumption is that most of the tax
reduction will be spent.
There are two reasons that a capital gains tax cut is less likely to be spent. First,
there are both theoretical reasons and empirical evidence for the view that individuals
with higher wealth would save a larger portion of a tax cut.2 Capital gains taxes are
perhaps the most heavily concentrated among higher income and higher wealth
individuals than virtually any other tax. For 1999, those with earnings over $200,000,
who constitute the top 1.8% of income, account for 78.6% of capital gains taxes.3 While
the average capital gains tax paid for all returns was $476, the average for the highest
income class was $20,536 and the average for all returns in the bottom half was less than
$10. The capital gains tax is 4.5% of total federal income, payroll and excise taxes;
however, it is 14% of total taxes in the highest income bracket, and less than one half of
1% for the bottom 70% of the population. For the income tax alone, capital gains taxes
are 8.1% of total income taxes, but 16.2% of income taxes in the top income class. In the
bottom 70% of the distribution, the capital gains tax is less than 1% of income taxes.
Secondly, a capital gains tax cut may increase savings through incentive effects
(although most empirical evidence does not support a large savings response).
2 While simple life cycle models do not necessarily support the notion that marginal propensities
to spend a permanent tax cut would vary across individuals with different permanent income
levels, realistic modifications of the model do. First, lower income, young individuals may be
liquidity constrained, so that they are prevented from spending as much as they want because
they cannot borrow against future income. A tax cut would be wholly spent in that case. Second,
higher income individuals are more likely to have higher lifetime savings rates (and thus would
save more of any marginal income) because they are more likely to leave significant bequests.
A recent study that finds evidence of higher marginal propensities to save among wealthy
individuals is Jonathan McCarthy, “Imperfect Insurance and Differing Propensities to Consume
Across Individuals,” Journal of Monetary Economics, Vol. 36, No. 2 (November 1995).
3 These data are derived from Joint Committee on Taxation estimates. See CRS Report
RL30317, Capital Gains: Distributional Effects, by Jane G. Gravelle, for further details.

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Both of these effects suggest that a larger fraction of a capital gains tax cut will likely
be saved than would be the case with other types of tax cuts, and thus the capital gains tax
cut is less likely to stimulate the economy.

Note that there has always been a tension between short run and long run fiscal
policy. Measures that increase consumption are expansionary in the short run, but may
detract from growth in the long run because deficit finance causes aggregate savings to
fall (unless the economy is at such a low rate of employment that the stimulus induces
sufficient output to offset the loss in savings). That is, government spending and tax
reductions financed by deficits tend to crowd out investment in the long run. There are
exceptions, however. Government investment spending, such as spending on
infrastructure, may provide a short run stimulus without detracting much from long term
growth (and can even enhance long-term growth if the productivity of the government
investment is greater than the productivity of private investments). However, it is often
difficult to enact such spending in a timely fashion. Subsidies directly to private
investment spending (such as investment credits) may mitigate effects on growth because
they may directly stimulate investment. Unfortunately, the evidence supporting a positive
short-run response of investment to a stimulus is very weak, and such a tax cut may be
largely saved in the short run (by reducing debt) or paid out in dividends. (This effect
may occur because firms are reluctant to add to the capital stock during a period of excess
capacity as is typical in a recession.) Whether a subsidy that directly targets investment
would be more likely to induce short-run spending than a subsidy that is directed at
saving is uncertain, however.

Some macroeconomists have modeled a capital gains tax cut as a direct revenue
stimulus, perhaps because macro-models do not have a direct lever to use to introduce a
capital gains tax cut. This approach does not reflect, however, the appropriate
transmission mechanism of a capital gains tax cut, which must first induce saving, and
only after a lag might induce investment.
Some modelers have also assumed an increase in stock market prices, by capitalizing
the tax into asset values. While one might expect some upward pressure on stock market
prices, its magnitude is uncertain because a capital gains tax cut also induces selling,
which causes downward pressure on prices. Any effect on stock prices is temporary,
however, because economic pressures cause asset prices to adjust back to reflect asset
values, with the period of transition dependent on the cost of adjustment. This analysis
reflects the standard view of investment modeling which focuses on the ratio of market
value of assets to their costs (Tobin’s q).4
Finally, note that many economists doubt the efficacy of any fiscal policy in
countering a recession because it is very difficult to enact such a stimulus in a timely
fashion and fiscal stimulus can be easily dissipated in an open economy with flexible
4 This part of economic analysis is technically complicated and there is a difference between
average q and marginal q. However, a fundamental outcome of this analysis is that a tax rate
change, such as a change in the individual or corporate rate, will not affect the long run valuation
of the stock market. For a technical analysis, see David Romer, Advanced Macroeconomics,
Chapter 9 (New York, McGraw-Hill, 2001).

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exchange rates and international capital flows (through a fall in net exports). Monetary
policy may be more effective in such an environment.
Temporary Tax Cut
A temporary tax cut differs from a permanent one. As noted above, it may raise
revenue initially and then lose a larger amount of revenue in a very short time horizon.
Essentially, it is the equivalent of borrowing from high income individuals at a higher
than market interest rate, and redeeming the bonds relatively quickly.
For these reasons, any explicit tax reduction will be delayed until the future when
assets are sold with a higher basis, so that for those who believe that some portion of any
cash flow derived from a tax cut is spent, this incentive will not occur until 3 to 5 years
in the future (or perhaps more). There will be a present-value tax benefit, but it will be of
negligible size, temporary in nature, and unlikely to have much effect on aggregate
consumption because any income effects should be spread over a long period of time.
Because of the temporary nature of the tax cut, there is no permanent stimulus to
invest in stocks. A person investing immediately and planning to hold an asset for at least
one year (to qualify for the long term rate) but no more than 2 years, would receive some
benefit, but that is likely to be a limited category of investments. Since there will be an
incentive to sell assets, but not an incentive to invest, the more likely short-run effect is
to depress the stock market, although such effects would probably be modest because of
the modest size of the tax revision.
Other Issues
Three other issues not discussed in this report have played a role in the capital gains
tax debate, and they primarily apply to permanent tax cuts. The first is that capital gains
tax cuts may increase economic efficiency by reducing the lock-in effect of the tax, and
also by reducing the tax burden on corporate equity investment. However, capital gains
are favored relative to dividends, because of the lower tax rate on gains, the deferral of the
tax, and the possibility of passing on gains untaxed at death, and magnify that distortion.
Capital gains tax cuts are often criticized by some because they are particularly beneficial
to the wealthy as noted above. Finally, arguments are made that lower capital gains taxes
encourage entrepreneurship, although it is difficult to find empirical evidence to support
this claim and most capital gains tax cuts go to owners of established large corporations
and real estate.5
5 For a further discussion, see CRS Report RL30040, Capital Gains Taxes, Innovation and
Growth, by Jane G. Gravelle.