A Capital Gains Primer
October 15, 2007; Page A22

'The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital . . . the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy."

John F. Kennedy, 1963

When it comes to taxes, Barack Obama is no Jack Kennedy. The Illinois Senator recently announced that he wants to raise the capital gains tax to restore "fairness" to the tax code.

That makes it a three-peat: All of the leading Democratic contenders for President have endorsed higher taxes on stock ownership. Hillary Clinton is the "moderate" in that so far she'd merely raise the tax to 20% from the current 15% -- a 33% increase. John Edwards and Mr. Obama want to nearly double it, to 28%.
[Gainful Economy]

This would repeal not only the Bush capital gains tax cut of 2003 but also the 1997 bipartisan tax cut signed by Bill Clinton, which cut the rate to 20% from 28%. In explaining his proposal, Mr. Obama ignores JFK's arguments about economic growth and instead plays the envy card: "For decades, we've seen successful strategies to ride antitax sentiment in this country toward tax cuts that favor wealth, not work."

But it's not only the wealthy who will take a hit from higher capital gains taxes. Recent surveys indicate that roughly 52% of American adults own stock in some form, and last year 8.5 million of these investors paid a capital gains tax. The value of those assets will decline if capital gains taxes go up because financial markets instantly capitalize higher taxes on stock profits into lower stock prices.

We saw this effect in May of 2003 after the passage of President Bush's investment tax cuts. An analysis by the investment advisory firm Strategas shows that stock values rose by 10.3% in the following weeks, and over the last four years the net worth of Americans's stock holdings has increased by some $6.2 trillion. Economic growth was the largest driver of stock prices, to be sure, but a higher after-tax return on capital also played a role.

Taxing capital gains at a lower rate than ordinary income is a long-established policy to encourage risk taking and investment. Since we already tax corporate earnings at 35% through the corporate income tax, taxing those profits again when the stock is sold imposes a double tax on risk capital. That's why 12 industrialized nations, including Hong Kong and Korea, impose a zero capital gains rate.

The differential rate also compensates for the fact that the tax applies to the value of inflated capital gains, rather than the real gains. Former Federal Reserve Board member Wayne Angell discovered that between 1973-1993 the majority of gains from stock sales were a result of "phantom gains due to inflation." The tax code also taxes people fully on their gains, but only allows a $3,000 deduction each year on losses. The lower capital gains rate makes up in part for that failure to deduct losses from risk-taking investments.

Mr. Obama is wrong when he assumes that the returns to capital accrue exclusively to rich investors. A study by former Treasury Department economist Gary Robbins has found that from 1946-1998, about 90% of the returns to capital investment accrued to workers in the form of higher wages, because when workers have more tools like computers, forklifts and robotic equipment, they produce more.

Ah, but won't the Treasury benefit from a revenue windfall? Almost certainly not. For the past 40 years, capital gains tax increases have been associated with a decline in tax revenues. Rate cuts have generated more tax collections. One reason is that higher rates give investors an incentive to hold their assets to avoid paying the tax. The capital gains rate was last raised in 1986. Revenues from the tax tripled in the year before the increase, as investors cashed out of assets before the window of the lower tax rate slammed shut. But in each of the five years after the rate jumped to 28% from 20%, capital gains revenues remained below the pre-1986 level, according to a study by the National Chamber of Commerce Foundation.

Conversely, the 1997 capital gains tax cut had a stock market unlocking effect. Congress's consistently mistaken Joint Committee on Taxation predicted that the government would collect $195 billion from 1997 to 1999 from capital gains payments. The actual amount was $279 billion. In other words, the lower tax rate raised $84 billion more than expected -- which is one reason the late 1990s produced budget surpluses. Most recently, as the nearby chart shows, the 2003 tax cut produced a doubling of tax receipts to $97 billion in 2005 from $47 billion in 2002. That's twice what Congress predicted.