BPC's Tax Reform and the Capital Gains Exclusion

In early November, the super committee held a hearing on prior deficit reduction plans. All of the witnesses, including former Senator Pete Domenici (R-NM) and Dr. Alice Rivlin (co-chairs of the Bipartisan Policy Center’s (BPC) Debt Reduction Task Force, with the agreement of all of the members of the Task Force) and former Senator Alan Simpson (R-WY) and Erskine Bowles (co-chairs of the Fiscal Commission), concluded that both increased revenues and outlay cuts will be necessary to contain the nation’s rising public debt.

Because of this fact, BPC has invested considerable time and effort in developing a fundamental tax reform package, which the Task Force believes would meet three essential criteria: increase revenue, stimulate economic growth, and distribute the additional burden progressively. To achieve all three goals, we determined that it is essential to eliminate the current preferential tax treatment of capital gains and tax them as ordinary income.

This recommendation, however, has precedent under the Reagan Administration. The Tax Reform Act of 1986, passed by a Republican Senate and a Democratic House and signed by President Reagan, eliminated the tax preference for capital gains and reduced the top-bracket individual income tax rate to 28 percent. The Task Force proposal is quite similar.

Increasing Revenue

The evidence shows that the elimination of the capital gains exclusion in the 1986 Act increased tax revenue, as expected, and did not significantly reduce sales of assets. In fact, tax revenues on capital gains reached their highest level ever (setting aside the transition year of 1986) as a percentage of the economy in 1987, and then surpassed that level in 1988. Capital gains tax revenue exceeded that record level in 1996, the final year in which the tax treatment of capital gains remained virtually unchanged from the 1986 law. Currently, the reward for legal manipulation that re-characterizes ordinary income as capital gain, or capital loss as ordinary loss, loses the federal government significant revenue. Ending that manipulation will allow the government to tax ordinary income at a lower rate, thereby increasing the incentive to work by bringing down marginal tax rates for all working Americans.

Increasing Economic Growth

Capital gains tax preferences are much more a bonus for the already-wealthy portfolio investor than an incentive for the budding entrepreneur. The preference is irrelevant for the many entrepreneurs who hope to build and run successful businesses and earn salaries from them. Even for such entrepreneurs who look forward eventually to selling their businesses upon retirement, the tax on any resulting capital gains is years away, and its impact on their ultimate outcomes will be overwhelmed by the degree of their success in running their businesses. Even with the higher capital gains tax rates under the 1986 Act, the economy in 1996 had recovered from the 1990-1991 recession, economic growth was robust, and a full-fledged investment boom was underway. In sum, we believe that the Task Force tax proposal would on net be more conducive to economic growth than the current system – by substantially reducing rates on individual and corporate income to 28 percent – while also reducing the deficit directly.

Establishing Fairness

The capital gains preference is a key reason why many people of extraordinary wealth can pay lower tax rates on their income than people of far more modest means who simply work for a living. For the wealthy who make over $1 million annually, capital gains make up 39 percent of their income. In stark contrast, only 5.2 percent of people in the median income group ($30,000 to $40,000) have any tax-preferred capital gains, and those constitute only 0.9 percent of their total income. These statistics demonstrate that the special treatment of capital gains overwhelmingly benefits the wealthiest taxpayers. Any capital gains preference implicitly forces higher tax rates on ordinary income, thereby transferring income from people who work – including many job-creating entrepreneurs – to people who already have accumulated wealth.

Conclusion

In an uncertain world with complex issues at play, the tax reform proposal of BPC’s Debt Reduction Task Force provides the best balance that we have found among the nation’s revenue needs, the imperative of economic growth, and society’s need for a foundation of fairness of contribution according to ability to pay.

Related Posts

• Tax Reform and the Twenty-Eight Percent, November 18, 2011
• The Case for Eliminating the Preferential Treatment of Capital Gains, November 16, 2011
• Supercommittee has the way, needs the will, POLITICO, November 8, 2011
• Entitlement and Tax Reform: The Two Must-Haves, November 7, 2011
• BPC’s Recommendations to the Super Committee