The Capital-Gains Quandary

Obama is wrong on capital-gains taxation. So are Gingrich and Romney. An overhaul is in order.

If there is one issue that seems to stymie the political class these days, it’s capital-gains taxation. Nobody seems to understand the rudiments of the economic conundrum posed by this issue. So herewith a review of where various politicians stand on the issue and a modest description of where they should stand.

Take, first, President Obama, who wants to raise the top capital-gains tax rate to 20 percent from the current 15 percent. This would not be smart, for reasons to be explored below.

Former House speaker Newt Gingrich, meanwhile, wants to eliminate capital-gains taxation altogether. This isn’t much better, for different reasons also to be explored below. Former Massachusetts governor Mitt Romney would eliminate such taxes also—but only for those making less than $200,000 a year; for those above that threshold, the rate would be 15 percent. Again, it’s difficult to see the logic in this. Former Pennsylvania senator Rick Santorum would reduce the rate to 12 percent from the current 15 percent.

The tax on capital gains—or the financial gain from investments in such things as real estate, stocks or commodities—has a history that is quite instructive on what kind of policy might be best. If the tax is too high, it stifles capital formation, retards entrepreneurialism and holds back the economy. But if it is significantly below personal income-tax rates, it can distort economic decision making, with attendant deleterious effects on the economy as well.

Take Richard Nixon’s tax-reform legislation of 1969, which increased the top capital-gains rate to 32 percent, effective in 1970. Initial public-stock offerings declined that year to 358 from 780 the year before. By 1974, when the top tax hit 45 percent, IPOs numbered only nine. Commitments to venture capitalists, in dollars, declined to $272 million in 1970 from $506 million the previous year. By 1975, that number had plummeted to just $20 million.

Now, consider the stock market during this time. At the end of 1969, when the new tax was enacted, the Dow Jones Industrial Average was at $948. By December 1982, it was at $1,046. During those twelve years, the high was $1,031, and the low was $805—in other words, no real gain through a dozen years. There can be no doubt that high capital-gains taxes contributed to that stock-market stagnation.

In the meantime, a dramatic series of events unfolded in Congress in 1978 when a Republican congressman named William Steiger brought forth an amendment to drop the top capital-gains tax rate to 28 percent from the prevailing 49 percent at that time. Steiger, from Wisconsin, had been shocked when one California entrepreneur, testifying before the Ways and Means Committee, said he could find venture capital only in Japan. Steiger was convinced a big reduction in capital-gains rates would stir serious business investment in America, but many Democrats recoiled at this presumed giveaway to the rich.

Democratic House speaker Thomas P. "Tip" O’Neill railed against it, and President Jimmy Carter argued in a press conference that the tax benefit would go to wealthy Americans to the tune of billions of dollars while ordinary Americans would get only "two bits" out of the legislation. But the country was tired of economic stagnation (mixed with high inflation), and the result was that a number of House Democrats bucked their party and voted with Steiger. It passed.

This represented a significant development in tax-policy discourse in Congress. Wall Street Journal editor Robert Bartley said "a decade of envy came to its close, and the search for a growth formula started in earnest." Certainly the following years, with Ronald Reagan in the White House, were marked by strong growth arguments that largely carried the day in Congress and blunted the kind of "class-warfare" politics that characterizes the Washington debate from time to time (including now).

In the early Reagan years, capital-gains taxation came down to 20 percent for a number of years. Then, with Reagan’s big tax-overhaul legislation in 1986, a novel argument carried the day. That legislation was designed to reduce personal income-tax rates dramatically while eliminating a host of tax preferences—thus expanding the tax base to make up for the reduced rates. One big philosophical argument for closing those so-called loopholes was that they distorted economic activity as businessmen and investors moved capital based on favorable tax treatment and not on more sound long-term financial considerations.

And the disparity between capital-gains taxation and personal income-tax rates was considered to be one of those distortion-inducing disparities. Hence, the top capital-gains rate was raised to 28 percent as the top rate on individual income was dropped to 28 percent.

Bingo. Here was a policy to match a very sound philosophy: low personal income-tax rates, with a capital-gains rate to match.

It didn’t last, alas. First, the top income-tax rate was increased to 35 percent, so the disparity was restored (the capital-gains rate actually hit 33 percent in 1988 and 1989). Then, President Bill Clinton dropped it to 20 percent in 1997. Then it came down further to 15 percent in 2003 at the behest of George W. Bush.

So now we have a system in which personal income-tax rates are too high, while capital-gains rates are too low—and the disparity introduces distortive economic incentives that aren’t good for the country.