Do We Really Need a Gains Tax Cut? In the Long Term, Yes

From the breathless manner with which proponents of a capital gains tax cut have pleaded for it in the 1990s, you would think the U.S. stock market has merely been limping along, barely able to attract investment because of Uncle Sam’s grabbing hand.

Instead, as most investors well know, in this decade we have enjoyed the longest sustained bull market in U.S. history. The fact that the government takes as much as 28 cents of every $1 in long-term capital gains obviously hasn’t been enough to discourage investors from throwing hundreds of billions at stocks.

As the debate in Washington over how to implement the landmark balanced-budget accord begins to ramp up, the capital gains tax cut that is part of that accord--although undetailed either by President Clinton or Republican leaders--is sure to come under attack by key Democrats in Congress. And one argument certain to be used is that the stock market doesn’t need a lower gains tax to keep doing what it has been doing.

Indeed, the torrent of money pouring into stock mutual funds isn’t likely to stop soon just because the government fails to cut the gains tax. Many people are simply chasing performance: Because the stock market has been so hot for so long, the assumption is that it will continue to be hot--and so for now, stocks are seen as the place to be, taxes or no.

Moreover, the only important tax issue for many baby-boomer investors is the tax-shelter issue: If they’re investing through tax-deferred retirement plans, such as a 401(k), the capital gains tax rate is virtually irrelevant.

Ditto for the mutual fund managers who are getting those baby-boomer dollars. Taxes aren’t

even an afterthought for most of them. Same with pension funds, which are tax-exempt by law.

Who, then, believes that a drop in the top capital gains tax rate from the current 28% to about 20%--back to what it was for most of the Reagan Era--is so critical?

For zealots like Bill Archer, the Texas Republican who heads the tax-writing committee of the House of Representatives, a key issue is the long-term cost of capital for American businesses.

The greater the tax burden imposed on capital formation, the higher the cost of raising equity capital for businesses.

The basic idea here is that if investors know they will sacrifice to the government some significant portion of the capital they risk, they will consciously or subconsciously “raise the bar” and demand that businesses pay more to attract that capital.

That, in turn, may cause businesses to decide that many projects or ideas aren’t worth funding. In the aggregate, a decline in investment by American businesses ultimately may mean a far less robust economy.

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It’s not a specious argument in the long run. But in the 1990s, business capital spending has been quite strong, especially on computers and related equipment. U.S. companies have been world leaders in raising productivity through investment in new technology.

More important, there has hardly been a shortage of smaller American companies going public in the 1990s, as individual investors have flung record sums at stock mutual funds, and fund managers have in turn been eager financiers of new businesses.

Now, contrast our healthy economy and capital markets with those of Europe. Germany, for example, has no long-term capital gains tax, period. Great for individual investors.

Yet Germany is no hotbed of entrepreneurial spirit. And its key stock market index, the DAX, is up 99% since year-end 1989, while the Dow Jones industrial average has rocketed 160%. (Of course, some would argue that our market should have a higher rate of return, precisely because a capital gains tax is imposed.)

Beyond the economic implications, the question of “fairness” also has become an inescapable aspect of the debate over the capital gains tax in America.

How much is too much for the government to charge for this tax? And who benefits most if the tax is cut--the mass of society, or just the “wealthy”?

Investing icon Warren Buffett didn’t help the Republican cause last week. At the annual meeting of his holding company, Berkshire Hathaway, Buffett told shareholders that the 28% maximum capital gains tax rate is “just about right,” adding that “I just don’t think it’s inappropriate in a country like this to have me taxed at 28% if I sell my Berkshire shares.”

In terms of the tax’s importance to the federal budget, in recent years it has supplied in the neighborhood of $30 billion annually to Uncle Sam’s coffers, or about 3% of total federal revenue. Democrats will argue that that’s a small price to pay, given the size of our capital markets. Republicans will argue that precisely because the tax is so small, in relative terms, it’s not asking much of the government to pare it back for the sake of long-term economic growth.

Yet within the context of the $135-billion total in tax cuts that Clinton and Republican leaders allowed for over the next five years, a gains tax cut is in competition with numerous other tax breaks favored by Democrats and Republicans alike. By late last week, Archer was warning that there may be no way to accommodate all of the cuts on the two parties’ wish lists.

Which may make the gains tax cut idea even more of a target than usual for the most damning criticism usually leveled at it: that it is a welfare for the upper class--a “Head Start” program for the rich.

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Many reports have been done over the years trying to answer the question of who gets the most benefit from a capital gains tax cut. Conservative think tanks like the Tax Foundation have argued that the middle class benefits far more than Democrats allow.

A Tax Foundation study found that 38% of all taxable capital gains reported from 1942 to 1992 were earned by taxpayers with under $100,000 in annual income, measured in constant dollars.

But that still means that 62% of the gains went to the minority who are well off, by any measure.

That shouldn’t be a surprise, or an issue. Of course the rich will benefit more from a capital gains tax cut--they have more capital, and they always will. But as millions of average Americans also have become investors in the 1990s, there is no denying that a gains tax cut now would benefit a much larger cross section of the population than 10 or 20 years ago.

Perhaps the best argument in favor of a gains tax cut is the simplest: America still has a savings problem. We don’t save enough, and we all know it. Anything that might get us to save more, therefore, should be encouraged.

A lower capital gains tax certainly wouldn’t hurt savings; it could only help it--especially when the day arrives that stock market returns regress back to historical means, and investors begin to look much more closely at the risk-to-reward ratio in putting capital to work.