Effects Of Lower Capital Gains Taxes On Economic Growth
CBOPAPERSEFFECTS OF LOWERCAPITAL GAINS TAXESON ECONOMIC GROWTHAugust 1990CONGRESSIONAL BUDGET OFFICESECOND AND D STREETS, S.W.WASHINGTON, D.C. 20515
PREFACEThis paper responds to separate requests from the Committee on Ways and Means,the Senate Committee on the Budget, and the House Committee on the Budget.It examines the effects of cutting capital gains taxes on saving, investment, andeconomic growth. The study was prepared under the direction of RosemaryMarcuss and Frederick Ribe by Joseph Cordes, Leonard Burman, and Larry Ozanneof CBO's Tax Analysis Division and Kim Kowalewski of CBO's Fiscal AnalysisDivision. Other individuals inside CBO who made valuable comments includeRobert Dennis, Maureen Griffin, Jon Hakken, Robert Hartman, Richard Kasten,and Joyce Manchester.Francis Pierce and Sherry Snyder edited the manuscript, and Denise Thomas typedthe drafts.Robert D. ReischauerDirectorAugust 1990
CONTENTSIINTRODUCTION AND SUMMARY1Effects of Cutting Capital GainsTaxes on the Level of Saving,Investment, and GNP 1Effects of Cutting Capital GainsTaxes on the Composition ofSaving and Investment 2nEFFECTS ON SAVING, INVESTMENT,AND GNP4The Common Framework 4Studies of the Effects of CuttingCapital Gains Taxes 12Summary 26IIICAPITAL GAINS TAXES ANDTHE EFFICIENCYOF INVESTMENT27Capital Gains Taxes and Risk Taking 27Capital Gains and New Ventures 29Capital Gains and the DoubleTaxation of Corporate Equity 30Capital Gains and Tax Shelters 31APPENDIXESABCRevenue Effects of the Proposed30 Percent Capital Gains Exclusion34Impact of a 30 Percent Exclusionon Saving38Simulation of a 30 Percent CapitalGains Exclusion in WUMM48
TABLES1.B-l.B-2.Estimated Economic Impact of the30 Percent Capital Gains Tax Exclusion22Percentage Increase in Rate of Returnfrom 30 Percent Capital Gains Exclusion40Distribution of Assets Held by Households43FIGURES1.Determinants of Investment and Saving2.Effect of Deficit-Financed Capital GainsExclusion on Investment and Saving3.Effect of Capital Gains Exclusion WhenSaving Is Infinitely Responsive4.Effect of Capital Gains Exclusion WhenInvestment Is Infinitely Responsive5.Effect of Capital Gains Exclusion WhenSaving Is Totally Unresponsive
SECTION IINTRODUCTION AND SUMMARYA number of proposals have recently been made to cut taxes on capital gains.The proposals were intended, in part, to spur economic growth by fosteringsaving, investment, entrepreneurial activity and risk-taking. For example, inhis 1991 budget, President Bush proposed to exclude a portion of realizedcapital gains from taxation. The exclusion would vary with how long an assetwas held: 10 percent for assets held between one and two years, 20 percentfor assets held between two and three years, and 30 percent for assets held forthree or more years. The exclusion would not apply to capital gains earnedby corporations or to works of art and other collectibles held by individuals.Reducing the taxation of capital gains could affect growth in severalways. Lower taxes on capital gains raise the real after-tax rate of return tosavers, which may lower the cost of capital to businesses. Various quantitativemodels can be used to show how changing the rate of return and the cost ofcapital affects the level of saving, investment, and gross national product(GNP). These models, however, do not take account of the fact that cuttingtaxes on capital gains could change the mix as well as the amount ofinvestment and saving-for example by reducing the double taxation ofcorporate equity, and improving incentives for entrepreneurship and risktaking. Though these latter effects are difficult to quantify, they also influenceeconomic growth and should be considered in assessing the effects ofproposals to lower taxes on capital gains.EFFECTS OF CUTTING CAPITAL GAINS TAXES ON THE LEVEL OFSAVING, INVESTMENT, AND GNPThis paper discusses several quantitative analyses of whether lower taxes oncapital gains are likely to raise GNP by increasing the total amount of savingand investment in the economy. Most of the studies, including two by theCongressional Budget Office (CBO), consider the effects of a 30 percentcapital gains exclusion. Of the eight studies reviewed, five, including the twoCBO studies, found that cutting taxes on capital gains is not likely to increasesaving, investment, and GNP much if at all. Three studies found that cuttingcapital gains taxes increases GNP by enough so that the addional tax revenuecollected on the higher level of income offsets the initial losses in tax revenuethat the Joint Committee on Taxation and the Congressional Budget Officehave estimated would result from such tax cuts.
The findings vary for several reasons. The studies make differentassumptions about how saving responds to changes in the return to saving andhow investment responds to changes in the cost of capital. Studies that haveestimated the effects of a 30 percent exclusion also use different estimates ofthe degree to which an exclusion of this size would raise the return to saversand lower the cost of capital to businesses.The more that a capital gains tax cut raises the return to savers andlowers the cost of capital to businesses, and the more that saving andinvestment respond to such changes, the more likely it is that such a tax cutwill spur saving and investment and raise GNP. Studies that found thatcutting capital gains taxes has large positive effects on GNP made optimisticassumptions about how much cutting capital gains taxes would raise the realafter-tax return received by savers and reduce the cost of capital faced bybusinesses. These studies also made optimistic assumptions about theresponsiveness of saving and investment to changes in the rate of return andthe cost of capital. These assumptions-especially that private saving is quiteresponsive to changes in the real after-tax rate of return-are at the high endor outside of the range of most empirical evidence, and are thus likely tooverstate the positive effects of cutting capital gains taxes. If theseassumptions do not hold, cutting capital gains taxes has little or no positiveeffect. Under plausible assumptions, cutting taxes on capital gains could evenslow capital formation and slow growth if the deficit was increased by morethan the increase in private savings. Taken together, the studies thus raisedoubt about whether cutting taxes on capital gains can be counted on to raisesaving and investment enough to significantly increase GNP.EFFECTS OF CUTTING CAPITAL GAINS TAXESCOMPOSITION OF SAVING AND INVESTMENTONTHELower capital gains taxes would favor assets that pay off in the form of capitalgains. This would have both good and bad effects on the mix of investment.A lower capital gains tax would reduce the double taxation of corporateequity and might encourage risk-taking and investment in new, innovativeventures. But lower capital gains taxes would also create a tax incentive forcorporations to retain earnings rather than pay dividends and would providean impetus to tax shelters that does not exist under current law. Thus, it isuncertain whether cutting capital gains taxes would cause capital to beallocated more efficiently.For these reasons, cutting taxes on capital gains could not be countedon to significantly boost output and increase economic growth. Moreover,even if cutting capital gains raised GNP somewhat, it is unlikely that the
increase in income would generate enough additional tax revenue to pay forthe revenue losses estimated by the Joint Committee on Taxation.
SECTION IIEFFECTS ON SAVING, INVESTMENT, AND GNPSeveral studies have estimated the effect of a 30 percent capital gainsexclusion on growth in GNP. These studies first calculate how much theexclusion would raise the after-tax return to saving, or reduce the cost ofcapital to businesses, and then incorporate these changes in models ofeconomic growth to determine the resulting effects on saving, investment, andoutput.THE COMMON FRAMEWORKAll of the studies discussed in this paper start from the same generalframework, which provides a guide for reviewing and comparing their findings.Saving, investment and rates of return are assumed to be determined in themarketplace by the interplay of the supply of savings by individuals and thedemand for savings by businesses.Individuals save, and their savings finance business investment. The rateof return that businesses must pay individuals for use of their savings is thatwhich will equalize the demand for savings with the supply. Taxes on incomefrom capital, which include capital gains taxes, drive a wedge between thereturn on business investment and the amount received by individuals. Byreducing this wedge, a cut in taxes on capital gains can increase the incentiveto save and invest. At the same time, cutting taxes on capital gains is alsolikely to reduce federal revenues and lead to increased government borrowing.A higher federal deficit lowers public saving, which reduces the amount ofsaving available to finance private investment. If the total increase in privateand public saving is large enough, the economy can reach a permanentlyhigher level of GNP. Otherwise GNP will be less than it would have beenunder existing tax law.The Suoolv and Demand AnalysisIn this framework, individuals supply savings by reducing current consumption.Individuals may save by directly investing in their own businesses or bychanneling their savings into stocks and bonds, bank deposits, pension funds,and the like. When a corporation reinvests its profits, it is saving on behalf
of its stockholders. Individuals have an incentive to save more when the rateof return rises.1On the other side of the market, businesses demand saving to financeinvestments. Businesses face a range of investment projects paying differentrates of return. The lower the rate of return that businesses must payindividuals for their saving, the more of these projects that can be profitablyundertaken. Thus the amount of saving demanded-that is, investment-increases as the return that businesses must pay falls.Taxes drive a wedge between the amount a business earns on a newinvestment and the amount an individual gets to keep. Higher taxes on bothbusinesses and individuals add to the size of this wedge. Businesses will notundertake new investments unless they earn a high enough rate of returnbefore tax to cover both the taxes on the income earned by such investmentsand the after-tax rate of return required by individuals. The before-tax rateof return businesses must earn on new investments is often referred to as thecost of capital.2Figure 1 illustrates the way in which individuals and businesses interactto determine saving and investment. The horizontal axis is the annual rate ofsaving and investing relative to the size of the economy, and the vertical axisis the inflation-adjusted, or real, rate of return. The upward-sloping line fromleft to right, S0So, gives the amount of saving individuals will supply at eachreal after-tax rate of return. The line includes public saving or dissaving(deficits), assumed initially to be zero. The steepness of the line indicateshow responsive individual saving is to changes in the real after-tax return.The flatter the line the more saving responds to either increases or decreasesin the rate of return. The downward-sloping line, II, shows that higher levelsof investment will be undertaken if the rate of return declines. The lineslopes downward because more investment becomes profitable as the requiredreturn on investment declines. The steepness of this line indicates howresponsive business investment is to changes in the before-tax rate of return.The flatter the line, the more business investment responds to such changes.When income from capital is not taxed, the equilibrium rate of savingand investment would tend toward X, where business investment pays a return1. A higher return also decreases the amount of saving needed to reach any specific future level ofconsumption. This raises the individual's lifetime real income, which can reduce the amount of savingsupplied. This possibility is considered in a subsequent section.2. The terms "required before-tax rate of return" and "cost of capital" are used interchangeably in thefollowing discussion.
Figure 1. Determinants of Investment and SavingRate of ReturnInvestment, Saving
of R just equal to the return savers must receive to supply enough saving tofinance this level of investment. When capital income is taxed, however, thereal after-tax rate of return that can be paid at any given level of investmentis reduced. The reduction is shown in Figure 1 by I which is the real aftertax return received by savers. The amount of saving individuals supply andthe amount of investment businesses undertake is the amount at which thereal before-tax return earned by businesses on an additional dollar investedjust equals the taxes owed on the income from the investment plus the aftertax return individuals must be paid. This is shown in Figure 1 at a level ofsaving and investment of XQ. At this amount the before-tax rate of returnearned on an additional dollar of investment, RQ, equals corporate andindividual taxes-the 'Tax Wedge" in Figure l plus the real after-tax return,TO-Effects of a Capital Gains ExclusionExcluding part of capital gains from taxation affects the level of saving andinvestment in two ways. It reduces the gap between the return businessesearn on investments and the return individuals receive. It is also likely toaffect federal revenues and therefore the deficit. The Treasury Departmenthas estimated that the President's proposal to exclude up to 30 percent ofcapital gains from taxation would raise revenues and reduce the deficit by 12.5 billion between 1990 and 1995. The Congress's Joint Committee onTaxation has estimated that the President's proposal would lose revenue andadd to the deficit by 11.4 billion over the same period. Revenue estimatessuch as these assume that GNP is constant They provide a measure of thedirect impact of capital gains tax cuts excluding feedback effects.CBO judges that the direct impact of the exclusion would be to reducerevenues for reasons explained in Appendix A. In the following analysis, theexclusion is thus shown as increasing the deficit and the amount ofgovernment borrowing.An exclusion lowers the effective tax rate on capital gains, which reducesthe gap between before- and after-tax returns. This raises the real after-taxreturn received by savers. If savers respond to the higher after-tax return bysaving more, saving and investment will increase. If an exclusion increases thedeficit, however, public saving falls, which offsets the increase in privatesaving. The overall effect of cutting taxes on capital gains depends onwhether the increase in private saving is greater or less than the increase inthe deficit.
Figure 2. Effect of Deficit-FinancedCapital Gains Exclusion on Investment and SavingRate of ReturnFigure 3. Effect of Capital Gains ExclusionWhen Saving Is Infinitely ResponsiveRate of ReturnInvestment, SavingFigure 4. Effect of Capital Gains ExclusionWhan Investment to Infinitely ResponsiveRate of ReturnInvestment, SavingFigure 5. Effect of Capital Gains ExclusionWhen Saving to Totally UnresponsiveRate of Returns.Investment, SavingX,X,Investment, Saving
The effects of cutting capital gains taxes are shown in Figure 2.Lowering the tax rate on capital gains raises the real after-tax return receivedby savers by the amount of the tax reduction from I to IJj. If there wereno other effects of the tax cut, the rise in the real after-tax return would causeprivate saving and investment to rise to X'. If the tax cut increases the deficit,however, the amount of total saving available to finance private investmentwill be less than that shown along S0S0. National saving-private plus publicsaving-will be less at any interest rate than private saving so that the savingline shifts to the left by the amount of the revenue loss to S . This effectof cutting taxes tends to raise the cost of capital to business. The net effectof cutting taxes on capital gains on the level of investment is thusindeterminate. Investment could rise, to a level such as XJf which is less thanX\ not change at all, or decline belowAny increase in saving and investment will be larger, for a given deficit,the larger the reduction in the tax wedge (as shown by the upward shift in IJjin Figure 2). The increase in saving and investment will be larger the morethat saving responds to changes in the rate of return and the more thatbusiness investment responds to changes in the cost of capital-that is, theflatter are the lines S0S0 and I0Io in Figure 2. Total saving will increase morefor a given change in private saving the smaller is the initial revenue loss fromcutting taxes-thai is the less SjSj shifts to the left in Figure 2.The analysis can be simplified if certain extreme assumptions are madeabout either supply or demand. One is that the supply of savings is infinitelyresponsive in the sense that savers are willing to accommodate any increaseddemand without an increase in the rate of return. The other is that businessdemand for investment is infinitely responsive in the sense that businesses arewilling to accommodate any shift in total saving without a change in thebefore-tax rate of return.When the supply of savings is infinitely responsive, the effect of anexclusion depends only on how much the tax wedge is reduced and on howmuch investment increases in response to the drop in the cost of capital.Figure 3 shows that when the supply of saving, SoSo, is infinitely responsive,the upward shift in the demand for saving caused by the tax reduction doesnot change the real after-tax return. Because the after-tax return remainsunchanged, the full tax rate reduction shows up as a lower before-tax rate ofreturn that businesses must pay on new investment As a result, the increasein the rate of saving and investment depends only on the responsiveness ofbusiness demand, as shown by the slope of line I . Additional borrowing bythe government to finance a higher deficit does not crowd out any businessinvestment because savers are willing to lend the government all it needs atthe same after-tax return.
When private investment is infinitely responsive, the exclusion can eitherincrease or decrease the rates of saving and investing, depending on the sizeof the revenue loss relative to the tax rate reduction and the responsivenessof saving. Figure 4 shows that when business investment demand is infinitelyresponsive, the upward shift in the demand for saving ends up entirely as anincrease in the after-tax return to saving. Private saving rises by an amountthat depends only on how responsive individuals are to the increased return.Greater private saving, however, would be offset by greater public dissavingthrough the deficit, reducing total saving to SjSj. If the exclusion increasesthe deficit-thai is, decreases public saving-by less than it increases privatesaving, total saving will increase, leading to greater investment. If theexclusion increases the deficit by more than it increases private saving, totalsaving and business investment will fall.The extreme assumptions that the supply of saving is infinitelyresponsive or that the demand for savings is infinitely responsive place upperbounds on the increase in saving and investing that can be expected fromcutting taxes on capital gains. As discussed below, there is considerableempirical evidence that neither saving nor business investment is highlyresponsive. As a result, the actual increases in saving and investment will beless than those indicated by using models that make either of these extremeassumptions. The net effects will depend on the specific magnitudes of all thefactors discussed above and illustrated in Figure 2: the reduction in the taxgap, the increase in the deficit, and the res
of CBO's Tax Analysis Division and Kim Kowalewski of CBO's Fiscal Analysis Division. Other individuals inside CBO who made valuable comments include Robert Dennis, Maureen Griffin, Jon Hakken, Robert Hartman, Richard Kasten, and Joyce Manchester. Francis Pierce and Sherry Snyder edited the manuscript, and Denise Thomas typed the drafts.
2. Realized Net Long-Term Gains and Corporate Equity of Households, 1954-1985 28 3. Ratio of Realized Long-Term Gains to Gross National Product, by Income Group, 1954-1985 30 4. Average Marginal Tax Rates on Long-Term Gains for Selected AGI Groups 39 5. Marginal Tax Rates on Long-Term Gains and the Ratio of Long-Term Gains to Gross National .
the elasticities is small: We estimate a short -term gains elasticity of -0.52 and a long -term gains elasticity of 1.0. We find that high income taxpayers are more respon sive with elasticities of -0.75 for short term gains and 1.5 for long term gains. We also find evidence that taxpayers minimize their tax liability by timing their gains and
Since 1979, tax rates on long-term capital gains have risen and fallen while the overall tax rate structure has simplified. Before the Tax Reform Act of 1986, taxpayers were allowed a 60 percent deduction of any net capital gain. As a result, the maximum tax rate on capital gains was 20 percent (0.4 x 50 percent, the maximum ordinary rate).
(e.g., by allocating capital gains to trust accounting income in the trust document), it might also be possible to distribute the trust’s capital gains to the beneficiaries, in order to avoid the higher capital gains rates typically applicable to trusts, as well as the 3.8% net investment income tax.
2019 Ordinary Income Tax Brackets1 Long-Term Capital Gains Tax Rates2 10%, 12% 0% 22%, 24%, 32%, 35% 15% 37% 20% Notes: 1. Typically a taxpayer's short-term rate will equal the ordinary income rate. 2. Some taxpayers may be required to pay an additional 3.8% net investment income tax in addition to the applicable long-term capital gains tax rate.
to multiple other taxes, including the net investment tax and state capital gains taxes. Senators Sanders and Warren are proposing tax increases which would impact capital gains rates as well. Table 1 lists the numerous taxes that founders would pay upon sale of their ownership interests. Table 1. Capital Gains Tax Rates, Current Law and Proposed
in short-term capital gains tax rates. Even when other capital gains tax rates (e.g., long-term tax rates) are also increased, lower-income investors may still become better off because marginal utility of wealth is higher when there is a capital loss, and thus the tax rebate effect of a higher short-term rate can
Tax legislation in 1997 reduced capital gains taxes on several types of assets, imposing a 20% maximum tax rate on long-term gains, a rate temporarily reduced to 15% for 2003-2008, which was extended for two additional years in 2006. Legislation enacted in December 2010 extended the lower rates for an additional two years, thorough 2010.
