Bear Left!

Capital Games
Tim Francis-Wright

(Part 1 of our series Cracking the Internal Revenue Code: How the tax system rewards the rich.)

The perennial refrain from most Republicans and some Democrats in Washington is the call for a capital gains tax cut. Both the federal government and most states tax income from capital gains more lightly than they do income from interest, dividends, or wages. Government does have a real need to keep tax policy from quashing entrepreneurial ventures. But most capital gains have nothing to do with entrepreneurship or venture capital. The real reason for the preferential treatment has more to do with the beneficiaries of capital gains than with the assets themselves.

Much about the tax treatment of capital gains is perverse. If a taxpayer sells an asset up to one year after the original purchase, then the tax on any income is at the taxpayer's normal rates. But after a magical one year and one day, the maximum tax rate on any gain drops to 20 percent. For taxpayers in the 15 percent tax bracket, the rate on these "long-term" gains is 10 percent. (Until 1997, the maximum rate on capital gains was 28 percent, so only the most affluent taxpayers got any benefit.)

A superficially attractive notion is to index capital gains for the effects of inflation. For example, if I bought stock five years ago for $1,000 and sold it today for $1,200, I would have a gain of $200, even though the $1,200 that I have after the sale is not worth much more than my $1,000 used to be worth. But consider an alternative investment. Let's call this exotic investment a savings account. If I deposit $1,000 into this account and earn $40 in interest per year for five years, then I have to pay taxes each year on the $40 of interest. My stock investment already had an advantage over the savings account because I did not have to pay any capital gains taxes until the sale. It does not need the bonus of a lower tax rate on the gain. Ironically, despite its less favorable tax treatment, the alternative savings account is potentially more important to the health of the economy: my investment allows my bank to lend money to businesses and individuals who need it.

Real estate provides two other wrinkles on the perversity of capital gains taxes. First, a taxpayer who sells her home at a profit pays the normal capital gains taxes, unless she owned the home for at least two years. In that case, any gain, up to $250,000, is free of any federal income taxes. For a married couple, the exclusion can be $500,000. Taxpayers can take advantage of these exclusions any number of times. And this is just one of many tax subsidies for affluent homeowners. Second, individuals who own rental and other commercial property have a special tax break. They can deduct the depreciation of their properties against the associated net income, so the tax rate of the depreciation losses is equal to their marginal tax rate. On sale, however, any gains attributable to recapture of that depreciation is taxed at no more than 25 percent. The real estate industry, of course, believes that what is unfair about this situation is that the 25 percent cap is too high, not that owners of real estate get an extra reward.

Finally, favorable capital gains treatment applies not only to entrepreneurs or to the venture capitalists who help get companies off the ground, but to any investor. Almost every stock market investment does not contribute capital to the coffers of a corporation, but instead goes to the wallet of another investor and to the income statement of a brokerage house.

Each year, the IRS compiles heaps of information about individual tax returns in Publication 1304. The latest version has information from a large sample of 1999 tax returns. The statistics tell an intriguing tale of just who benefits from capital gains. The IRS estimates that it received 127,075,145 individual income tax returns for 1999. Of these, 553,380 (0.44%) were for taxpayers with over $500,000 of adjusted gross income. These richest Americans reported fully 15.18% of the adjusted gross income on these returns. That figure reflects a staggering imbalance of income among the rich and poor in America.

Where that income came from is even more illuminating. The richest Americans reported only 7.72% of the salaries and wages among those tax returns, but they reported 20.62% of the taxable interest, 26.49% of the dividends, and a whopping 59.09% of the capital gains. Just over half of all capital gain income was received by the 205,124 taxpayers with adjusted gross income over $1,000,000. The 7.5% of taxpayers with adjusted gross income over $100,000 recognized 84.9% of the capital gains. These numbers spell out the sheer audacity of continued calls for capital gains cuts. The major beneficiaries will be the richest Americans. Fully half of the benefits would go not just to millioaires, but to those Americans who make over one million dollars per year.

The booming stock markets of the 1990s generated capital gains that brought in oodles of cash for the federal government. The unexpected government surpluses at the end of the Clinton administration depended on the unexpected levels of capital gains income from the exercise of stock options and from the sales of stock of investors. Many states became accustomed to the revenue from their capital gains taxes, and squandered their share of the windfall. Capital gains taxes provide a bizarre counterpoint to traditional Keynesianism. It is hard for government spending to act as regulator for the economy if the stock market is a key driver of government revenues. In 1999, capital gains accounted for almost 10 percent of federal adjusted gross income.

The Federal and many state governments have often sought to spur on stock markets by lowering capital gains rates. The federal government lowered its maximum capital gains rate to 28 percent in 1987 and to 20 percent in 1997. But the stock markets have risen since 1987 and since 1997 not just because of the lowered capital gains tax rates. The stock markets grew because of a host of factors. Corporate profits rose, making stock more valuable. When interest rates fell, stocks became more viable when compared with bonds. Finally, the popularity of 401(k) and other pension plans increased the amount of money in the stock market: demand for stocks increased as more and more Americans bought stocks through mutual funds in their retirement plans. But capital gains policy is instrumental in the continued propping up of the stock and real estate markets. The key consideration is not that the capital gains rate is a certain number, but that it is significantly below the maximum ordinary income rate. It rewards the rich for playing the market.

A capital gains cut can only benefit those who pay taxes on capital gains. The majority of the capital gains themselves are enjoyed by the rich and very rich. This has two important reasons. First, most of the capital gains that the working and middle class might enjoy is hidden in whatever retirement funds they own. Most money retirement funds—whether in IRAs, 401(k)s, 403(b)s, or 457s—is not taxed until it is withdrawn, and it is ordinary income then. Second, those who have the money to invest in the stock market are precisely those with the most money.

Republicans like to talk about how the majority of Americans now own stock. They do not like to talk about how much of that stock the rich own. The truth of the matter is that the rich stand to claim the vast majority of the benefit from any cut in capital gains taxes. The rich are vital to the political health and power of conservatives in Washington. And that is why conservatives, the unabashed apologists for the rich, have tried, are trying, and will continue to try to cut capital gains taxes.