Capital Gains: Here's One The Democrats Can Win

It will take a lot to rescue Bill Clinton and the Democrats. But the Republicans could do just that by going to the barricades for a capital-gains tax cut.

We have been here before. During the first supply-side era, lower taxes on capital gains were supposed to pay for themselves--in two ways. First, a lower capital-gains tax would unlock long-held investments by encouraging investors to cash them in. Investors would then pay taxes at a lower rate, but the increase in taxable transactions would bring in more revenue. Second, the greater amount of capital freed to seek its most efficient use would yield more growth, more investment, and more revenue.

Alas, the experiment of the 1980s was inconclusive at best. Taxpayers did cash in more capital gains. However, most studies find that taking stock profits fluctuates with stock prices, not with changes in tax laws. The stock market boomed during the mid-1980s mainly because of steady disinflation and the decline in interest rates. Low inflation and low interest rates are usually good for stock prices--but that has far more to do with what the Federal Reserve does than with the tax code. The even stronger bull markets of the late 1980s and early 1990s occurred after the Tax Reform Act of 1986 raised the top capital-gains rate from 20% back to 28%.

The current Republican proposal would give a 50% tax exclusion on capital gains and also index gains for inflation. This would produce an average effective tax rate on capital gains of barely 10%. With such a generous tax cut, no conceivable increase in stock sales would make up the revenue loss. The Congressional Joint Tax Committee, which assumes that there would be significant stock sales in response to the lower rate, still projects an accelerating revenue loss to the Treasury that would reach $22 billion a year by 1999 and $40 billion a year by 2004.

OVER A BARREL. The promise of capital mobility enhancing economic efficiency is also dubious. Any increased efficiency effect will likely be offset by inefficient investment decisions motivated by tax avoidance. The 1981 tax act, which created a preference for capital gains, lit a boom in tax shelters. The 1986 Tax Reform Act eliminated the extreme gimmicks. But a new 50% exclusion on capital gains will reopen the game of converting ordinary income to capital gains purely to duck taxes--hardly an efficient use of scarce capital.

It is also paradoxical that enthusiasts of a capital-gains tax cut hymn the virtues of increased portfolio churning just when many students of the U.S. economy think investors are too quick to sell stocks rather than hold for the long term. If a capital-gains preference is to be considered at all, it should be limited to long-term holdings and new stock issues. But the GOP plan doesn't differentiate between long- and short-term holdings, nor between productive assets and investments in Impressionist paintings, rare books, pre-Columbian art, and other investments that do nothing for productivity.

SILVER SPOONFUL. So the proposal for a capital-gains tax cut is unconvincing on its own terms. And because about 50% of the value of stocks and 60% of bonds are held by the richest 1% of the population, the cut would bestow tax relief on the wealthiest Americans at a time when the bottom 80% of the population, which would get 5% of the tax relief, has seen real incomes fall.

Therein lies the political vulnerability of the proposed tax cut. Much of the GOP's Contract With America makes political sense. Voters are feeling tough on crime, illegal immigration, and welfare. But just when hapless Democrats are looking in vain for populist themes to offer angry middle-class voters, here come the Republicans with a tax cut for the rich.

The GOP contract offers a $500-per-child tax credit, too. But here is the rare "bidding war" on tax cuts that Democrats can actually win--simply by insisting that every nickel of any tax relief go to the stressed middle class.

Of course, it's not yet clear that Democrats will rise to the challenge. When Senate Majority Leader Bob Dole (R-Kan.) briefly threatened to hold the General Agreement on Tariffs & Trade hostage for the capital-gains tax cut, I was waiting for President Clinton to reply: "Go ahead, make my day." Instead, Clinton cut a deal with Dole. Democrats could also blunder politically by trying to be the more fiscally responsible party and resisting any tax relief. It would be shrewder politics to fight over who gets the relief.

The GOP has the upper hand on social issues, but Republicans shouldn't get cocky. Ordinary voters revert to supporting Democrats based on pocketbook issues whenever the GOP starts behaving like the country-club party.

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