Capital Gains Taxes and Federal Revenues

Capital gains taxes often garner policy attention that is disproportionate to their importance in generating federal revenues. One reason is that the realization of gains is very sensitive to capital gains tax rates, leading to speculation that changes in rates--and the alleged failure to take into account their effect on taxpayers' willingness to sell assets--explain how revenue forecasters have been surprised by movements in tax receipts. Another reason is that gains are a way in which earnings are paid to investors, prompting the idea that well-designed changes in the gains tax rate can significantly influence economic growth, with potentially large feedback effects on revenues. This revenue and tax policy brief outlines the basics of capital gains taxation in the context of estimating individual income tax receipts.

Characteristics of Gains and Gains Taxes

A capital gain is an increase in the value of an asset; a decrease in an asset's value is a capital loss. The concept applies to all assets, including corporate stock, commercial real estate, collectibles, homes, and nonincorporated businesses. Assets fluctuate in value all the time, and as their prices change, capital gains and losses accumulate. Those accrued losses and gains are not realized, however, until the assets are sold and the former owner captures the gain (or loss).

When a gain accrues, it is a form of income for the holder of the asset. But a gain is not counted as income for income tax purposes until it is realized.⁽¹⁾ At that time, the difference between the sale price and the asset's "basis"--the acquisition price minus depreciation and other adjustments--is includable in the owner's taxable income. Even then, the gain may not be subject to tax. A gain from the sale of an owner-occupied home, for example, typically is not taxed. And when an asset holder dies, the basis of the asset that is passed along to heirs is "stepped-up"--that is, the basis becomes the asset's value at the time of the holder's death, effectively exempting from taxation the gains that had accrued until then.⁽²⁾

The way the tax code treats capital gains income is in certain respects more favorable and in others less favorable than the way it treats income from some other sources. Because of inflation, the difference between the sale price of an asset and its basis overstates the income that the asset holder earns; taxes are thus imposed on phantom income created by inflation, a characteristic that the taxation of gains has in common with the taxation of interest income. At the same time, gains are treated favorably by not being taxed when earned but when realized, which is often many years later. Because money today is worth more than the same amount of money in the future, deferring payment of capital gains taxes is a powerful advantage and can overwhelm the disadvantageous effects of inflation, especially for assets that are held a long time. Finally, realizations of long-term capital gains--defined generally as those on assets held for more than a year--are taxed at rates lower than those imposed on regular income. The result is that even after inflation is taken into account, capital gains are generally taxed at effectively lower rates than are most other forms of income.

Most of the sources of taxable capital gains can be discerned from tax-return data, although some cannot be easily identified since many gains are passed through to taxpayers from other entities, such as partnerships and trusts. Examination of those data show that the composition of taxable gains has varied over time. In 1985, before the stock market began booming and when real estate was faring especially well, gains from directly held stock accounted for only about 40 percent of taxable realizations, with real estate accounting for roughly another 25 percent. The most recent available data indicate that more than half of gross taxable realizations now come from corporate stock and about 10 percent come from real estate (see Figure 1).
 

Figure 1.
Sources of Taxable Capital Gains in 1985 and 1998
Source:	Congressional Budget Office based on Internal Revenue Service, "Sales of Capital Assets Reported on Individual Income Tax Returns," SOI Bulletin (forthcoming).
Note:	Numbers in the figures do not add up to 100 percent because of rounding.

Capital Gains in Revenue Forecasts

Individual income tax receipts from capital gains realizations normally make up about 4 percent to 7 percent of individual income tax revenues (see Table 1); they are usually between 2 percent and 3 percent of total receipts. Yet they receive a great deal of attention in revenue forecasting. First, they figure significantly in why tax receipts do not move proportionately with the economy. Second, they are volatile and therefore contribute more to changes in total receipts than their size would indicate.

In general, federal revenues rise and fall with overall economic activity. The common measure of that activity, gross domestic product (GDP), and its components--such as taxable personal income and corporate profits, which make up much of the tax base for individual and corporate income taxes--do not include capital gains. Gains therefore become part of a wedge between overall income as measured in GDP and taxable income, with the result that growth in GDP or in the tax-base components of GDP does not yield the same growth in income tax receipts. Consequently, when the stock market rises rapidly or the real estate market collapses, for example, or when there are big changes in capital gains tax rates, total receipts may grow faster or more slowly than the overall economy because of what happens to capital gains realizations.

Because the prices of assets in well-developed markets are inherently impossible to predict, gains accruals are almost impossible to project. A further difficulty is the lack of understanding about how investors decide to realize those accrued gains. Even when asset prices are known, it is not clear how realizations will behave; sometimes a market for assets may be falling, and yet investors choose to realize the gains accrued over past years. A great deal of research has been devoted to modeling how gains realizations respond to various factors, but those attempts are all subject to big estimating errors.

Largely because of the stock market boom of the 1990s, gains rose as a percentage of individual income tax receipts from about 7 percent in each year in the first half of the decade to about 12 percent in 2000. The jump in realizations in the late 1990s accounted for about 30 percent of the growth in income tax receipts in excess of GDP growth that occurred from 1994 to 1999.⁽³⁾ No one yet knows for sure, but a fall in capital gains realizations may have played a similarly important role in the drop in receipts in 2002.⁽⁴⁾

The Response to Capital Gains Tax Rates

Because taxes are paid on realized rather than accrued capital gains, taxpayers have a great deal of control over when they pay their capital gains taxes. By choosing to hold on to an asset, a taxpayer defers the tax. The incentive to do that--even when it might otherwise be financially desirable to sell an asset--is known as the lock-in effect. As a consequence of that incentive, the level of the tax rate can substantially influence when asset holders realize their gains, as can be seen particularly clearly when tax rates change (see Figure 2). For instance, the Tax Reform Act of 1986 boosted capital gains tax rates effective at the beginning of 1987. Anticipating that increase, investors realized a huge amount of gains in 1986. Then, in 1987, realizations fell by almost as much, returning to a level comparable to that before the tax increase.
 

Figure 2.
The Ratio of Realized Gains to GDP and the Top Gains Tax Rate, 1952 to 2000
Sources:	Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of the Treasury.

The sensitivity of realizations to gains tax rates raises the possibility that a cut in the rate could so increase realizations that revenue from capital gains taxes might rise as a consequence. Rising gains receipts in response to a rate cut are most likely to occur in the short run. Postponing or advancing realizations by a year is relatively easy compared with doing so over much longer periods. In addition, a stock of accumulated gains may be realized shortly after the rate is cut, but once that accumulation is "unlocked," the stock of accrued gains is smaller and realizations cannot continue at as fast a rate as they did initially. Thus, even though the responsiveness of realizations to a tax cut may not be enough to produce additional receipts over a long period, it may do so over a few years. The potentially large difference between the long- and short-term sensitivity of realizations to tax rates can mislead observers into assuming a greater permanent responsiveness than actually exists.

Because of the other influences on realizations, the relationship between them and tax rates can be hard to detect and easy to confuse with other phenomena. For example, a number of observers have attributed the rapid rise in realizations in the late 1990s to the 1997 cut in capital gains tax rates. But the 45 percent increase in realizations in 1996--before the cut--exceeded the 40 percent and 25 percent increases in 1997 and 1998 that followed it. Careful studies have failed to agree on how responsive gains realizations are to changes in tax rates, with estimates of that responsiveness varying widely.

Nevertheless, the Congressional Budget Office's (CBO's) revenue forecasting takes into account the influence of tax rates on realizations. In projecting capital gains realizations for the current year in order to estimate tax liabilities, CBO includes in its estimating equation both the legislated tax rate for the following year (to model the permanent response) and any difference between that rate and the current rate (to model the transitory response). Measures of output, the current level of the stock market, and other relevant factors are also part of the equation. In projecting realizations beyond the current year, CBO gradually moves them to their historical level relative to output, adjusted for the tax rate on gains. That latter adjustment recognizes that with lower tax rates--even in the long run--realizations should be higher relative to GDP than they would be with higher tax rates.⁽⁵⁾

Estimates of the revenue effects of capital gains tax changes by the Congress's Joint Committee on Taxation (JCT) and the Treasury's Office of Tax Analysis (OTA) also take into account how realizations respond to tax rates.⁽⁶⁾ In 1990, when the Congress considered a 30 percent cut in the rate on gains, OTA estimated that such a cut would increase revenues by $12 billion over five years; the JCT projected a loss of $11 billion. If they had not factored in a realizations response, the two agencies would have estimated revenue costs of $80 billion and $100 billion, respectively--effectively illustrating how large a behavioral response is incorporated in capital gains revenue estimates.

The Effects of Gains Taxes on Growth

The JCT's and OTA's cost estimates include the feedback effects that gains tax rate changes exert on the tax base through the realizations response. But they do not include the revenues that might result from the effects on overall economic activity. That omission has been criticized as a failure to perform "dynamic" scoring.⁽⁷⁾ Critics often claim that the omitted feedback effects on output, and thus revenues, are substantial, and that not taking them into account both biases policy against cuts in capital gains taxes and contributes to large forecasting errors. Yet feedback effects on growth are likely to be small, and their omission from cost estimates has no bearing on the accuracy of CBO's budget projections, which include growth effects.

In general, there is significant consensus that broad-based reductions in taxes on capital have the potential to boost economic growth over the long run. Reductions in capital taxation increase the return on investment and therefore the formation of capital. The resulting increase in the capital stock yields greater output and higher incomes throughout much of the economy.

But the potential for big growth effects from a capital gains tax cut is much smaller than it is for a more general cut in the tax on capital. For example, Congressional researchers estimated that a cut of the magnitude proposed in 1990 or enacted in 1997 (25 percent to 30 percent) would reduce the tax on corporate capital by only 2.7 percent and would decrease the cost of capital by less than 1 percent.⁽⁸⁾ Some additional reduction in the cost of capital might result from the salutary effects of improved liquidity as a consequence of less lock-in. But such an impact would also be small.

One reason for those limited effects is that about half of gains are not taxed anyway because they are associated with assets whose basis is stepped up at death. A second reason is that although a cut in capital gains taxes helps reduce the cost of capital, it only affects the cost of a portion of a firm's financing. It has no effect on the roughly one-third of corporate investment financed through debt. And it does not affect the estimated half of the return on equity-financed capital that comes in the form of dividends, which are subject to regular rather than capital gains tax rates. A third reason is that the tax rate on gains is already low relative to regular rates, so even a large percentage cut in the gains rate would have a relatively small effect on the cost of capital.

Reducing the taxes imposed on the return from capital raises investment demand, but an increase in the capital stock depends as well on how much of its resources an economy makes available for investment--that is, how much it saves and how much capital it attracts from abroad. Analysts disagree about the effect on saving of cutting taxes. And the availability of resources would also depend on how the government financed any loss in revenue resulting from a tax cut. If the loss was offset by reduced spending, the outcome would be increased economic growth. If it was not offset, the cut's overall impact on the economy might be negative: its growth-promoting effects on investment demand could be insufficient to overcome either the decline in investment resources resulting from additional government borrowing or the effects of the government's need to raise taxes later to make up for the lost revenue.

The Effects of Gains Taxes on the Allocation of Capital

Capital gains taxes may influence the level of output not only through their effects on the accumulation of capital but also through the way that capital is allocated among various uses. By shifting capital from lower-value to higher-value activities, a change in capital gains taxes may increase the overall efficiency of the economy by increasing the return from capital that is placed in service. In particular, treating capital gains favorably can reduce the inefficiency caused by the double taxation (under both the corporate income tax and the individual income tax) of corporate profits. And innovation and entrepreneurship may also respond positively to lower capital gains tax rates.

Eliminating the lock-in effect on the allocation of capital is often cited as a potential economic benefit from reducing capital gains rates. However, that effect is not about actual capital being locked in to particular uses but about asset holders being locked in to their ownership of existing capital. Moreover, the lock-in effect is unlikely to influence relative returns on different investments or to impede the movement of capital to new or promising growth firms because a large portion of capital gains--such as those earned by pension funds--are tax-exempt. Consequently, while lock-in makes it both more difficult and costly for individual asset holders to diversify their portfolios, its effect on the allocation of capital is likely to be minimal.

The favorable efficiency effects derived from lowering capital gains tax rates may be offset by the inefficiency generated by increasing the wedge between the tax treatment of capital gains and other income from capital. The differential between those tax rates can channel economic activity into endeavors that lend themselves to accruing gains: they distort a firm's choice, for instance, between reinvesting earnings internally (to provide capital gains) and paying dividends that stockholders might reinvest more productively elsewhere. Indeed, the favorable treatment of capital gains plays a role in many tax shelters that misallocate investment. It is difficult to determine the net impact on the allocation of existing capital that might be produced by these second-order efficiency effects from changing the treatment of gains.

Conclusion

Revenue estimators are often faulted for the way they project tax receipts and prepare legislative cost estimates related to capital gains taxes. But the relationship of realizations and receipts to gains tax rates is neither predictable nor obvious. And while reductions in the overall taxation of capital income can measurably increase economic growth, a cut in capital gains taxes alone is likely to produce much smaller macroeconomic effects. Inaccuracies in projecting revenue and disagreements about the effects of tax changes stem not from a failure to incorporate the behavioral responses of asset holders but from the complexities inherent in the nature of gains and gains realizations.