Taxing capital gains at 27%, per new bill, would be a blunder
PRESSURES are building to restore the deduction on individual retirement accounts in the Senate's tax-reform plan. That's all very well. But the IRA change, on second thought, doesn't seem to be the one that should be questioned the most.
The most radical thing the Senate has done is take away the distinction between ordinary income and capital gains. By doing this, the top rate on long-term capital gains goes from 20 percent to a rate on almost all capital gains of 27 percent. Since most people with gains of any size would be above the 15 percent bracket, these gains would be taxed at 27 percent.
Since the early 1920s, the federal tax code has recognized that gains in the value of capital assets are different in nature from earned income.
Money put aside for investment is money that could have been spent on current consumption. When it is invested, the owner of the capital is deferring spending that money and instead adding it to the stream of savings and investment that makes any economy grow.
When an investment is made in an asset that can grow in value -- either in shares of a company or directly in real estate -- the owner also takes a certain risk. Unlike a bank account, the investment may actually decline in value. For such risk-taking, any gain has long been thought worthy of special treatment.
Just how special it is has been a subject for much argument, of course. For the good senators who worked hard to produce some kind of acceptable compromise on the tax reform bill, one must assume that capital gains don't rank very high, or that in their midnight rush to produce a bill they either forgot or threw out the economic theory about the nature of capital and risk-taking.
There are certainly groups that will fight to restore preferential capital gains treatment. But the investment bankers do not seem overly worried, probably in part because by removing capital gains from special treatment the Senate has also de facto eliminated any kind of holding period. That's more incentive for trading stocks.
Simplifying taxes may sound like fairness to most people. But this kind of simplification is dangerous. Certain kinds of capital investment are certainly full of risk, and the return should be treated differently. If anything, the tax code on this probably should be made more complicated instead of simplified.
For instance, the holding period could be lengthened from the current six months. A venture-capital investment, which is highly risky, usually takes several years to bring to fruition. Perhaps the code could be changed so the tax rate decreases depending on the number of years it takes to realize a gain.
One risk in treating capital gains the same as income is that Congress has yet to deal with the budget deficit in a realistic way. Sooner or later taxes are going to have to be raised. Then the tax on capital gains may be not just 27 percent, but 30 percent or higher. One can imagine some tax preferences (such as the IRA) being restored as this bill moves through conference. The quid pro quo for these changes might be the addition of a third, higher tax bracket.
President Reagan is understandably eager to have a major piece of legislation pass during his second term. Yet he was arguing earlier for a lower rate -- 17.5 percent -- on capital gains. It would be unfortunate if the White House, in its eagerness to get a bill passed, cooperated in a blunder with long-term, anti-growth results.