Spreading the Wealth

By Donald J. Devine and David A. Keene

January 23, 2001

Can Bush stimulate the economy by minimizing the capital gains tax?

Summary

With the Dow Jones down 6.2 percent, the Standard & Poor's off 10.1 percent and the Nasdaq plunging an incredible 39.3 percent for the year 2000, and considering other more recent sagging indicators, it is time to start thinking about how to prevent an economic slowdown from turning into a full-scale recession. A reduction in the capital gains tax rate is one obvious way to stimulate investment and revive a faltering economy. This is even more practical today than previously, for Americans have become capitalists. They are stockholders who help finance wealth accumulation, capital formation and the creation of new jobs. They make returns on their investments and that means they will eventually have to pay capital gains taxes. No longer is capital gains taxation of interest only to the rich.

A participant at a private campaign meeting reported that George W. Bush was reluctant to consider capital gains reductions because he saw personally how successful former Democratic Senate Leader George Mitchell was in demagogueing the issue to the detriment of his father. Yet, not only is the capital now sorely needed to produce the jobs upon which all Americans depend but, today, many more families own securities. Once capital ownership becomes a mass phenomenon, it is no longer good politics to play class warfare with the issue. Especially as economic conditions worsen, the majority wants jobs and greater income. Suggestions are made here to not only spur prosperity--especially by indexing capital gains--but also to spread the wealth further, especially through the small businesses that produce most of the innovation in the marketplace and virtually all of the net new jobs.

Spreading the Wealth

The old world of class warfare is as extinct as the dodo. It is hard now to tell who are the capitalists. Today, almost half of Americans own stock or mutual funds. Seventy-six million Americans representing 43 percent of households own stocks or stock funds. This represents a 126 percent increase in 15 years. As shown in Table 1, stock ownership was basically flat between 1935 during the Depression (if one believes the polling data) and 1983. Then, something remarkable happened. In 1989, stock ownership really began to take off, today representing four in ten citizens.

Table 1: Stock Ownership As a Percent of Population in the United States, 1935-1995

Year	Percentage
1935	21
1938	22
1962	18
1983	19
1989	32
1992	37
1995	40

Sources: Mildred Strunk and Hadley Cantrill, eds., Public Opinion, 1935-1946, (Princeton: Princeton University Press, 1951), p. 337; "Survey of Financial Characteristics of Consumers," Federal Reserve Bulletin, March 1964; "Survey of Consumer Finances, 1983," Federal Reserve Bulletin, September 1984; Statistical Abstract of the United States (Washington, D.C.: Bureau of the Census, 1999), No. 846.

According to the Federal Reserve, two factors account for the increased ownership of stock. The variety of mutual funds available for average families expanded and employers increasingly offered tax-deferred savings plans for retirement. More variety meant more appeal to more people. The defined contribution retirement plan was especially important. Replacing the old fixed result defined benefit plan, the defined contribution type gave the advantage of early or immediate ownership of retirement assets for the individual rather than the "boss," and the pleasure of seeing one's assets grow. Now investments were owned by the individual rather than the employer. This was something very new and different, and people noticed.

The Employee Benefit Research Institute found that defined contribution retirement plans produced a return of 6.8 percent verses 6.0 for defined benefit plans. Importantly, the employee could keep all of the invested return. By 1998, defined contribution plans rocketed to $2.2 trillion in assets. The 401(k) type of defined contribution plan represented 68 percent of the total with a total value of $1.5 trillion. Shareholder accounts in mutual funds grew from 12 million in 1980 to 171 million in 1997 and their value increased from $135 billion to $4.5 trillion. While the more wealthy obviously owned more stock, ownership spread to those further down the income ladder. While 81 percent of individuals earning over $100,000 hold stock, and 67 percent of those earning between $50,000 and $100,000, 47 percent earning between $25,000 and $50,000 also do. The later category has increased by 46 percent since 1989. Ownership by non-whites in defined contribution accounts increased by 35 percent over this period.

Most importantly, this change in ownership appears to result in changes in views about work and government. Not surprisingly, views on capital gains tax-cuts change dramatically. Whereas, only 46 percent of individuals without significant investments sampled in a survey conducted by Rasmussen Research supported a capital gains tax cut, 66 percent of those with a portfolio did. But ownership has a broader impact. In one study, 68 percent of those interviewed said that participation in an employee plan improved their attitude toward work. Several other studies found similar findings. Moreover, those with investments are much more suspicious of relying upon Social Security as their primary source of retirement funds. This attitude change, in turn, inspired the proposals, such as that made by Republican candidates Steve Forbes and George Bush, to have part of the government's Social Security retirement system consist of private investment accounts similar to 401(k)s.

How to Create More Wealth: Capital Gains Tax Reduction

The secret for a secure retirement and a prosperous working life is to grow the economy to produce more wealth and jobs for everyone. And the secret to growth is capital formation. Capital is more than money, it is plants, buildings, tools, machines, computers and even intangibles such as ideas like computer software. A fellow named Bill Gates used the latter to build Microsoft and to employ 15,000 workers. A $20,000 investment in that firm in 1986 would be worth nearly $1 million today. It is capital that allows the American worker of today to earn as much in ten minutes (adjusted for inflation) as a worker in 1900 earned in an hour. That is why the United States has been so much of a success and why so much of the world is in poverty. Even Europe and Japan have been stagnant in recent years. The difference over time has been a strong capital market, a sound monetary system, reasonable taxes and a more free regulatory marketplace.

But the American miracle is slowing down. From 1776 until 1996, Gross Domestic Product per capita in the U.S. had grown an incredible 458 percent. It had doubled every 40 years or so. Yet, since 1978, the economy has still been growing but at the slowest rate "ever before in U.S. history." The cause is not hard to find. Federal taxes consumed 20.5 percent of the economy's output in 1998, the highest peacetime level the U.S. ever experienced--exceeded only in 1944, during World War II. This represented $13,000 from every worker in the nation, or 50 percent higher than as recently as 1993. And everyone knows that high taxes reduce growth. In a statistical test of the various means likely to spur the economy, it was found that the effects of the other remedies disappear without a cut in capital gains tax rates.

Government regulation and high levels of spending have had their effect too. Yet, not only have tax rates been high in recent years, but taxes in 1995 on capital directly were higher than at any time in history, at 28 percent, other than during the slow growth period of 1970 to 1981. The corporate gain rate of 35 percent was the highest ever. As shown in Table 2, most countries had lower effective capital gains than the U.S. in 1995. Even countries with higher nominal rates such as Australia and the United Kingdom, with rates of 48 and 40 percent respectively, hindered growth less because they allow indexing for inflation, which lowers the effective rate below that of the U.S. In effect, the U.S. had the highest capital gains rate in the world. At a minimum, these laws penalized thrift and investment, lowered capital formation, decreased wealth and reduced the potential for new jobs, even if they were offset by investments from poorer economies overseas.

Changes in the U.S. rate can have dramatic effect. A DRI/McGraw Hill estimate found that about 25 percent of the growth in the value of the stock market in 1997-8 was due to the lowering of the capital gains tax in 1997 to 20 percent. The problem with high taxes, especially on capital, is that owners of capital will charge a higher rate for the use of capital when taxes make them pay more for it. Along with keeping government small, opening the economy to trade and investment, respecting property and the rule of law, low levels of regulation and investment in human capital, the evidence is clear that low taxes--especially on capital--are the recipe for prosperity.

Table 2: Capital Gains Tax Rates around the World, 1995

Country	Percentage
United States	28
Italy	25
Canada	23.8
Japan	20
France	18
Sweden	16.8
Belgium	0
Hong Kong	0
Netherlands	0
Singapore	0
South Korea	0
Taiwan	0

Source: American Council for Capital Formation, 1995. (Australia has a rate of 48.3 percent and the United Kingdom has 40 percent, but allowed indexing, which reduced the nominal rate dramatically.)

Higher capitol gains tax rates do not even necessarily result in higher tax revenue for the government. Indeed, the history has been that higher rates result in lower collections. The reason is the so-called lock-in effect. Even critics in the Congressional Budget Office could not ignore its influence. Since the tax is paid only when the asset is sold, payment can be avoided by holding on to the investment. When rates are high, people hold on to their stocks. It is estimated that $7.5 trillion exists in unrealized capital gains that could be unlocked by lower or zero rates. Imagine what that could do for economic expansion and new jobs.

Not Just the Rich

President Bill Clinton said he opposed capital gains tax cuts because they "give a tax break to the rich." Like much else in his repertoire, the conclusion depends upon the meaning of a word, in this case, "rich." If an uncle sells a business or a retired grandmother sells long-held stocks for retirement, the slick count the funds received from the sale as "income." So your poor grandmother is counted in the government statistics that year as earning the results of the whole sale of an asset she may have accumulated for years and might spend over many more years. But, according to Mr. Clinton and his allies in the class warfare school, she is "rich" for that year at least. If income is defined as income without investments--as it should--more than 50 percent of capital gains go to lower and middle income individuals.

The typical household declaring a capital gain had an income from other sources of $58,729 per year, not what most would call rich. Another 27 percent were elderly or blind--with incomes of $43,637. Moreover, in the Calvin Coolidge tax cuts of the 1920s, the John Kennedy tax cuts of the 60's and the Ronald Reagan reductions of the eighties, the "rich" paid more money from capital gains with lower rates. But the biggest effect of a capital gains cut is on the average worker, even the poor, since the freed-up capital produces more jobs for them. As economics consultant Jude Wanniski testified to the Senate Finance Committee, "the poorest, youngest, those at the beginning of their careers, those who are the furthest from the sources of capital" are the ones who need the capital that creates jobs the most because they are most in need. Capital gains cuts help those working as well. As Nobel laureate and Kennedy economic advisor Paul Samuelson and William D. Nordhaus put it: "Because each worker has more capital to work with, his or her marginal product rises. Therefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rate."

Small Business Is the Major Source of New Wealth

While capital accumulation is critical for all businesses, it is an especial challenge to small business. One of the major reasons for large size is to consolidate capital. Naturally, small and individual proprietors do not have this advantage. Yet, small businesses produce the majority of new jobs and spur the whole economy's growth. Firms of under 500 employees account for almost half of all business receipts. Indeed, businesses with more than 500 employees suffered a net loss in jobs of 645,000 between 1992 and 1996. Firms of under 500 employees created all of the net new jobs in the U.S. during those years, 11.8 million total.

Most high-risk, small business start-ups get their funds from friends, family and other informal investors . Capital gains taxes greatly affect their ability to lend the funds. For small public offering companies, venture capital is also highly influenced by capital gains rates. A detailed study by Merrill Lynch created an index of performance for small-capitalization stocks relative to large ones and then related that to the capital gains rate. While the stock prices of all size firms are sensitive to capital gains rates, small firms are especially sensitive. Their regression estimate is that every cut of five percentage points in the capital gains rate translates into approximately 12.5 percentage points of additional return for smaller stocks above the return for other stocks.

The recognition that small firms have unique capital needs resulted in legislation to lower the capital gains rate for small businesses under sections 1045 and 1202 of the tax code. These provisions lowered the present capital gains rate of 20 percent to 14 percent for certain small firms. On its face, it appears attractive. The six point reduction applies to the life of the investment so it adds less to the annualized after-tax rate than it appears, but the effective rate can still be substantially lower. Yet, it can be higher too. Even where there is no gain, this is more than offset by a second provision that allows the investor to roll over the investment to another qualified small business every six months (for a maximum of five years) without realized tax liability. Since the gain is taxed only when finally cashed out, the power of compounding allows the original investment and the after tax profit to grow far larger. So, it is a good deal.

The problem is that few individuals or businesses qualify. That, indeed, may have been Congress' intention to keep presumed tax "losses" low—even though history shows that total taxes do not decrease when capital rates are reduced. First, the firm must have less than $50 million in assets. But that makes sense if small companies are the target. Second, the business must be a producer of goods rather than services. Third, the company specifically may not be in any of the following businesses: professional services (doctors, lawyers, engineers, etc,), financial services, farming, extraction or hospitality. Fourth, the stock must be purchased at issue rather than through the larger secondary market. Fifth, the investment must be held five years, although this is mitigated by the rollover provision. Sixth, the company cannot be an intermediary for a non-qualified small business. Obviously, these provisions exclude most businesses in the U.S. No wonder Larry Fisher of the New York Times calls it the Small Business Tax Break Nobody Understands. It is the break for which no one qualifies.

How to Spread the Wealth and Spur the Economy: Proposals for Reform

1) Index the Capital Gains Rate for Inflation. Countries with very high capital gains tax rates such as Australia and the United Kingdom allow indexing of capital gains to mitigate their high rates. If an asset increases solely because the monetary unit has inflated, there has been no real gain. Former Federal Reserve Board governor, Wayne Angell calls this the "most damaging tax on capital--the tax on phantom gains" and found that the real capital gains tax rate on NASDAQ stocks from 1972 to 1992 was an incredible 68 percent. A Congressional Budget Office study found that excluding inflation, there would have been no capital gains at all in 1981 for those with adjusted gross income below $100,000 per year rather than the paper gains but the real taxes they paid. A law indexing the purchase price for capital to inflation would limit the tax to a tax on real gains only and just constitute basic fairness. This sense of equity makes this proposal the most saleable politically in the United States at this point in time. It should be on the top of any national agenda for reform.

2) Repeal the Capital Gains Tax. Since any capital gains tax lowers investment, which lowers wealth creation and which, in turn, reduces the number of new jobs, the best economic solution--if not the most political--is to completely eliminate it. Many of the major nations of the world, including growth-leaders Hong Kong, Singapore, South Korea, and Taiwan, as well as dynamic Western economies such as Belgium and the Netherlands, have no capital gains tax at all. Former Treasury officials, Gary and Aldona Robbins estimate that elimination of the capital gains tax in the United States would, after five years, lead to a $300 billion increase in national output, 877,000 new jobs and $2.5 trillion of additional capital. There is no economic reason to give up this potential gain in wealth and new jobs. The poorest suffer most from this loss. The only reason not to eliminate it is political. Must the United States be at such a comparative disadvantage indefinitely and deny the poor of the nation access to so many new jobs or might it be possible to convince a majority of the need? Only inspired leadership would ever be able to answer that question.

3) Cut the Capital Gains Rate. Most other nations have a lower capital gains rate than the United States. At the very least, the rate should be substantially reduced to recover some of the lost output and new jobs. It is likely this would not even lead to a loss in government revenue. As Moore and Silvia note, over the past 30 years, "every time the capital; gains tax has been cut, capital gains tax revenues have increased." Obviously, the lower the rate, the more jobs would be created and the greater the wealth. Even a very modest Heritage Foundation proposal for a 50 percent exclusion of individual capital gains declarations and a 20 percent reduction in the tax rate for corporate gains would free-up trillions in assets currently locked from investment because of high rates. The increase in numbers of jobs from this would be incalculable.

4) Expand the Small Business Lower Gains Rate. If a reduction in capital gains rates from 28 to 20 percent can produce such great increases in jobs and wealth, a further reduction to 14 percent would create that many more, even if it applied only to small business. The latter produce most of the jobs, anyway. To make the law effective, however, the restrictions should be modified. At a minimum, sections 1045 and 1202 must be amended to allow all small business to qualify on asset grounds alone and for the calculation to be made annually and without the rollover. In particular, the capital gains tax reduction should be extended to service industries--the major part of the economy today. And there is little reason to restrict purchases in secondary markets from the lower rate either. H.R. 5455 introduced in the House by Representative Jim Greenwood would achieve much of this goal.

5) Stockholder Notification and Lowering the Stock Holding Period. Unnecessary regulation is the bane of productivity but it, nonetheless, is difficult to eliminate once imposed by government regulation. There is little evidence of fraud from so-called insider trading and what there is can be effectively eliminated by requiring stockholder notification and approval for major business decisions. Securities and Exchange Commission rules 144 and 145 require that stock issued to "insiders" be held for one year and for directors for two years. Reducing holding period for firm "insiders" from one year to three months, as proposed by Sen. Phil Gramm, and cutting holding periods for directors to one year, is a prudent step in the right direction This one little change would free trillions of dollars for new business investment and keep prosperity going.

Conclusion

With the most closely divided Congress in many years, President Bush is wise to consider the political aspects of any proposals. Clearly, many Democrats will oppose his policies merely because he proposes them and this will especially be the case for something they can attack as "favoring the rich." Yet, reducing capital gains is such an obvious solution to a slowing economy that he should at least consider the proposals offered here. As noted above, capital gains tax reductions are the essential part of any plan to spur economic activity. The president should especially consider indexing capital gains, in the name of simple fairness, as a politically feasible solution for the year 2001. If the economy turns as far South as now appears possible, he just might get more support for capital gains reduction than conventional wisdom might suggest

Donald Devine is a vice chairman and David Keene is the chairman of the American Conservative Union.