A Capital Idea

If America is serious about competing in the world economy, it must cut its high capital cost. The cost of capital in the United States is now about three times that of Japan and almost double that of West Germany.

One way to reduce the cost of capital is to reduce the capital gains tax. This was proposed as a campaign issue last year by George Bush, and the idea has picked up the support of some Democratic members of Congress. But the House Democratic leadership has decided to play politics with the issue, deriding Bush's proposal as a tax cut for the rich.

In July, House Ways and Means Committee Chairman Dan Rostenkowski said he opposed the cut for one reason: "I'm a Democrat." Majority Leader Richard Gephardt and House Speaker Tom Foley were less cryptic. They argued that a capital gains tax cut would be unfair because it would make the rich richer. "This is an issue that describes a vast difference between the two parties at a time when the gap is widening between the rich and the poor," said Gephardt.

Despite the populist, class-warfare rhetoric of Rostenkowski, Foley, and Gephardt, the capital gains tax cut is not a rich-versus-poor issue. The middle class also suffers when the gains tax is too high. A cut will relieve the burden on the middle class, as well as on the wealthy. And the resulting economic expansion will benefit everyone.

For decades, economists have studied the effects of capital gains taxation. Although there is some disagreement on particulars, there is a general consensus that a low gains tax encourages greater savings and investment by increasing the return on investment. Increased investment stimulates business formation, job growth, and economic activity. Significantly, those countries that are considered models of economic growth—Japan, Hong Kong, Taiwan, and South Korea—do not tax capital gains at all.

At home, experience confirms the benefits of a low tax. In 1968, Congress increased the gains tax. The result was a capital drought and a drop in the formation of new companies. In 1978, the rate was cut. The result was an explosion of new companies.

Still, the Democratic leadership ignores an opportunity to enlarge the economic pie, preferring instead to divide what is already there. They seem to fancy themselves modern-day Robin Hoods, taking from the rich to give to the poor. But Gephardt, Foley, and Rostenkowski have a strange definition of rich.

Every time someone sells a farm or a business or stock in a company, she has to pay tax on the capital gain. Tax data show that about 21 percent of all gains are realized by taxpayers with less than $10,000 in wages and ordinary income—mostly retirees cashing in their lifetime savings. An additional 24 percent of all gains are realized by persons with incomes between $10,000 and $50,000.

These are hardly wealthy people. The dishonest claim that the wealthy are the prime beneficiaries of capital gains is based on a definition of rich that includes the capital gain. In other words, if a farmer sells his farm, the capital gain might swell his income to $100,000 or more that year; Foley and Gephardt want to call him rich, even though the farmer's yearly income before and after the sale would make him middle class.

While their leaders railed against the rich, some rank-and-file Democratic members of Congress took the unusual step of actually talking to voters. They found that middle-income taxpayers are being hit hard by the tax.

"Of course there are wealthy people who are going to benefit. But the people I hear from are the people who have a gain from the sale of a farm or small business. They now pay 33 percent in capital gains to the federal government, and then about 15 percent to the state," said Rep. Ed Jenkins (D–Ga.). Jenkins and five other Democratic members of the Ways and Means Committee joined the committee's 13 Republicans in support of a bill to cut the top rate on capital gains from 33 percent to 19.6 percent and to index gains for inflation.

At first, Rostenkowski and Foley berated Jenkins and the others for un-Democratic behavior. But Rostenkowski saw that he might not have the votes to defeat a tax cut and offered a compromise. This plan would index capital gains, exempting from taxation any rise in value due to inflation.

To encourage long-term investment, the plan would also let anyone who held an asset for five years choose to pay tax on only 75 percent of the sale price, as an alternative to indexing. For assets held 10 years or more, the investor could pay tax on only 50 percent of the price.

Rostenkowski's plan would apply only to investments made after it becomes law, thereby favoring new investment. Gains on assets purchased earlier would not be indexed. Critics note that spurring new investment is only one goal of a tax cut. Easing the burden on taxpayers is also important.

Still, the fact that Rostenkowski is willing to compromise gives hope that both sides can hammer out an agreement that will at least index gains and reduce the tax rate for long-term investment. And that will be good for taxpayers and the economy.