Republicans and Tax Realities

Why the GOP was wrong to cut the capital gains tax

In the 1980s, a Republican House member, fed up with bipartisan efforts to reduce the budget deficit, denounced Republican Sen. Bob Dole as the "tax collector for the welfare state." Newt Gingrich, who later became Speaker, had captured something essential about the party's mood. It was not against the welfare state. It was just against paying for it.

That remains the case today, as John McCain and his supporters make clear. He rules out tax increases to cut the deficit, while vowing to get tough on spending. But the Committee for a Responsible Federal Budget says that while his proposals would slow the growth of spending, total outlays would still rise faster than inflation. Result: a larger deficit.

Republicans used to argue that keeping taxes down was the only way to restrain spending. But as taxes have been cut under President Bush, spending has soared by 29 percent (after adjustment for inflation). Meanwhile, a $236 billion budget surplus has morphed into a deficit of more than $400 billion.

If we want to cut federal spending, apparently we have to do it directly. And if we don't want to cut spending, the least we can do is pay for it ourselves instead of running up debts for our children to pay.

But Republicans object to raising taxes in general, and one in particular: the tax on capital gains. Obama's plan to increase the rate applied to the sale of assets has provoked howls of outrage on the right.

McCain said it proves Obama "doesn't understand the economy." An editorial in The Wall Street Journal claimed that lower rates yield higher revenues and drew a damning conclusion: "Either the young Illinois senator is ignorant of this revenue data, or he doesn't really care because he's a true income redistributionist who prefers high tax rates as a matter of ideological dogma regardless of the revenue consequences."

You don't have to be a Democrat to doubt that logic. Conservatives regard Obama as a true-blue liberal who itches to expand the size of the federal government. Do they think he would forfeit money to do that just for spite?

As it happens, Obama is the one who is heeding data rather than ideology. Most economists believe that in the long run, the 2003 cut in the capital gains rate reduced revenue rather than raising it. For that matter, even the Bush administration's budget admits as much. Keeping the rate at 15 percent rather than letting it revert to 20 percent, it estimates, would cause a revenue loss of $79 billion over the next decade.

It's true that rates and revenues may sometimes move in opposite directions. When the rate rose in 1987, capital gains realizations dropped. But there's an obvious explanation for that transitory effect. In 1986, seeing the increase coming, people hurried to cash in capital gains while the rate was low.

It's also true that after the rate fell in 1997, realizations rose. But as University of Michigan economist Joel Slemrod notes, that increase began well before the cut—and they plunged after 2000, without any rate increase. Assessing the last two decades, the Congressional Budget Office reports that any positive effect on realizations is "certainly not large enough to offset the losses from a lower rate."

Sensible people might not mind the lost revenue if the change strengthened the economy. But chances are it does just the opposite, by encouraging taxpayers to jump through hoops to reduce their tax liability.

A low capital gains rate hinders the free market by inducing people (especially very wealthy ones) to find ways to take earnings as capital gains instead of ordinary income. In other words, it encourages them to do things that would not make economic sense otherwise. A modestly higher rate would discourage such wasteful avoidance.

Like all taxes, capital gains taxes are a burden. But given that the federal government spends nearly $3 trillion a year, taxes are a regrettable necessity. When we cut capital gains taxes, we have to raise other taxes to make up the loss. Or we have to borrow more money—which means raising taxes in the future.

Republicans may abhor the obligation of paying for the welfare state they helped preserve. But for the moment, the only real choice is between doing that job better and doing it worse.

COPYRIGHT 2008 CREATORS SYNDICATE, INC.