Losing Big on Capital Gains

By Dan Goodgame/Washington

In an election campaign largely unencumbered by substance, Democrats and Republicans last year were sharply divided by one pocketbook issue: whether to cut the tax on capital gains. George Bush favored the move as a way to encourage investment and create jobs. Democrats attacked it as welfare for the wealthy, since nearly 70% of individual capital gains are reported by taxpayers earning $100,000-plus a year.

Since the election, though, many Democrats have begun to see a certain expediency in welfare for the wealthy. The reason: a cut in the capital-gains tax would produce a burst of revenue for the Treasury, helping Congress meet its targets for reducing the federal budget deficit, at least in the short term -- the only term that seems to matter in Washington. During the first few years of a lower tax, investors would rush to realize the appreciation on their stocks and other assets and thus pay taxes on them earlier than planned. Once this spurt of early tax collections was exhausted, however, a lower capital-gains rate would produce much lower revenues.

As Congress adjourned last week for its August recess, the capital-gains-cut bandwagon gained momentum. Amazingly, Republicans and conservative Democrats, who make up a narrow majority of the House Ways and Means Committee, rallied around a scheme even more shortsighted than the President's.

The Administration plan would cut capital-gains taxes to 15% but would also phase in a rule requiring investors to hold an asset for three years in order to qualify for this rate. The House measure, proposed by Georgia Democrat Ed Jenkins, would cut capital-gains taxes to 20% on investments held at least a year. But the cut would be short-lived; in two years the rate would return to 28% with indexing for inflation. Investors would be sure to roll over their assets and produce a quick windfall for the Treasury -- at the expense of future tax collections. House Speaker Tom Foley calls it "robbing from future generations." Lawrence Summers, a Harvard public-finance expert, calls it "probably the worst tax proposal in the history of the Republic."

If the President and Congress are serious about spurring new investment and jobs, insist experts on Wall Street, in Silicon Valley and in academia, they should redesign their tax reform. Some of the experts' suggestions:

-- Target new investments, not old ones, by cutting capital-gains taxes only on assets bought after, say, Jan. 1, 1990.

-- Offer a larger tax cut for investments that are held longer, and raise the tax sharply for speculation in which assets are churned in days or minutes.

-- Close the loophole that exempts inherited assets from capital-gains tax, a reform that would be worth $5.5 billion a year in new revenues.

-- End the capital-gains exemption for pension funds. New York City investment banker Felix Rohatyn believes that the funds' managers would then focus more on productive investment rather than on short-term speculation.

-- Impose a security-transactions tax on each sale of a stock or bond to further encourage longer-term investment over churning. At the 0.5% rate charged by Britain and Japan, such a tax would raise $10 billion a year for the Treasury.

-- Cut the tax subsidy for corporate borrowing, which now distorts investment decisions and encourages the use of debt for speculative purposes.

Sadly, such measures may be a little too bold to be entertained by Congress when it reconvenes in September. The Jenkins plan would be "a terrible thing for the economy," admits a congressional economist, "but it solves so many political problems for so many people that it may be unstoppable."

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