THE VIRGINIAN-PILOT
Copyright (c) 1995, Landmark Communications, Inc.
DATE: Monday, March 6, 1995 TAG: 9503040313
SECTION: BUSINESS WEEKLY PAGE: 05 EDITION: FINAL
TYPE: Opinion
SOURCE: BY CHARLES V. McPHILLIPS
LENGTH: Medium: 76 lines
The promise of a 50 percent cut in the capital gains tax rate may be the most significant bone thrown to business owners and investors in House Speaker Newt Gingrich's Contract with America.
Capital gains represent the profit an investor makes by selling assets such as real estate, gold, bonds and corporate stock.
The contract promises to reduce the maximum federal tax rate on long-term capital gains to 14 percent for individuals and also index capital gains for inflation. The latter reform is extremely overdue.
If stock is purchased in 1994 for $100 and sold in 1998 for $115, the investor must pay tax on a $15 capital gain. But if the 1994-98 inflation rate averages 3.6 percent, the gain is entirely illusory: $115 in 1998 would be actually worth less than $100 in 1994. An investor could wind up paying tax on an economic loss.
Reducing the tax rate on capital gains should inject adrenalin into the capital markets. Moreover, investors should become more willing to bet their money on start-up companies.
In 1978, Congress slashed the maximum capital gains rate to 25 percent from about 50 percent. In 1981, the maximum rate was dropped to 20 percent.
These supply-side measures bore great fruit. Whereas the venture capital industry had raised only $300 million to $600 million (1991 dollars) annually in the 1970s, by 1986 it was pulling in $4 billion a year.
The Tax Reform Act of 1986, however, brought this burgeoning capital investment to a sputtering halt. The '86 law decreed that capital gains would be taxed at the same rates as ordinary income, or up to 28 percent.
The '86 act also provided that the 28 percent rate would be assessed against an inflated income base because the measure stripped away many of the deductions still available in 1981.
Just like the luxury tax assessed against yachts, the bump in the capital gains rate was intended to separate the rich from more of their ill-gotten gains.
Opting not to buy yachts or to pour their wealth into venture capital financing, the rich did not become the chief victims of either tax: the employees of boat builders took the luxury tax in the neck, and entrepreneurs and their prospective employees suffered for the dearth of capital caused by the high tax on successful investment.
Regardless of economic consequences, how could it be fair to tax a worker's salary at a higher rate than a millionaire's windfall from a few idle investments?
Easy. Investment capital, after all, is the residue left after the IRS has taxed earnings at least once, perhaps twice.
If the source of the earnings is salary, the investor has a W-2 to show for his pain; if the source is business profits, then he has accumulated only those earnings which survive both the corporate income tax and then the individual income tax on his dividends.
Even the oft-scorned, indolent heir to a great fortune, whose only job is to invest his idle millions, is gambling with merely the leftovers from the IRS.
The '86 tax hike eventually plunged the capital markets into a recession, with new venture capital dropping to $2.1 billion a year by 1990.
With the cut proposed in Gingrich's contract, investors who have been holding capital assets for fear of the tax bite finally should be liberated from the lock-in effect of high, non-indexed capital gains taxes.
This inhibition is itself a tax on the efficient allocation of capital, because economically productive transfers of assets are stopped cold by concern for the tax consequences. Moreover, capital assets will prove to be more valuable to prospective investors when they know that they can be resold later without punitive taxation.
Whether the boost to capital transactions will suffice to generate more revenue for the Treasury is an arguable proposition. MEMO: Charles V. McPhillips is a partner with Norfolk-based law firm of
Kaufman & Canoles. by CNB