NEWSLINK, V5N3 Spring 2001:Capital gains taxes: Not just for the rich

A June 1999 BHI FaxSheet dealt what we thought was a fatal blow to the myth that increases in capital gains taxes hurt high-income taxpayers the most. BHI showed that a state law raising long-term capital gains taxes would have raised tax rates most for taxpayers making less than $20,000 per year. The legislature sustained Governor Cellucci's veto of this law.

Like an android in the Terminator movies, however, the capital gains myth keeps coming back to life. Under current law, the state tax rate on long-term capital gains falls in increments from 5% (for assets held one to two years) to zero (for assets held six years or more). The latest attempt to modify this law, sponsored by the Tax EquityAlliance of Massachusetts, took the form of a proposal to create a flat rate on all capital gains, rising to 5% by 2003.

This time the proposal died in committee.

Here are the facts: Of the 732,127 Massachusetts tax filers who reported capital gains or losses in 1998 (the latest year for which data are available), the distribution of filers across income groups was roughly even. Of these filers, 19% had an adjusted gross income (AGI) less than $20,000. Forty-three percent had an AGI less than $50,000. Only 26% had an AGI greater than $100,000.

Hence, any proposal to raise capital gains taxes hurts taxpayers across the income spectrum. More importantly, the latest proposal, like the earlier one, harms rich and poor alike. The net effective tax rate increases associated with the proposal follow a U-shape pattern, with the highest rate increases at the bottom and the top of the income spectrum and the lowest rate increases in the middle. The chart below shows the 2001 rate increases that would have resulted from the latest proposal.

Low-income taxpayers suffer the most.

The rate increase is highest of all for the very lowest AGI group. The rate would have risen by .8% for tax filers with an AGI less than $20,000, as compared to .7% for those with an AGI of $200,000 or more.

While this result might seem counterintuitive, it is easily explained. Low-income households often sell assets in order to support themselves over periods of economic hardship (unemployment, for example). If a household sees its income fall, say from $40,000 per year to $20,000 per year, it is not likely to reduce its consumption by half. Rather, the household is likely to finance part of its consumption from capital gains. Raising the capital gains tax imposes a greater burden on this household than it would on a middle or high-income household.

Federal and state tax laws treat long-term capital gains more favorably than other kinds of income for this and other reasons. Most fundamentally, capital gains aren't “income” at all and, arguable, should not be taxed at all. Taxing capital gains amounts to double taxation. The taxpayer pays once when he earns his wage and again when he sells assets paid for out of his wages. This double tax can lead to hardships on the lowest wage earners, as we have shown.

But that is not the only burden to bear. Increasing the capital gains tax would also have adverse economic effects on Massachusetts. A rise in the capital gains tax deters business from spending on capital – factories, computers, office buildings, warehouse space and other equipment and structures. BHI estimates that the latest proposal would have caused the Massachusetts stock business capital to fall by $5 billion.

The capital gains myth has been laid to rest for another year. But stay tuned. As Nobel laureate James Buchanan was fond of saying, economics consists largely of impressing “alien ideas on reluctant minds.”* So long as that is true, the job of dispelling popular economic myths remains unfinished.

*from James Buchanan quoting Herbert Spenser in The Demand and Supply of Public Goods (http://www.econlib.org/library/Buchanan/buchCv5c2.html)