AN ECONOMIST'S VIEW

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Rebecca Summary, Phd., is chairperson, Department of Economics, Southeast Missouri State University.

A capital gain is the difference between the buying and selling price of an asset. For example, if a person buys some corporate stock for $100,000 and sells it some time later for $125,000, a capital gain of $25,000 has been realized. Under the current tax code, the taxpayer will pay a maximum capital gain tax rate of 28 percent on the $25,000.

President Bush has proposed a reduction in the capital gains tax rate from 28 percent to 15.4 percent for assets held at least three years. According to proponents, such a reduction in the capital gains tax will increase investment in the U.S., thus improving the economy and its competitive position in the world. They argue that people will be willing to put more money into stocks and real estate if the tax rate is lowered on gains from the sale of such assets. Tose favoring a reduction also argue that it will encourage companies to switch from debt financing (borrowing money) to equity financing (sale of stock). Thus, the debt burden in the U.S. economy will be reduced.

Congressional Democrats generally oppose such a broad based reduction in the capital gains tax, arguing that it favors wealthy taxpayers. Democrats favor a narrower cut, in which lower-income people pay a zero capital gains tax while wealthy taxpayers continue to pay the current maximum of 28 percent. This would especially help lower income taxpayers who are forced to sell assets to meet larger expenses, such as catastrophic medical costs. Also, Democrats favor a reduced tax rate of 14 percent on all gains from the sale of new stock in small businesses.

There is no clear evidence that a broad based capital gains tax cut will stimulate a large increase in investment. Economists define investment as the purchase of new plant and equipment. That is, investment increases the productive capacity of the economy. A reduction in the capital gains tax rate would apply to the sale of "old" assets as well as "new." Therefore, one result of a cut in the capital gains tax would simply be a turnover in existing assets. More importantly, it applies to the sale of essentially nonproductive assets such as antiques and artwork, which does nothing to improve the performance of the economy.

Targeting the capital gains cut to certain assets, such as proposed by Democrats, would be one way to avoid some of these problems. Alternatively, there are other changes in the tax code, such as investment tax credits and accelerated depreciation allowances for business equipment purchases, which would be more effective in stimulating productive investment.

President Bush and the Democrats have also proposed various changes in the tax code designed to help middle class families. The Democrats have proposed a $300 tax credit to families with an adjusted gross income of $70,000 or less. This tax cut would be paid for by an increase in the tax rate on couples with a taxable income of more than $140,000 a year and a 10 percent millionaires surtax. President Bush does not favor broad based middle income tax relief but has proposed a $5,000 tax credit for first time home buyers.

Why has the issue of middle class tax relief come to the forefront? Statistics from the 1980's indicate that the after-tax income distribution became more unequal during the decade. For example, figures from the Commerce Department show that, in 1978, the top 20 percent of families earned 41.5 percent of total income. By 1989 that figure had risen to almost 45 percent. The income share of the remaining 80 percent decreased, and this decrease fell most heavily upon the middle 60 percent of families.

This change in income distribution was the intentional result of the supple-side economics of the early 1980's, which favored tax cuts to the wealthy. These tax cuts were designed to give added income to the wealthy, with the idea that most of the added income would be saved. This increase in saving could then be borrowed by businesses to invest in new plant and equipment.

Unfortunately, the supply side policies did not generate the expected increase in saving. In 1975, the U.S. saving rate was 8.6 percent; by 1989 it had fallen to 4.6 percent.

The push for middle class tax relief is, in part, a response to the changes that occurred in the 1980's. Giving tax relief to this group will probably have little short-run effect on the economy as a whole. There might be some net increase in spending, but in all likelihood many taxpayers would use the increase in income to pay off debt. This could help the economy in the long run.

Overall, the proposed tax changes are unlikely to have any profound effect on the economy. A broad based reduction in the capital gains tax won't result in an outpouring of new productive investment. Middle class tax relief is unlikely to have any lasting impact on saving or spending. Indeed, if tax cuts cause an increase in the federal deficit, they could be harmful to the economy. Perhaps the best tax policy at this point is no middle class tax relief and no change in the capital gains tax.