USA DESPERATELY NEEDS A CUT IN TAX RATE ON CAPTIAL GAINS

If you own real estate, stocks, bonds, a small business or other tangible or financial assets, you need a tax cut. We tax-cutters are often derided by those who skewer us for our single-minded commitment to reducing the cost of capital. But let's revisit the overwhelming case for such a rate reduction.

Begin with definition. Capital gains are gains realized by any owner of an asset on the sale of that asset. Note immediately the obvious fact: This is an optional tax. Optional, that is, in the sense that the taxpayer can defer paying it by hanging onto (refusing to sell) his asset. The type of asset varies: Land, buildings, shares of stock, a small business, etc. Upon the sale of such items, any excess of sale price over the seller's original acquisition cost is classified for tax purposes as a capital gain. Such "gains" are taxed at special rates apart from ordinary income taxes.

The astute reader will notice that the government thus stands to benefit from the very inflation caused by its overspending and the money printed to finance its own profligacy. How? Because the capital gains tax rate does not distinguish between an increase in the asset's value flowing from inflation (a false or "illusory" gain) and a real gain in the asset's value (i.e., one that adjusts valuation to take inflation into account).

To illustrate: You own a piece of real estate for 10 years. You bought it in 1981 for $5,000, and sell it in 1990 for $10,000. You have a "gain" of 100 percent, or a healthy 10 percent per year, right? But wait: Assume for purposes of this discussion that inflation was, say, 6 percent annually during the decade. Over the decade you owned that ground, then, the Consumer Price Index escalated 60 percent. Thus, an astonishing 60 percent of your terrific 100 percent "gain" is false, illusory, no "gain at all entirely a function of government's cheapening the currency. (Factor in the real estate taxes you paid each year during the time you held the ground, and see whether you've "gained" anything at all).

When you sell your ground, the tax man doesn't distinguish between the real, non-inflationary gain and the false perception of "gain" caused by inflation. He takes his cut on the entire "gain" in our example, 100 percent both inflationary and real alike. Every shrewd investor knows this. It isn't a matter of anyone's opinion; we're talking about iron laws of economics, and the inevitable consequences flowing from them.

Our current tax rate on capital gains is 28 percent. Thus that rate, in combination with its failure to account for inflation, is the most punishing in our history. This was not always the case; with a wave of tax-cutting that began in 1978 (the Steiger amendment to slash capital gains tax rates) through the Reagan reforms of the early '80s, America experimented with lower rates on this crucial tax. From late 1982 (effective date of President Reagan's 1981 tax cut bill) until the 1986 Tax Reform bill, the capital gains tax rate dropped all the way to 20 percent.

Capital has been accurately called our economy's "seed corn." It's elementary that when you tax something, you get less of it, just as when you subsidize something, you get more of that. With capital taxed at the lower rates from late '82 until '87, it became much more accessible to ordinary Americans with a dream. With capital unlocked, entrepreneurial activity and job growth exploded. America experienced history's largest number of new, small business start-ups. 20 million net new jobs were created, concentrated overwhelmingly in small business. How did investors respond? The Dow Jones average zoomed from a pitiful 776 (August '82) all the way past 2200 just five years later, as a couple of trillion dollars in higher net worth was added to American industry and households.

Did the rich get richer? Sure, but so did the poor, and every other income level, as well.

So much business was stimulated by the lower rates of the early and mid-'80s that tax collectors actually took in more revenue than they had at the higher tax rates. Once derided even by then-Republican Senate Majority Leader Howard Baker as a "riverboat gamble" and the fanciful hope of dreamy supply-siders, this indisputable fact has now been vindicated again and again.

In that 1986 Tax Reform, which contained many laudable provisions, there was one major bummer. In exchange for dramatic reductions in marginal rates on ordinary income, a Congressional majority (led especially by New Jersey Sen. Bill Bradley and Missouri's Richard Gephardt) demanded and got the higher rates on capital gains. "The rich," their argument went, "will get a windfall in lower rates on ordinary income." Therefore, they insisted, we must "equalize" things in the name of "tax fairness" to prevent this "unfair windfall for the rich" by hiking taxes on capital gains.

Sadly, the predictable results are in, and a bitter harvest it is. Real estate especially commercial real estate went into the tank beginning in '87. Owners of office buildings, apartments, retail space and other commercial real estate saw asset values plummet as their industry tumbled into a depression from which it has not yet emerged. Banks and insurance companies own and collateralize real estate; their balance sheets took a beating, and some even went under. Remember the optional nature of this tax. People elected not to pay it which is to say they stopped turning over assets as quickly as they had during the previous five boom years.

And why should this surprise us? If the government gets its 28 percent of the entire "gain" (both real and illusory), which in many cases leaves the seller with a meager return or even a loss, why should that seller not hold onto assets postponing the release of the dollars tied up in them? This is a prescription for locking up capital, a recipe for gridlock in the economy.

Meanwhile, what asset is it that made up the largest part of the portfolios of the nation's savings and loans? Why, real estate, of course. If the real estate market is under stress as described here, then what effect can this have other than to worsen the condition of the S&Ls?

This, of course, is precisely what happened. Senate Majority Leader George Mitchell singlehandedly blocked a capital gains cut in the fall of 1989, even after it had passed the House and clearly enjoyed majority support in the Senate. This action vastly increased the cost of the S&L bailout by devaluing the very real estate that every thrift institution owned. In the bargain, any chance of avoiding a recession was gone in Sen. Mitchell's blind partisan spite, cloaked in a fog of hoary cliches about an "unfair windfall for the rich." To the Bush administration's great discredit, they have seemed ever since to be intimidated by this rhetoric, and quit a tax-cut fight they had nearly won in both houses of Congress.

Behold the predictable and avoidable "monument" to the Senator from Maine the Mitchell Recession.

Cutting the capital gains tax rate, even now, would instantly reduce the S&L bailout cost by increasing the value of all real estate commercial, residential or farm.