The Economic Effects of Capital Gains Taxation

Summary

One provision of the 1913 individual income tax that generated a great deal of confusion was the
taxation of income from the sale of property (i.e., capital gains income). This initial confusion has
led to almost 100 years of legislative debates over capital gains. Beginning in 1922 capital gains
were first subject to lower tax rates than ordinary income. This preferential treatment has
continued throughout most of the history of the income tax. Proposals dealing with the taxation of
capital gains have ranged from the outright elimination of capital gains taxation to the reduction
of capital gains tax rates for certain classes of taxpayers to the elimination of the preferential tax
treatment.
Overall, capital gains tax revenues have been a fairly small, but not trivial, source of government
revenue. Since 1954, revenue from the capital gains tax as a share of total income tax revenue has
averaged 5.2%. It reached a peak of 12.8% in 1986 and a low of 2.0% in 1957. Nonetheless, the
2007 capital gains tax revenue of $123 billion was equal to 75% of the FY2007 budget deficit.
Some argue that reducing capital gains tax rates will increase tax revenues by dramatically
increasing capital gains realizations. While the effect of changes in the capital gains tax rate
continue to be debated and researched, the bulk of the evidence suggests that reducing the capital
gains tax rate reduces tax revenues.
Higher income households are substantially more likely to own assets that can generate taxable
gains than lower income households. Additionally, high income households own most of these
assets, realize most of the capital gains, and pay most of the capital gains taxes at preferential
rates.
Capital gains tax reductions are often proposed as a policy that will increase saving and
investment, provide a short-term economic stimulus, and boost long-term economic growth.
Capital gains tax rate reductions appear to decrease public saving and may have little or no effect
on private saving. Consequently, many analysts note that capital gains tax reductions likely have a
negative overall impact on national saving. Furthermore, capital gains tax rate reductions, they
observe, are unlikely to have much effect on the long-term level of output or the path to the longrun
level of output (i.e., economic growth). A tax reduction on capital gains would mostly benefit
very high income taxpayers who are likely to save most of any tax reduction. A temporary capital
gains tax reduction possibly could have a negative impact on short-term economic growth.

By Thomas L. Hungerford