Capgains Deal in the Works/Indexing Isn't Enough Jude Wanniski August 4, 1989

CAPGAINS DEAL IN THE WORKS

A last-minute capgains deal between Richard Darman and Ways & Means Chairman Dan Rostenkowski is possible before the recess, if critical details can be worked out. The 50% exclusion after a 10-year holding period brought Rosty's proposal into the ballpark. It will have to be shortened to five years and cover existing assets before it will fly. Also, as Alan Reynolds points out in the following analysis, a 30% exclusion is preferable to Rosty's 25% for the shorter holding period. If there's no deal, the President will almost surely stump for his package during the recess. The inflation/exclusion option is okay by us. The package can always be improved in the Senate, where there are 65 votes for a lower rate! Darman seems very optimistic about the way the process is unfolding and I feel better getting a clearer line on what's unfolding.

Jude Wanniski  

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INDEXING ISN'T ENOUGH

Democratic Congressmen, sensing they're on the unpopular side of the issue of reducing capital-gains taxes, are rushing to embrace various indexing schemes as their alternative. Compared with a lower tax rate, indexing would be relatively favorable to established blue chip stocks, rather than growth stocks in emerging companies. This helps to explain why the stronger performance of over-the-counter stocks earlier in the year has lately given way to superior performance by the blue chips.

The expected benefits of indexing, at a time when expected inflation is moderate and declining, are greatest for investors who plan on holding a security for many years. Blue chip stocks are often held for years, since they pay decent dividends and usually appreciate over time. Small, new enterprises, on the other hand, rely on the hope that the stock market will see beyond their high start-up costs and zero dividends, and quickly bid up the value of the company's shares because of high hopes for the future. The entrepreneurs who start such companies raise capital by selling shares. Investors who buy shares in new companies do so in the hope that they are picking winners, and will be promptly rewarded for their insight and courage when the market lifts the value of the shares. Indexing mainly benefits the passive, coupon-clipping investor in old, established corporations. A lower tax rate within a reasonable time frame, on the other hand, benefits entrepreneurs and the bold and clever capitalists who dare to finance them.

By itself, indexing doesn't help the economy much, doesn't really make the tax code significantly more "fair" or more secure against change, and it costs the Treasury over $5 billion a year. Inflation is indeed one problem with the capital-gains tax, but not the only problem. Indexed or not, a combined federal/state tax of up to 39% will still discourage investors from selling the assets they have, and also encourage investors to prefer the interest on bonds and commercial paper issued by giant companies to the possibility of capital gains from stock in successful new companies.

By itself, indexing does little or nothing to alleviate the current double taxation of corporate savings that are reinvested in a firm (which raises stock prices and therefore taxable capital gains). Unlike a lower tax rate, indexing also does nothing to alleviate the asymmetrical treatment of capital losses, where the government takes up to a third of the gain from any successful new venture but leaves entrepreneurs holding the bag when such efforts fail. While a lower tax rate on capital gains would immediately make people feel more wealthy, since they know they'll get to keep more of the proceeds from any assets they sell, indexing merely provides insurance of questionable permanence for a possible problem of unknown severity.

As for "fairness," a lower tax rate helps to offset the effects of actual past inflation for those who bought assets a decade or two ago. All of the indexing proposals would instead continue to levy steep taxes on purely illusory, inflated gains on past investments.

The new Rostenkowski plan would offer indexing for assets bought after July 31 and held from 1 to 5 years. The plan would later provide a choice of either indexing or a 25% exclusion for assets held between 5 and 10 years, and a choice of indexing or a 50% exclusion (14-16.5% tax rate) after 10 years. These extremely long holding periods for a 25% or 50% exclusion are heavily biased toward the coupon clippers and against entrepreneurial capitalism. Despite all the rhetoric from both Democrats and Republicans about "getting investors to take the long view," there is absolutely no economic rationale whatsoever for bribing people to hold shares in a company after some other investment becomes more attractive. The increased "lock-in" effect (delayed sales) from waiting 5 or 10 years for a lower tax rate would greatly increase the Treasury's revenue losses from the Rostenkowski plan. That problem is made even worse by the fact that Rostenkowski would provide neither indexing or an exclusion for assets bought before July 31 of this year, and no relief at all for those who bought bonds (this tax bias against bonds would raise long-term interest rates, which helps explain the bond market setback today).

In addition to the revenue loss from the incentives to hold stock too long, the indexing provisions of Rostenkowski's plan would quickly run into the $6 billion annual losses that the Jenkins plan at least postpones until 1993. Rosty's plan is unquestionably a huge revenue loser from day one, even though the Joint Tax Committee apparently thinks the 5-year losses would be small. According to Alan Murray's Wall Street Journal story (Aug. 4), Rostenkowski's plan would supposedly raise a billion in the first year "by encouraging people to sell their assets and pay taxes at the lower rate." That is impossible. Rostenkowski's plan wouldn't offer a lower rate until mid-1994, which discourages sales before then. And indexing would only apply to assets bought after July 31, which leaves nearly all investments at least as "locked in" as they are now.

Rostenkowski's idea of applying either indexing or a lower rate only to assets bought in the future is brutally unfair, and it minimizes the revenue-raising effects of encouraging people to sell appreciated assets, even in 1994. The Wall Street Journal story claims that "administration policy makers point out that if the purpose of the capital gains is to encourage investment, there's no point in giving it to investments that have already been made." That is total nonsense. Just as people have to sell their old house before buying a new one, they likewise often have to sell stock in a fading company in order to channel equity into a new winner. Besides, a capital-gains tax is a penalty on selling assets, not on buying, and there is nothing to be gained by making it easier to sell recent investments rather than older investments. In any case, the whole idea of taxing previous investors at a higher rate than new investors, particularly by offering inflation insurance only to the newcomers, is so outrageous that it could never survive the political backlash. In many cases, this would literally amount to a higher tax rate on older people, just because they're older and started saving earlier.

How could the spirit of the Rostenkowski options be preserved without the useless inequities of penalizing the sale of older assets and without losing huge bundles of tax revenue? Only by allowing investors at least a 30% exclusion (or, even better, a 20% maximum rate) after 1 or 2 years, regardless of when the asset was purchased. Such medium-term investors could be offered the choice of indexing instead of the lower rate, but it's less likely to be attractive over that time horizon. To placate the Brady-Rostenkowski favoritism for loyal holders of blue chips, investors could be offered the choice of indexing or the larger 50% exclusion (or 15% rate) for assets held more than 5 years, which is when indexing can really begin to make a difference.

Alan Reynolds