Lower Rate, Higher Revenue

Capital gains tax revenues have increased in the three years since President Bush cut the capital gains tax rate, proving free-market economists right, and bureaucrats wrong. As Nobel laureate Milton Friedman often says, when you tax something you get less of it, and when you tax something less you get more of it. The “it” in this case is capital gains, which are the amount of money you make when you sell something for more than you paid for it.Capital gains have jumped because the rate reduction boosted the after-tax return on capital, reviving the stock market as well as unlocking longer-term gains that can now be realized with a smaller tax bite.The numbers tell an impressive story: In 2003, prior to the capital gains cut, the Congressional Budget Office was projecting capital gains tax revenues of $51 billion, $56 billion, and $62 billion respectively for the years 2003-2005, on capital gains realizations of $294 billion, $322 billion, and $350 billion. After the rate cut, the CBO predicted that realizations would be basically unaffected, and that therefore revenues would decline because of the lower rate.The actual numbers for those years were re leased by the CBO last week, and the opposite happened – revenues were significantly higher than predicted before the capital gains tax rate cut – in other words, it more than paid for itself. In 2003, the year the rate was cut, realizations jumped from a projected $294 billion to an actual $323 billion. In 2004 and 2005, realizations skyrocketed to $479 billion and $539 billion, versus pre-rate cut projections of only $322 billion and $350 billion.The dramatic rise in capital gains realizations fueled a corresponding increase in capital gains tax revenues – confounding the CBO model predictions. Cap gains revenues totaled $50 billion, $60 billion, and $75 billion in 2003, 2004, and 2005. Over those three years, revenues totaled $185 billion, $16 billion more than the CBO projected before the tax cuts even passed and a whopping $47 billion more than the CBO projected after the rate cut.This is deja vu for those of us who follow the capital gains data, because it happens every time. When the capital gains tax rate was cut in 1978 and 1981 revenues steadily increased. When the rate was hiked in 1987, revenues declined. The most recent precedent was President Clinton’s 1997 capital gains rate cut, which helped propel an incredible bull market run, more than doubling capital gains tax revenues from their pre-rate cut levels in just a few years.The flaw in the CBO projections is that, despite overwhelming evidence that lowering the cost of capital boosts economic growth, CBO does not include any increase in the level of economic activity in their modeling of the impact of a capital gains rate reduction.The CBO bureaucrats may never learn, but the American people and the congressmen who represent them should. As Dr. Arthur Laffer’s famous napkin drawing illustrated, when a tax rate is too high, it deters economic activity to such an extent that cutting the rate can actually increase revenues. Clearly, with respect to the capital gains tax, the erstwhile 20% rate was still on the wrong side of the curve.The fact that under present law the rate will be hiked back up to that inefficient level can only be described as gross policy negligence. Low capital gains tax rates are win-win for the economy and the U.S. treasury. It would make far more sense to reduce the rate again and index capital gains to inflation than to even for a moment consider letting this successful tax policy expire.Mr. Kerpen is policy director for the Free Enterprise Fund.

Lower Rate, Higher Revenue

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