Capitalist fools: capital gains make ordinary Americans richer. Why is Congress against this?

Capital gains make ordinary Americans richer. Why is Congress against this?

Of all the economically disastrous policies enacted by Congress over the past ten years, perhaps none rivals the 1986 increase in the capital-gains tax. Today, the United States finds itself squarely on the wrong side of the Laffer curve. We raise less money today with a 28 per cent capital-gains tax than we did ten years ago with a 20 per cent rate. In fact, the amount of tax dollars lost to the Treasury over the past eight years because of that rate hike is now estimated at $75 billion. With that much money Congress could by now have purchased a $100,000 house and a new Ford Mustang convertible for every homeless family in America.

All this did not dissuade Bill Clinton from vetoing the GOP's capital-gains tax cut late last year. To the utter frustration of both Main Street and Wall Street, Clinton for once acted against his own political self-interest -- alas, out of pure economic stupidity, not out of righteousness.

Of course, the rationale for cutting the capital-gains tax is not to give Washington politicians more money to spend. The primary case for cutting is to allocate scarce investment capital more efficiently. High capital-gains tax rates effectively lock in the equity built up in Americans' assets -- their businesses, ranches, stocks, and houses. The preachers of greed and envy in Washington forget that the capital-gains tax is an optional tax: millions of Americans shelter their gains from the long arm of the IRS by deferring the sale of their assets. This lock-in carries a high economic cost. It deters investment capital from flowing to its highest-value usage.

The ratio of unrealized capital gains is near an all-time high. Economist Art Laffer estimates there are at least $6 trillion of appreciated capital gains in the American economy today --trillions of dollars of stored-up wealth patiently awaiting liberation. Opponents of the capital-gains tax cut complain that a rate cut simply rearranges Wall Street investors' stock holdings with little overall gain to the economy. Wrong. The function of capital markets is to value assets: to allow dollars to finance investments with the highest possible return. We want Americans to sell their holdings in declining industries and pour risk capital into potential twenty-first-century titans -- America's next TCI, Intel, or Walmart.

For all the redistributionist babble about a capital-gains tax cut aiding Wall Street fatcats, it's not at all clear that a cut will benefit the stock market. Indeed, the short-term effect of a capital-gains tax cut is usually bearish. Michael Harkins, president of the money management firm Levy, Harkins and Co., predicts that for the first six months, a capital-gains tax cut "will act as a depressant [on financial markets] . . . no matter how bullish the long term." Why? Because it is likely to incite profit taking as investors cash in on their current portfolio holdings.

New York investment analyst Claudia Mott of Prudential Securities has carefully analyzed the market response to the last two capital-gains tax cuts: the 1978 cut from an effective rate of 49 to 28 per cent and the 1981 cut from 28 to 20 per cent. She discovered that in the first quarter following the rate cut, a flurry of selling sent stock plummeting -- by about 10 per cent in 1978 and 14 per cent in 1981. But in the year after this initial sell-off, the stock market recouped its losses.

Much of the reinvested money tends to be steered toward high-risk, high-growth opportunities in smaller, often start-up firms -- Wall Street's young gazelles. Claudia Mott discovered that small-cap stocks (stocks of firms with smaller capitalization) are far more sensitive to changes in the capital-gains tax than large-cap stocks: they suffered greater losses in the short term and enjoyed about twice the gains in the longer term. "More investors were willing to invest in small caps when less of their potential gain would be going to Uncle Sam," she concludes.

Over the period 1968 to 1992, small and medium-sized firms outperformed large companies (the Standard & Poor's 500) in the year following a capital-gains tax cut. Large firms did relatively better after increases in the tax rate. "Smaller-capitalization stocks have greater sensitivity [to tax changes] because they tend to be capital-gains rather than income-oriented," according to a study by Merrill Lynch. The Merrill study's statistical analysis reveals that every capital-gains tax reduction of 5 percentage points translates into a 12.5-percentage-point higher return for small stocks relative to large stocks.

After both the 1978 and the 1981 rate cuts entrepreneurial activity in the U.S. soared. New commitments to venture-capital firms increased from $70 million in 1977 when the top marginal rate was 49 per cent to $5.1 billion by 1983 when the rate had been dropped to 20 per cent. This was a 700 per cent rise in capital raised for new firms.

The U.S. Civil Rights Commission reports that after 1978, when the capital-gains tax was reduced from 49 per cent to 28 per cent, "the number of black-owned businesses increased in a five-year period by one-third (to 308,000 from 231,200)." After the tax rate was cut down to 20 per cent, new black-owned businesses rose by an additional 38 per cent (to 424,000) by 1987. The Commission concludes that "The best hope of getting critically needed seed money into Los Angeles and other tense urban areas is by cutting the capital-gains tax."