In response to my post attempting to shoot down the Trump Administration’s trial balloon re capital gains indexation, a financial advisor wondered if I might be underestimating how many assets are being held simply because the owners didn’t want to pay capital gains tax. His question: Would cutting capital gains taxes, or better yet, eliminating them altogether unlock a flood of capital that could be reinvested in more productive assets, boosting the economy.
It is a common question, and worth considering. If you are in a hurry, the answer is, “no.” If you have more time, here’s why:
Capital gains taxation does create an incentive to hold assets too long. I did a fair amount of research on the size of this lock-in effect earlier in my career. The effect exists, but is smaller than one might expect, probably because non-tax factors are more important to investors when they are making portfolio decisions.
In addition, unlocking unrealized capital gains by cutting taxes won’t have much effect on the overall economy. That’s because the biggest lock-in effects apply to corporate stock and only a fraction of shares is held by individual investors in accounts subject to capital gains tax. Most corporate stock holdings are in tax-preferred retirement accounts or held by nonprofits or foreigners.
In an efficient market, buyers and sellers will respond to market signals and make sure that the stock price reflects the collective best assessment of the company’s prospects. If you hold shares of a particular company too long due to tax considerations, you might be worse off because your portfolio is not quite what you’d prefer, but the overall market is indifferent to your tax planning strategy.
Sales of business and real estate are probably even less responsive than stock to capital gains taxes because other buying and selling costs are so large. However, distortions in those markets are more economically significant. A business owner who holds on to their company too long may run it into the ground. A purchaser might have made it thrive. However, indexing may not help entrepreneurs much since they often have low basis so the inflation adjustment would be a very small part of the gain.
But the biggest problem with exempting capital gains from tax—or even cutting the effective tax rate on capital gains—is that it spurs the creation of tax shelters. There is a whole industry devoted to turning highly taxed ordinary income into lightly taxed capital gains. Some very smart people devote their prodigious talents to inventing complex multi-layer schemes to skirt anti-avoidance rules and convert wage and salary income into capital gains. That is a big waste of resources that saps our economy.
The best way to deal with lock-in without reducing tax revenues or generating tax shelters would be to tax capital income as it accrues rather than when an asset is sold. This would be straightforward for publicly traded securities, but more complicated for illiquid assets like real estate or a family business. The Dutch impute a rate of return on such assets each and every year in exchange for zero capital gains tax when the asset is sold. Some academics have come up with more complex schemes (e.g., Berkeley economics professor Alan Auerbach’s proposal for retrospective capital gains taxation), but they are hard to explain to non-economists.
Another option would be to tax capital gains at death, which President Obama proposed in several budgets. This reform would also be politically challenging, but would eliminate the largest incentive for investors or business owners to hold assets for too long. So-called “step-up in basis” currently allows the appreciation in value of assets held until death to completely escape income taxation.
The bottom line is that indexing capital gains is likely to do more harm than good. And it’d be another giant tax cut for the most fortunate among us at a time when we are already running unsustainable budget deficits.
