The Capital Gains Tax Paradox

The Obama Administration is now considering nearly doubling the tax rate on capital gains when it should be seriously considering reducing or eliminating those taxes. Many economists assert that a reduction in capital gains tax rates will spur private investment in the stock market and ultimately help our economy recover and grow. The Obama Administration loathes the idea of cutting those rates for fear it will be criticized for offering tax cuts to the wealthiest strata of our society.

First, in these difficult times, every measure to spur recovery should be seriously considered as everyone will benefit from a strong economic recovery. Second, even though a reduced capital gains tax favors the wealthy who collect more capital gains, the centroid of securities ownership in this country is squarely in the middle class, not the wealthy. Half of all households, more than 100 million Americans, own securities. These owners typically have more than half their household financial assets in stocks and earn a median household income of $65,000. In today’s economy, these are not rich folks. The Obama Administration needs to acknowledge these facts. While it’s true that many owners hold securities in their tax-deferred IRA and 401K accounts that won’t benefit directly from a reduction of capital gains taxes, it’s also true that more than three-quarters of securities owners own some outside their retirement accounts. Also, if a reduction in capital gains taxes helps push up securities prices, all owners will benefit from the increase in wealth.

Third, given the fact that nearly half of global stock market wealth vanished within the past year, most capital gains have already been realized, taxed and ultimately lost by investors. Going forward, there will be few capital gains to be subjected to tax. In fact, on average at current index levels only investments made more than a decade ago will register any meaningful capital appreciation.

Last and most significant, it’s possible and ironic that the only way to stem the decline and reverse the stock market trend might be to eliminate capital gains taxes, thereby causing the impetus for new investment. Incremental new investments would push the market higher and lead to capital appreciation, i.e., eliminating the tax on gains may be necessary to produce capital gains going forward.

In view of these facts, a reduction or elimination of capital gains taxes could be a powerful stimulus for many middle class Americans, would cost taxpayers nothing in the short run, and minimally until both the economy and stock markets recover significantly. It would also be a no-risk proposition. If it doesn’t work, it doesn’t cost taxpayers anything.