Imagine a congressman from Texas voting against tax breaks for the oil industry on the grounds that they benefit wealthy special interests. It simply would not happen: a smart politician, regardless of his ideological bent, knows better than to oppose the interests of his own constituents.
Yet in 1989, 10 of New York City’s 13 representatives voted against a bill that would have particularly benefited the city’s most important industry, financial services. Only two local members of Congress supported the proposal to cut the capital gains tax to 15 percent. (One member did not vote.)
Cutting the capital gains tax is the single best thing the Federal Government could do to help New York City out of its severe and continuing recession. A capital gains tax cut would not only stimulate the national economy, but also encourage a higher volume of trading in New York’s financial markets, creating thousands of new jobs in the city.
Currently, profits from the sale of assets are taxed by the Federal Government at a top rate of 28 percent. By cutting the after-tax rate of return on investments, the tax reduces stock prices, increases the cost of capital, and discourages investment and economic growth.
Moreover, when capital gains taxes are high, investment decisions arc often driven by the tax rather than by economic considerations. To illustrate this effect, consider the case of an investor who purchased stock that was worth $20,000 in 1972 and $120,000 twenty years later. (This reflects a compound annual rate of return of 9.4 percent, which was fairly typical for stocks during that period.) If he sold his stock, realizing a nominal profit of $100,000, the investor would face a federal tax bill of $28,000.
Because the capital gains tax is not indexed for inflation, much of the taxable “profit” exists only on paper. The original investment of $20,000 in 1972 was the equivalent of about $67,200 in 1992, so the profit, after adjusting for inflation, would amount to only $52,800. The $28,000 tax is 53 percent of this real profit. A New Yorker would have to pay an additional $12,335 in state and city taxes, though part of this would be offset by a federal deduction.
The investor could avoid the capital gains tax by not selling the security. As a result, the capital gains tax creates what is known as a “lock-in” effect. Many investors hold appreciated securities until they die, avoiding the capital gains tax (though not the estate tax) entirely.
The effect of tax rates on investment decisions was borne out by evidence from the last major change in the capital gains tax. In 1986, Congress passed a tax reform bill that increased the top tax rate on capital gains from 20 percent to 28 percent, effective the following year. According to IRS data, total nationwide capital gains realizations had averaged $154 billion per year in 1984-1985. They more than doubled, to $326 billion, in 1986, then fell to an average of $152 billion in 1987-1989. Apparently, many investors liquidated their stocks and other appreciated assets in 1986, in order to avoid the 1987 tax increase.
Not all investors are subject to the capital gains tax. Many institutions, including pension funds and nonprofit organizations, are exempt. Still, cutting the tax would free up hundreds of billions of dollars in capital, thus revitalizing the U.S. economy. Smaller, fast-growing industries would particularly benefit from lower-cost capital.
In New York, moreover, an increased volume of trading on the financial markets would bolster the FIRE (finance, insurance, and real estate) sector that is central to the city’s economy.
Economist Donald Kiefer has developed a model for predicting the effects on the financial markets of changes in the capital gains tax rate. In a 1990 article for The National Tax Journal, Kiefer projected what would happen if the rate were cut from 28 percent to 15 percent, as the Bush administration had proposed doing the previous year.
During the first year of the lower rate, Kiefer estimated, realizations would increase dramatically, possibly by as much as 100 percent. They would decline for the next three years, but would remain well above the initial level under the higher tax. Thereafter, realizations would stabilize at an estimated annual level 58 percent higher than in the year preceding the tax cut.
Meanwhile, trading on the stock market would surge. Kiefer estimates that the “turnover rate” for stocks held by individuals—the number of times the average share of stock will be traded in a given period of time—would increase by 56 percent over the long run. In 1992, individuals traded an average of 100 million shares a day on the New York Stock Exchange. Even if we assume that stock turnover would go up a conservative 30 percent, an additional thirty million shares would be traded each day.
A statistical analysis I conducted for the city comptroller’s office shows that an increase of one million shares in the NYSE’s average daily trading volume creates approximately 730 new jobs in the city’s FIRE sector. Because the FIRE sector tends to stimulate the rest of the economy, each 100 new FIRE jobs arc accompanied by 180 other new jobs in the city. Thus, the projected increase in NYSE trading volume of thirty million shares would create some 61,200 new private-sector jobs in New York City. This expansion of the private sector would lead to about $428 million in new municipal tax revenues. The effect on federal revenues, according to Kiefer, would be minimal.
Despite these benefits, when the tax cut came up for a vote in 1989, New York’s congressional delegation split along party lines, with only Republicans Bill Green and Guy Molinari supporting the proposal. Democratic leaders had labeled the proposal, inaccurately, a “tax break for the rich.” In fact, many moderate-income taxpayers, their income inflated by a one-time gain, are “rich” only in the year they sell their assets.
Enough Democrats did support the proposal to give it a majority in both houses of Congress, but it died in a Senate filibuster. That Democrats would fight a major initiative of a Republican president is understandable, but for New York representatives to oppose a policy that would be a particular boon to the Big Apple is downright perverse.
City officials, for their part, ignored a May 1991 report commissioned by the Mayor’s Committee on Financial Services Competitiveness that urged “persistent lobbying in Washington” for reduced or indexed capital gains taxation. They should take this advice to heart and press President Clinton and the city’s congressional delegation to cut the tax. They should also call on legislators in Albany to reduce or eliminate the state and city taxes on capital gains, currently 7.875 and 4.46 percent respectively.
If Clinton-a Democrat committed to revitalizing America’s cities—embraced the idea of cutting capital gains taxes, he could almost certainly persuade New York’s legislators to abandon their foolish opposition to a policy that would benefit New Yorkers more than anyone else.