Statement of Gerald E. Scorse, New York, New York

Taxes on long-term capital gains are at their lowest level in over 70 years.  Should we be celebrating? Not to my mind, and I hope to win you over to my point of view.  First a brief preface:  President Bush has dubbed himself The Decider, and he most definitely is. Far away, about as far from deciding as a person could possibly get, I’ve dubbed myself a fact-finder.

Nobody can find all the facts so I had to pick a category and I chose taxes. Within the category I opted to focus on tax fairness for ordinary Americans.

This is the fifth year in which I’ve filed written testimony on a tax fairness issue, and I greatly appreciate these opportunities. It’s a wonderful country where a plain fact-finder gets to present his arguments directly to the lawmakers.

With that I invite you to read “The Spurious, Curious Case for Low Taxes on Capital Gains” plus an addendum. The addendum includes important, related points which would have slowed down the article itself.

 Once you have read all the material, I further invite you to draw your own conclusions based on (what else) the facts.

The Spurious, Curious Case for Low Capital Gains Taxes

These are heady times for backers of low taxes on capital gains. Presidents Clinton and Bush both cut the capital gains rate, bringing the current levy on long-term gains down to 15%. That’s the lowest in more than 70 years, “gloriously low” in the words of economist Ben Stein, and it means that profits on stock market transactions are now taxed at a lower rate than the wages of average Americans.

There’s no good reason for this preferential treatment, and powerful reasons to end it. Leading the list is the simple fact that stock market “investors” are almost never real investors in the first place.

The argument for a low rate on capital gains is invariable (and in recent years, invariably effective): it holds that investments in the stock market grow jobs, grow businesses, and provide vital fuel for the United States economy. Partly as inducement and partly in gratitude, the argument goes, it behooves government to reward investors with low capital gains taxes.

A potent blend of myth, propaganda and misimpressions. Let’s look instead at some truths.

It’s routine on Wall Street these days for trading volume to run in the billions of shares. On any given day, only a tiny fraction of those billions has any valid claim to growing jobs or businesses or the economy. On many days not a single share qualifies as a bona fide investment.

Almost all the time, all that’s happening is money changing hands as shares move from sellers to buyers. Not a cent goes to the companies whose shares are traded. No jobs are created (except in the financial community, which is not the point here). No businesses are expanded. Investments are really being made not in the economy but in personal portfolios.

The only genuine stock market investments are those in initial public offerings (IPOs) and secondary offerings. In those cases alone does the money move on to do the work it’s purported to do. All the rest is aftermarket noise as the players place their bets at the tables down on Wall Street.

Securities markets clearly play an energizing role in the American economy. All the same it’s nonsense to claim that buyers of stocks deserve a tax break when they sell their shares at a profit. A tax break? For making money in the market?Now for more reasons why this is poor policy.

There’s a fairness issue that flows from taxing one kind of income differently from another. Income is income and should be taxed at the same rates no matter where it comes from; what’s good for the goose is good for the gander.

There’s the issue of income inequality, which has soared in America lately.  According to the David Cay Johnston book Perfectly Legal, the top one percent of taxpayers controls about half the nation’s financial assets. Two-thirds of the income of the 400 highest-income Americans comes from long-term capital gains. Undeniably, the benefits of tax breaks for capital gains flow overwhelmingly to the already-wealthy; undeniably, preferential rates on capital gains exacerbate income inequality.

Finally there’s a tax equity issue which our forebears even considered a moral issue. In 1924 Congress first differentiated between earned income (wages and salaries) and unearned income (e.g., capital gains and dividends), and taxed the unearned income at higher rates. It was deemed the right thing to do; old-timers would have shuddered at the notion of taxing wages at higher rates than capital gains.

Those were the days.  Now it’s 2007.

Under the trumped-up cover of spurring economic growth, average American workers have to pay higher taxes on their wages than if they made the same amount of money in the stock market.  They’re getting stiffed by carrying a heavier relative tax burden, getting fewer services or some of both.

The latest capital gains tax cut is set to expire in 2010, and the new Democratic Congress has indicated that it has no plans to visit the issue until after the 2008 elections. This gives them plenty of time to look beyond the propaganda, and to consider taxing capital gains at least as much as earned income. A political pipedream? It was the rule not long ago: from 1988 to 1992, long-term realized gains were essentially taxed at the same rate as other income.

Then the K Street apostles went forth and preached, and the spurious case became gospel.   

SOURCES

Johnston, David Cay. Perfectly Legal (New York: The Penguin Group, 2003), pp. 16-17, 

        p. 310

Stein, Ben. “It’s a Great Country, Especially if You’re Rich,” Sunday Business, The New 

York Times, February 11, 2007

Weisman, Steven. The Great Tax Wars (New York: Simon and Schuster, 2002), p. 351

ADDENDUM

1) A Way to Pay for Repeal of the Alternative Minimum Tax

The Congress could look at restoring equal taxes on ordinary income and capital gains as a way to fund repeal of the AMT.

It will immediately be objected (by Republicans and likely some Democrats), no doubt at high decibel levels, that this is a tax increase, and that the increase will have a chilling effect on investments. Let’s go straight to these arguments, starting with the “tax increase”:

Millions of Americans for whom the AMT was never intended are already paying a tax increase because of the AMT.  In 2006 about 20 million taxpayers qualified for the AMT and about 3.5 million actually paid it (the difference between those numbers being those who were spared by the latest of Congress’s AMT patches).

But the patches have become increasingly expensive as millions more cross into AMT territory. Estimates are that 30 million taxpayers will qualify by 2010 and 60 million within a decade. According to a news article in The New York Times on March 14, a two-year freeze currently being considered by Congress would cost $200 billion.

There’s an idiom for Congress’s handling of the AMT:  “kicking the can down the road.” The kicking has to stop sometime.

This is a choice you have: continue a tax increase that was never intended, or let expire a tax decrease that should never have been enacted.

(Regarding the Iraq War, Senator Hagel admonished his fellow senators that they were in politics to make the hard choices. Do the Senator’s words also apply to the choice between continuing the AMT or annulling the capital gains tax cuts? Only you can decide.)

Now to the supposed ill effects on investments of the increase in capital gains taxes:

If it wishes, Congress could in fact continue the favorable taxation of capital gains on shares purchased in initial public offerings (IPOs) or secondary offerings. Current technology would make it a simple matter to identify and track these shares for tax purposes.

It might also be argued that investors need no extra tax incentive: the profit motive is alive and well, and can be counted on to operate even when the tax on capital gains is the same as the tax on earned income.

2) Average Americans’ Capital Gains Are Taxed as Ordinary Income

One defense of low taxes on capital gains is the notion that stockholding has become commonplace in America: everybody owns stocks, so everybody benefits.

The argument contains an ounce of truth and a pound of deceit.

Stock ownership by average Americans has surely risen in recent years, most particularly since the government’s creation of tax-deferred retirement accounts in 1974. The number and type of such accounts has increased continually as Congress has approved (and the financial community has created) new ways for workers to save for retirement.

But workers and their families have run into strong headwinds. U.S. employment has undergone a structural shift away from higher-paying, higher-benefit jobs in manufacturing and toward lower-paying, lower-benefit jobs in the service sector. Defined-benefit pension plans, once the norm, have steadily given way to defined-contribution plans. The new plans carry no guarantees and essentially amount to cuts in retirement benefits. 

Moreover, despite incentives such as tax deductions, tax deferral, and matching contributions by employers, the percentage of workers enrolling in retirement plans has not lived up to expectations. Congress took note of this as recently as last summer when it included, in the Pension Protection Act of 2006, a provision for automatic enrollment of workers in companies offering 401(k), 403(b) and 457 plans.

Dollar amounts put away for retirement have also fallen short. The 2006 Fidelity Retirement Index showed that the typical working American household had saved only $20,000 toward retirement, and 15% of families had not even started to save.

So one part of the deceit is the idea that “everybody” owns stocks, and “everybody” benefits, from low capital gains tax rates.  The Cato Institute unwittingly underlined the second, most telling part in its Policy Analysis No. 586 (January 8, 2007). 

On page 6 of the analysis Cato’s Alan Reynolds correctly notes that “…in recent years, an increasingly large share of middle-income investment returns have been sheltered inside tax-favored accounts.” On page 7 Reynolds notes, also correctly, that when these investments are withdrawn they will show up as ordinary income.

This means, of course, that the realized capital gains of average Americans are taxed as ordinary income. They are not covered by the capital gains tax cuts passed under Presidents Clinton and Bush (nor should they be, but that is irrelevant here).

To sum up: stockholding is not genuinely widespread in America, and most middle-income Americans who do own stock do not benefit from low capital gains tax rates because their capital gains are taxed at ordinary income rates.

An ounce of truth, a pound of deceit.

3) Repeal The $3,000 Annual Capital Loss Tax Write-off

All the arguments against preferential taxation of stock market capital gains apply with equal force to the tax write-off of the first $3,000 of net capital losses (and more: amounts greater than $3,000 can be carried forward indefinitely until they too are amortized).

Investors in original and secondary offerings fully deserve these write-offs, and for them the amounts should be increased; $3,000 is little more than chump-change these days.

But the write-offs for all other “investors” should end. The government has no business subsidizing stock market losses. It serves no public policy purpose; as for fiscal policy, the only possible result is to cost the Treasury billions upon billions, year after year.

Congress can end these losses, and strike a small blow for tax fairness, by repealing this provision of the Internal Revenue Code.

4) Bond Interest Taxed As Ordinary Income

The arguments for low taxes on capital gains are totally undercut by the taxation of bond interest at ordinary income rates.

Initial and secondary-issue corporate bonds are vital debt instruments. They do create jobs, do grow businesses and do stimulate the economy.

Please note that there is no lack of demand for these offerings. This is true even though the major reason for their purchase, the interest they pay, is taxed at ordinary income rates.