Is It Smart to Repeal the Capital Gains Tax?

The argument for retaining the capital gains tax is multifaceted, with several compelling reasons that underscore the value of maintaining this portion of the tax code. Despite generating significant revenue, the capital gains tax plays a vital role in achieving fiscal equity and economic stability. However, proponents of its repeal often overlook the complexities and potential downsides.

Revenue Generation and Economic Stability

One of the most cited justifications for preserving the capital gains tax is its contribution to federal revenues. On average, it accounts for approximately 4.2% of the total federal revenues, a figure derived from both individual and corporate capital gains. Without this tax, there would be a significant shortfall in government resources to fund essential programs and services.

Illusory Gains and Inflation Adjustment

A significant drawback of the capital gains tax is the focus on nominal rather than real value. Often, the gains reported as capital gains are not true economic gains but rather artifacts of inflation. In the case of a long-held capital asset, such as stock in a business, the purchase price in 1980 of $100,000 would have a much lower purchasing power today. Selling this asset for $300,000 would result in a taxable gain of $200,000. However, adjusting for inflation, the true value could be equivalent to $311,000, indicating a net loss rather than gain. Applying the capital gains tax in this scenario would not only fail to reward the real work of capital growth but could exacerbate the perceived loss by further reducing the total proceeds.

Shift in Risk and Employee Compensation Structure

Abolishing the capital gains tax would likely incentivize individuals and companies to restructure transactions to leverage capital gains exemptions. For instance, companies compensating employees with stock options could become increasingly prevalent. This shift could lead to the misallocation of resources, as companies might pay their employees less in real value while taking the tax savings and the employees gaining more in terms of unrealized capital growth. Such a scenario would shift a substantial amount of financial risk to employees, who would be exposed to the volatility of the stock market, where the value of their options may never materialize. This strategy benefits the corporation and potentially the government, but it subjects employees to considerable financial uncertainty and risk.

A notable benefit of maintaining the capital gains tax is the potential for capital to flow more freely from older, stable companies to newer, riskier startups. However, the current low capital gains tax rate is already conducive to such flow. Raising the tax rate could mitigate this flow but would also curtail the economy's dynamism. Therefore, the potential to streamline capital allocation is already maximized at the current rates, with the current setup being sufficiently flexible to support a thriving market without necessitating abolition.

Impact on Economic Services and Efficiency

Proponents of repeal often argue that reducing the capital gains tax to zero would benefit the economy by enhancing its efficiency. This is not guaranteed by any means. If the government were to increase efficiency to make up for the lost revenue, it could indeed seem like a good idea. Unfortunately, the reality is that a reduction in tax revenue would translate to either a reduction in services or an increase in other taxes, both of which have their downsides. Raising taxes elsewhere tends to unfairly distribute the tax burden and can lead to a reduction in the activities that are taxed, thereby undermining the economy.

In conclusion, the argument against repealing the capital gains tax is robust and involves a nuanced understanding of economic principles. While the tax does generate revenue, its role in addressing inflation-induced gains and promoting fair economic incentives cannot be underestimated. Additionally, the potential risks associated with restructuring transactions to exploit tax benefits and the challenges of reallocating capital without a tax disincentive provide compelling reasons to maintain this important part of the tax code.