Would Repealing the Tax Break for Capital Gains Raise Revenue?

A lot of attention has been given to a recent report from Congress’s non-partisan Joint Committee on Taxation (JCT) on one possible approach to tax reform. Very generally, the gist of the findings is that getting rid of itemized deductions and the exemption for state and local bond interest can raise enough revenue to offset the cost of repealing certain tax provisions meant to limit tax expenditures for the well-off (the Alternative Minimum Tax being the most prominent among them) and offset the costs of a very small reduction in income tax rates.

There’s a lot to be said about the debate around this, but right now, we’d like to focus on one particularly confusing aspect of the report — its treatment of capital gains.

Currently, capital gains (profits from selling assets) are taxed at lower rates than other types of income like wages. Most capital gains go to the richest one percent of taxpayers, and this tax preference is the main reason why wealthy investors like Mitt Romney and Warren Buffett can pay a lower percentage of their income in federal taxes than many middle-income people.

So there’s an obvious fairness-based argument for ending special, low income tax rates on capital gains and simply taxing them at the same rates as other income, which would be a tax increase mostly on wealthy investors. But would this actually raise much revenue? Surprisingly, two non-partisan Congressional research agencies disagree on this point.

JCT seems to believe that little or no revenue can be raised from this reform, while the Congressional Research Service (CRS) believes JCT is too pessimistic. Citizens for Tax Justice recently followed the approaches supported by CRS, which seem far more plausible, and estimated that ending the preference for capital gains would raise $533 billion over a decade.

JCT assumes large behavioral effects on the part of investors, who (the argument goes) would be inclined to hold onto their assets longer if they will be taxed more upon selling them, resulting in fewer capital gains to be taxed. JCT finds these behavioral effects to be so large that it might estimate no revenue gain from taxing capital gains at the same rates as “ordinary” income. The recent JCT report on tax reform seems to suggest that taxing capital gains as ordinary income either loses some revenue or has no effect on revenue.

On the other hand, CRS has reviewed quantitative research and concluded that JCT significantly overestimates these behavioral impacts. CRS notes, for example, that several economists believe that there are some short-term behavioral effects that JCT and others confuse for long-term effects.

One of the economists cited by CRS is Len Burman, a professor at Syracuse University and former head of the Tax Policy Center, who testified in September before the House Ways and Means Committee and the Senate Finance Committee on the benefits of ending the tax preference for capital gains. CTJ’s $533 billion estimate is calculated assuming the behavioral effects found in Burman’s research, which are much smaller than what JCT assumes. (The appendix in our report on revenue-raising options goes into great detail on the methodology.)

It’s not obvious which approach lawmakers will find more convincing. JCT usually has the final say on revenue estimates, but not always. For example, JCT estimates that both the Republicans’ approach and the Democrats’ approach to the Bush tax cuts would cost trillions of dollars in revenue (because Republicans would extend all of those tax cuts while Democrats would extend most of those tax cuts). And yet, nearly everyone in Congress has ignored those estimates. But that’s a topic for another day.