Don’t Cut Capital Gains Tax

IT’S AN old trick in politics that whenever there is a dramatic change in circumstances, you wheel out your favorite policy proposal and declare, “Now more than ever … .”

But it is hard to think of a more preposterous example than the plan circulating among congressional Republicans for a temporary cut in the capital gains tax as a response to the recent terrorist attack and the slowing economy.

Capital gains tax cuts, particularly the temporary kind, have three main effects.

First, they encourage investors to sell stocks they have long wanted to liquidate.

Second, they raise short-term tax revenue as people pay the (reduced) capital gains tax rate on their profits.

Third, they cut long-term tax revenue because when the tax rate goes up again there is no longer as much pent-up demand for re-balancing portfolios. That is, a temporary capital gains tax cut would cause a wave of selling on Wall Street in order to take extra tax money out of people’s pockets today at the cost of lower government revenues in five or 10 years when the baby boom is beginning to retire. To top it off, almost all of the net benefits would flow to the richest 2 percent of taxpayers. It would be hard to conceive of a tax proposal that is more perversely the opposite of everything the economy needs at the moment.

Possibly this new attempt to sell a capital gains tax cut by pointing to a slowing economy is attributable to President Bush’s recent success with the “now more than ever” strategy in selling his massive 10-year tax cut.

Originally, his tax cut was proposed as the appropriate response to a booming economy that was projected to generate a large surge in tax collections. But when the economy began to slow, Mr. Bush began arguing that exactly the same tax cut was just what was needed to counteract a slowing economy. In fact, it now seems likely that the long-term deterioration in the budget caused by the tax cut may actually be exacerbating the current slowdown.

The Federal Reserve’s aggressive cuts in short-term interest rates this year have not produced the usual corresponding decline in long-term rates, probably because investors realize that there will now be a lot more government debt than previously anticipated.

The goal of the Fed’s interest rate cuts was partly to revive the moribund business investment sector, but investment responds mainly to long-term interest rates. So if the tax cut has prevented long rates from falling, then it bears some responsibility for the economy’s current weakness.

If Congress wants to use tax policy to stimulate the economy in the short run, it can do several things that make much more sense than a capital gains tax cut.

One would be to roll back some of the tax cuts that are to take place over the longer run, in exchange for temporary cuts now (for example, another tax rebate or a temporary cut in Social Security withholding).

Another possibility would be to pass a temporary Investment Tax Credit (ITC). There is considerable evidence that an ITC would stimulate investment spending, so an ITC would target tax relief to the sector where it is needed most. Further, an ITC that was retroactive to the date of the terrorist attack would directly help the companies whose computer and telecommunications infrastructure was damaged in the attacks and make it cheaper for other companies to quickly adapt to newly increased security needs.

Finally, by making the cut in the ITC temporary, the long-term tax revenue loss would be fairly modest; in particular, the government would not be deprived of much revenue in the longer term, when baby boom retirement looms.

Milton Friedman long ago convinced most economists, liberal and conservative, that it is unwise to attempt to use tax policy for macroeconomic fine-tuning. But if Congress finds the temptation is irresistible, almost anything would be better than a temporary cut in the capital gains tax.