By Neil E. Harl, Charles F. Curtiss Distinguished Professor for Agriculture and Professor of Economics, 515-294-6354, firstname.lastname@example.org
Proposals pending in Congress would create varying degrees of preferential treatment of long-terms capital gains. For the reasons stated below, I believe this would be a mistake.
An important feature of tax policy over the past 30 years has been the gradual curbing of tax shelters. However, if investors can borrow and deduct interest at tax rates up to 39.6 percent and have the funds invested in assets that generate long-term capital gains that are taxed at 14 percent (half of the current rate), tax shelter activity is encouraged.
The effect of this would be to distort the allocation of resources. Due to the tax cut, assets will not move to the most profitable business activities. Rather, they will move to activities where the tax breaks are the greatest.
Assets used in the business
Under the proposals, preferential capital gains treatment would also be available for business assets (i.e. animals held for draft, dairy and breeding). For example, farmers would be inclined to maximize the tax benefits by selling sows after meeting the minimum holding period (12 months) even though economic and management considerations would suggest keeping them.
The greatest impact is to induce more investment in eligible assets, thus driving up the supply of the assets. An example occurred in 1978 when farmers received an extension of the investment tax credit for single purpose agricultural structures (confinement livestock facilities). It was later conceded, even by the most ardent proponents of the move, that it was an economic mistake for farmers. The outcome was that more facilities were built and, once built, were generally kept filled with hogs. This undoubtedly was one of the reasons for long periods of losses in hog production from 1981 to 1985. Once again, preferential tax treatment distorts resource allocation.
A major argument for restoring a capital gains tax break is to encourage older individuals to sell their assets. It is true that a disproportionate amount of farmland is owned by older landowners. However, implementing a lower income tax rate for long-term capital gains is unlikely to unlock assets. As long as land receives a new income tax basis at the owner’s death, many individuals will hold assets until death, even with a lower capital gains rate.
Moreover, the lock in effect is probably overstated for other taxpayers. The lock-in effect is the most serious when a shift to a more productive use of the resource is blocked. It is difficult to make a compelling argument that this is the case. Assets tend to gravitate to other uses because of economic pressures.
Impact on the budget deficit
The evidence is compelling that a reduction in rates for long-term capital gains would be costly for the Treasury. The Joint Committee on Taxation estimates that the more extreme proposals could cost $33.1 billion over the next five years (1997-2002) and nearly $129.3 billion more the next ten years (1997-2007).
Effect on growth
The advocates argue that the lost revenue from cutting capital gains rates would be made up with increased economic growth. Certainly, reductions in capital gains rates would increase investment incentives. However, the evidence is less than compelling that a cut in rates would produce the kind of economic buoyancy expected. For land, a boost in economic growth is only likely if the productivity of capital leaving land investment is greater than the productivity of capital replacing those funds. That difference, if it exits at all, is likely to be modest.
Tax cuts have been viewed for a very long time as a way to spur the economy in times of economic downturn. To cut taxes at a time when the economy is growing and the Federal Reserve is dispensing monetary medicine to limit economic growth and contain inflationary pressures is questionable at best.
Complexity of tax law
Without doubt, the different treatment of long-term capital gains is the biggest factor contributing to the complexity of the Internal Revenue Code. The Code is filled with provisions for limiting or targeting the benefits from the preferential treatment of long-term capital gains. In addition, a substantial body of regulations and rulings focus on distinctions among capital assets, assets used in the trade or business, and inventory-type property. Moreover, many, many cases are litigated each year over those distinctions.
The impact of a cut in capital gains rates on distributing wealth would be substantial. Much of the benefit would accrue to households in the top five percent of the income distribution. It is my view that in the decades to come, one of the great problems of this country will be the growing disparity in wealth among its citizens.