Capital Gains, Tax Reform, And The Budget

Two weeks ago, I wrote about a claim that increases in tax rates on capital gains reduce revenue (and vice versa).  This week, I would like to put that question in the context of the potential for a budget agreement in Washington – which three weeks ago I wrote is not going to happen in 2012, either before or after the election.

So where will capital gains taxation – and tax reform generally – stand in any budget deliberations?

If either party sweeps the board in November, then that party may succeed in resolving the budget issue all by itself, and all in its own way, early in 2013.  The House of Representatives can do anything that a bare but unified majority wants to do – essentially overnight.  (The “overnight” part is why the staff burn out so quickly, whether their marriages survive or not.)  And just about the only thing that a bare majority can do in the Senate is to pass a budget resolution that includes “reconciliation instructions,” which empower that same bare majority to pass a strictly budget-related “reconciliation bill” that is not subject to a filibuster (that is, endless debate – which can be terminated only with 60 votes).  If a President of the same party is waiting to sign that reconciliation bill, then, bingo – enormous change can be achieved in a very short time.

It isn’t necessarily quite that simple.

For example, although that is how the Congress passed the tax cuts of 2001, and those of 2003, those examples require a footnote.  Because the largest provisions of those laws actually worsened the budget (by reducing revenue), those provisions were required to expire within 10 years.  (That requirement of the budget process was a deal struck at its creation with Senate traditionalists, led by Senator Robert C. Byrd (D-WV).  That requirement is enforced through a “Byrd Rule,” named after that longest-serving Senator in history.)  So reconciliation is powerful, but not all-powerful.

Second, although a unified House and Senate majority can pass any budget-related bill (at least on a temporary basis, and with the “budget-related” qualification defined in the Byrd Rule), narrow majorities can fracture.  Once even small factions within majorities realize that they hold the balance of power, they tend to make demands.  If multiple factions realize that they have that power and begin to issue conflicting demands, a majority can be disempowered.  That almost happened in the 2009-2010 deliberations over health reform (the Patient Protection and Affordable Care Act of 2010) – when even a filibuster-proof Senate majority of 60 initially could not get the work done under regular procedures, and then that majority splintered but managed to hold 56 votes (with all Republicans and three Democrats voting no) to pass the crucial part of the law under reconciliation.

So yes, an election sweep either way could yield a one-party budget fix.  What would a sweep portend for capital gains taxation?  In a Democratic sweep, there likely will be no further tax cuts for capital gains.  If the Republicans sweep, there may well be a capital gains tax cut, and it may well be claimed to increase revenue – at least by its advocates, though probably not by the budget-scoring authorities.

But the probability of an electoral sweep is of course less than 100 percent.  What happens under the scenario of continued divided government?

Some belittle the notion of “balance,” but if control of government remains as it is now, any major budget repair must earn the assent of congressional chambers and a White House controlled by different parties.  Voila:  There must be balance.  So if government remains divided, and the next Congress and President believe that the problem is serious and sufficiently urgent to require action without waiting for the next election cycle, then the legislative package must have something for each party to like – which, in these times of polarization, the opposite party won’t.

Some might harken back to the bipartisan Balanced Budget Act of 1997 for a precedent.  Unfortunately, that one doesn’t fit.  Although the 1997 Act was scored as providing budget savings, the budget already was balanced by any reasonable judgment, and in fact there were goodies in the law for everyone.  The bill actually scored as losing money in fiscal year 1998, its first effective year, which was the year in which the budget attained balance.  And it cut taxes in every year; more than the net total of the budget savings came from spending cuts.  That Act included a capital gains tax cut – which as my earlier post demonstrated had no discernible effect to increase tax revenues.  Capital gains revenues already were growing in step with the economy before, and they grew in step with the economy after – until the economy stumbled in 2001, and capital gains tax revenues stumbled with it.

The most recent relevant precedent – with a divided Congress making hard choices on the tax side of the budget – was the Tax Reform Act of 1986.  The deal they cut was memorialized by the satirical Washington singing group, the Capitol Steps, in “ReaganPackwoodRostenkowskiTaxSimplification,” a play on the “Mary Poppins” tune of a similarly structured title.  (These days that name might look like an Internet address, but remember that this was 1986, back almost all of the way to B.C. – Before Computers.  But if you want an Internet story about the song, check this out.)

Per this song title, the Tax Reform Act garnered broad-based support – beyond President Ronald Reagan and House Ways & Means Chairman Dan Rostenkowski (D-Il), two policymakers who could not have been much farther apart politically.  The Senate Finance Committee vote was unanimous.  The floor vote on the Senate bill was 97-3.  Even after some last-minute loophole closers to raise additional revenue infuriated some previous supporters, the final votes on the conference report were 292-136 in the House and 74-23 in the Senate.  And this for a bill that eliminated dozens of tax preferences – including that for long-term capital gains.

How did the repeal of the capital gains exclusion contribute to the success of the 1986 Act?

Again, a bipartisan majority requires that both sides get something, while they also give something.  Democrats wanted what they perceived to be tax fairness, which included that people with equal incomes should pay equal taxes.  The exclusion for capital gains meant that some people with high incomes paid much less than other people with high incomes.  Eliminating the preference for long-term capital gains reduced the dispersion of tax outcomes substantially.

In return for that, Republicans demanded that overall tax rates be reduced significantly.  And meanwhile, President Reagan’s guidelines from the very outset were that no income group pay higher taxes, and that total tax revenues not increase (or decline either), based on static scoring.  Using the proceeds of a tax increase on corporations, the Tax Reform Act cut taxes for low-income families (in what Senator Daniel Patrick Moynihan (D-NY) called the greatest anti-poverty legislation ever, especially in its increase in the earned-income tax credit for working low-income taxpayers with children), but held income tax liabilities next to unchanged (a small decrease) for the highest income category ($200,000 and over).  All of that was done with a top-bracket tax rate of 28 percent, down from the previous law’s 50 percent.  And that low top-bracket rate would have been unattainable without the elimination of the capital gains exclusion.

So the elimination of the capital gains tax preference helped in the 1986 process in several ways:

First, as mentioned above, was the contribution to fairness through equal taxation of equal incomes.  That involved not only raising the taxes of upper-income people who paid little, but also reducing the taxes of upper-income persons who paid much more – through the lower top-bracket rate on ordinary income.  That in turn helped to create a cooperative and constructive legislative environment.  The objective of tax reform demonstrably was not to “soak” anyone, but rather to achieve fairness.

Second, simplification.  There are many ways to try to measure the intangible commodity of complexity in the tax code.  However, arguably one of the most meaningful had been defined more than a decade prior by tax law scholar Stanley Surrey, in terms of the effort of tax practitioners to reduce tax liability by manipulating economic activity.  Surrey observed that 95 percent of the time in the practice of tax law on behalf of private clients was spent either converting ordinary income into capital gain, or converting capital loss into ordinary loss.  Such manipulation, and the knowledge that it could be done, also distorted the allocation of economic resources toward activities that were so favored by the tax law, rather than activities that earned a higher return in the marketplace.

Third, studies after the fact of the 1986 Act documented that taxpayers simply decided because of the lower tax rates that it was not worth their time and effort to shelter their income from tax.  Rather than necessarily working more, highly compensated individuals took more of their income in taxable salary, and less in exotic forms that would either shield their income from tax or defer tax liability.  In that sense, the “Laffer Curve” worked, but not in the fashion that its advocates originally claimed.

Fourth, reducing the statutory individual top-bracket tax rate allows making it more equal to the corporate tax rate.  (In the Bipartisan Policy Center’s Debt Reduction Task Force proposal, to which CED contributed, the two rates are precisely equal.)  Usually, the corporate tax is an additional layer of taxation.  However, under some circumstances, there can be incentives to recharacterize income from one category to another, which causes waste and economic distortions.  Tax reform without a capital gains exclusion can minimize those distortions.

And finally and most simply, the deal got done.  The House had struggled in 1985 to pass a much more rough-and-ready bill, with a higher statutory tax rate, and only a slight trimming of the capital gains preference.  The Senate Finance Committee could not agree on that bill.  The breakthrough came in a totally new bill submitted to the Committee by Chairman Bob Packwood (R-OR), which got the Members’ attention with its substantial reduction in the maximum rate (in the Packwood version to 27 percent, later increased to 28 percent to meet the revenue target in the face of adverse changes in estimating assumptions), made possible by the elimination of the capital gains exclusion.

Circumstances now are very different.  Another revenue-neutral tax reform would not suffice; significant deficit reduction is urgently needed, and is perhaps the primary reason for tax reform today.  And that leaves a large circle to be squared.  It remains uncertain that congressional Republicans would be willing to yield a significant increase in tax revenue, scored without highly optimistic assumptions of increases in work, saving, investment, and GDP growth.  But if Republicans are to be brought along, they will need something in return.  A significantly lower top-bracket tax rate worked to sell the 1986 deal to Ronald Reagan.  Although President Reagan’s substantive standing with today’s congressional Republicans is unclear, his symbolic ranking apparently remains high.  Meanwhile, another requirement imposed by Democrats will be a greater share of additional revenues on higher- rather than lower-income taxpayers.  Elimination or a meaningful cutback of the capital gains exclusion will be one way to achieve that – with the subsidiary benefit that the additional tax burden will be distributed fairly within the upper-income groups.

Still, this barrier to a deal is just the beginning of the challenge.  Additionally, it is most unlikely that corporate tax revenues can be increased to ease the burden of adjustment on individual income taxpayers.  The 1986 Act started a worldwide trend of reducing corporate income tax preferences and reducing statutory tax rates.  After 1986, other nations followed in our footsteps.  And because many smaller nations do not have our substantial obligations (such as national – i.e. global – defense), some took the opportunity to reduce their corporate tax rates substantially and to campaign actively for global businesses to relocate their profits.  This could be as easy as hiring a resident law firm to hold the global corporation’s patents.  The end result could be characterized as a “race to the bottom” – which requires that the United States at least be competitive with other nations as a location for business headquarters as well as for business operations.

Another obvious complicating factor in the current environment is the mass of temporary tax cuts that are scheduled to expire at the end of 2012.  Allowing the tax system to snap back to its levels of 2000 would by itself virtually solve the budget problem for some years (although today’s healthcare cost growth, unchecked, eventually would overwhelm any level of revenues).  However, the taxpaying and voting public would not tolerate it, and the economy today could not tolerate it.  Implementing and phasing in tax reform now will be substantially more complex and critical than it was in 1986.

A final current complication follows from the overall budgetary situation.  Again, the deficit hole is so large that revenues alone cannot fill it.  In today’s political environment, however, the tax reform that we need would be a significant win for the Democrats, because many congressional Republicans continue to maintain that revenues are not at all the problem.  It is therefore inconceivable that such a tax reform could be agreed to and enacted in isolation.  Republicans would need their own compensation on the spending side, primarily with respect to Medicare, and that reform would be highly complex and difficult to negotiate.  So as difficult as tax reform will be, reaching agreement on tax reform alone will not suffice, and the other tasks that must be accomplished only add to the difficulty and complexity of achieving a much broader, one-piece budget agreement that can achieve enactment.

It is hard to imagine that our dysfunctional political and policy-making process will jump all of the hurdles to address the budget problem in 2012, or even beyond.  But we can and should contemplate the shape that any eventual successful agreement must take.  Revenues must be an important part of any solution; and tax rate reduction, financed with significant broadening of the tax base, is the win-win necessary to achieve bipartisan agreement.  Elimination or at least a significant reduction of the tax preference for capital gains may be the only way to square the circle of higher tax revenue, lower overall tax rates, and a sharing of the burden that will be acceptable in the political process.

The original version of this post referred to the existence of two “Byrd Rules,” named after the late Senator Robert Byrd (D-WV).  In fact, there are two Byrd Rules, but the second one, not discussed explicitly, was named not after Robert Byrd, but rather Senator Harry F. Byrd, Jr. (who was elected from Virginia as a Democrat, but later left the party and became an Independent).  The current version corrects this error.  My apologies to Senator Harry Byrd.

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