Geraldine Gerardi - 4205 

REPORT TO CONGRESS 

on the 

CAPITAL GAINS 

TAX REDUCTIONS 

OF1978 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

September, 1985 
REPORT TO CONGRESS 

on the 

CAPITAL GAINS 

TAX REDUCTIONS 

OF 1978 

September, 1985 

For &ale. by the Superinwocknt of Documonla, UA Govemmenl Pnnting Office 

Waahincl4n, D.C. 20402 
THE SECR ETARY OF THE TREASURY 

WASHINGTON 

September 12 , 1985 

Dear Mr. Chairman: 

Section 555 of Public Law 95-600, the Revenue Act of 1978, 

provides that •the Secretary of the Treasury shall submit 

to the Committee on Ways and Means of the Bouse of Representatives and to the Commi tte e on Finance ot the Senate 

a report on the effectivene ss of the changes made ••• in the 

tax treatment of capital gains of individuals and corporations in stimulating investment and increasing the rate of 

economic growth. The r e port shall also include an analysis 

of the effects these changes had on employment growth and on 

income tax r e venue." 

Pursuant to that section, I hereby submit the •Report to 

Congress on the Capital Gains Tax Reductions of 1978.• 

I am sending a similar letter to Senator Bob Packwood, 

Chairman of the Committee on Finance. 

The Honorable Dan Rostenkowski 

Chairman 

Committee on Ways and Means 

Bouse of Representatives 

Washington, D.C . 20515 

Enclosur e 
THE SECRETA RY OF THE TREASURY 

WASHINGTON 

September 12 , 1985 

Dear Mr. Chairman: 

Section 555 of Public Law 95-600, the Revenue Act of 1978, 

provides that •the Secretary of the Treasury shall submit 

to the Committee on Ways and Means of the Bouse of Representatives and to the Committee on Finance of the Senate a 

report on the effectiveness of the changes made ••• in the tax 

treatment of capital gains of individuals and corporations 

in stimulating investment and increasing the rate of 

economic growth. The report shall also include an analysis 

of the effects these changes had on employment growth and on 

income tax revenue.• 

Pursuant to that section, I hereby submit the "Report to 

Congress on the Capital Gains Tax Reductions of 1978.• 

I am sending a similar letter to Representative Dan 

Rostenkowski, Chairman of the Committee on Ways and Means. 

Sincerely, 

James A. Baker, III 

The Honorable Bob Packwood 

Chairman 

Committee on Finance 

United States Senate 

Washington, D.C. 20510 

Enclosure 
EXECUTIVE SUMMARY 

Overview 

The 1978 Revenue Act (the 1978 Act) reduced the taxation of 

capital gains. The specific changes enacted by Congress 

included: 1) the reduction of the fraction of net long-term 

capital gains included in taxable income from 50 percent to 40 

percent; 2) the elimination of the untaxed portion of capital 

gains from the list of tax preferences subject to an add-on 

minimum tax; 3) the elimination of the "poisoning" of the maximum 

tax on personal service income by the untaxed portion of capital 

gains; and 4 ) the reduction in the tax rate on corporate capital 

gains from 30 percent to 28 pe rc ent . The combined effect of the 

first three changes reduced the maximum individual marginal tax 

rate applied to net capital ga i ns f r om 49 percent to 28 percent. 

In addition, Congress eliminated the taxpayer's option to be 

taxed at a 25 percent rate on the first $50,000 of long-term 

capital gains and enacted a new alternative minimum tax under 

which the excluded portion of capital gains and other designated 

tax preferences were included in the tax base. The maximum 

marginal tax rate on net capital gains under this new alternative 

minimum tax was 25 percent. In the Economic Recovery Act of 1981 

(the 1981 Act), Congress further reduced the maximum marginal tax 

rate on net capital gains to 20 percent and also reduced to 20 

percent the maximum tax rate under the alternative minimum tax. 

In this report, t he Treasury Department presents an in-depth 

analysis of the effects of the 1978 changes in capital gains taxation on investment, economi c growth, economic efficiency, 

income distribution, and Federal tax revenue. The report 

concludes that the reduction in capital gains taxes enacted in 

1978 will over time cause the rate of investment, the capital stock, national income, labor produc t ivity, and the overall 

standard of living to be higher than if the tax treatment of 

capital gains had remained unchanged. For example, the eventual 

increase in national income is estimated to be approximately 0.24 

percent. The highest income group receives the largest proportional gain from the tax cut, while almost all other income 

groups, including the lowest groups, also benefit due to 

increases in the capital stock and i n labor productivity. 

The 1978 Act resulted in subst antial "unlocking" o r increased 

realizations of previously a c crued but unrealized capital gains. 

Two different statistical approaches were utilized to determine 

whether realizations increased sufficiently to prevent a decline 

in Federal revenue. A "cross-sec tion" approach, which analyzes 

how realizations vary across i nd i vidual taxpayers with diffe r ent 

marginal tax rates, p r edicts a n inc rease in realizations 

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sufficiently large to result in a substantial long run increase 

in Federal revenue. An alternative "time-series" approach, which 

analyzes how aggregate realizations respond over time to changes 

in tax rates, indicates a large increase in revenue in the first 

year following the tax cut but significantly smaller increases or 

small reductions in subsequent years . The further reductions in 

capital gains tax rates resulting from the general reductions in 

marginal tax rates in the 1981 Act were also analyzed. The 

cross-section approach again predicts an increase in realizations 

sufficiently large to result in a large long run increase in 

Federal revenue, while the time-series approach indicates a 

relatively small reduction in revenue in the two years following the tax cut. 

Background 

Capital gains taxes have accounted for slightly under 5 

percent of individual income tax receipts in the past decade. In 

1982, the last year for which final data from individual tax 

returns were available at the time of this study, households who 

reported net capital gains paid about $12.9 billion more in 

individual income taxes than they would have paid had their 

taxable capital gain income been zero. This tax on capital gain income amounted to 4.6 percent of individual income tax liability 

in 1982. 

Taxes paid on capital gains have increased in most years in 

the past decade, but have remained virtually constant as a share 

of individual income taxes. Following the 1978 capital gains tax 

cut, capital gains tax revenues increased from $9.3 billion in 

1978 to $11.7 billion in 1979, $12 .5 billion in 1980, $12.7 

billion in 1981, and $12.9 billion in 1982. Capital gains tax 

revenues as a percentage of individual income tax revenues 

increased from 4.9 percent in 1978 to 5.5 percent in 1979, 

declined to 5.0 percent in 1980 and 4.3 percent in 1981, and then 

increased to 4.6 percent in 1982. 

Income from capital gains and capital gains taxes are highly 

concentrated among upper income groups. For example, taxpayers 

with Adjusted Gross Income (AGI) over $100,000 in 1982 reported 8 

percent of total AGI but accounted for 53 percent of the capital 

gains included in AGI and 67 percent of capital gains taxes. 

Although most taxpayers report no capital gains, most returns in 

the very top income groups report some income from gains every 

year. In addition, capital gains (and dividends) are much more 

concentrated among upper income groups than is taxable interest 

income. 

Individuals realize capital gains and losses from the sale of 

a wide variety of different types of capital assets. Corporate 

stock is the capital asset with the largest number of 

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transactions and the largest amount of gross sales value, gross 

gains, and gross losses. Individuals also realize large amounts 

of gains from sales of real estate, business property, and other 

types of assets . 

The rules for taxing capital gains have been controversial 

and have been subject to frequent changes throughout the history 

of the Federal income tax. Major features of the tax treatment 

of capital gains wh i ch have been revi sed include the percentage 

of long-term gains i ncluded in taxabl e income, the holding period 

for classifying gains as short-term or long-term, the treatment 

of capital losses, and special provisions designed either to 

limit the maximum tax rate on long-term capital gains or to 

impose an additional or alternative "minimum tax" on otherwise 

untaxed capital gains. The frequent changes in the tax treatment 

of capital gains have reflected changes in emphasis and 

philosophy, as well as adjustments to other changes in the tax 

law such as changes in marginal tax rates. The 1978 capital 

gains tax changes reflected a growing concern with encouraging 

saving and economic growth, and with removing impediments to the 

sale of capital assets. 

Effects of Reduced Capital Gains Tax Rates on Economic Incentives 

Taxes reduce economic efficiency by distorting incentives for 

individuals and firms. In particular, any tax on the return to 

saving encourages current consumption relative to saving for 

future consumption by lowering after-tax returns to saving. The 

effect of U.S. income tax provisions, including the capital gains 

tax, on real after-tax returns is particularly severe during a 

period of inflation because the current method of computing 

taxable income overstates real income by failing to account for 

the decline in the purchasing power of money over the period the 

asset is held. In addition, the taxation of returns to 

investment under the U.S. income tax creates significant 

distortions among alternative uses of capital because effective 

tax rates vary greatly among different types of capital and 

different methods of financing investment. 

Many of the economic effects of reduced capital gains tax 

rates are positive, but there may also be negative consequences compared to a more general reduction in capital income taxation. 

Reducing capital gains taxes decreases the tax bias against saving and also decreases the incentive to hold, rather than to 

sell, assets with accrued gains. This "lock-in effect" occurs 

because income represented by changes in asset values is usually 

taxed only when realized by sale or exchange instead of as 

accrued, and because gains transferred at death permanently 

escape taxation. A potentially negative economic efficiency 

effect of reducing capital gains taxes, without simultaneously 

reducing other capital income taxes, is that such a change could 

increase the tax bias toward assets with returns in the form of 

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appreciation (growth assets) rather than assets providing 

immediate cash returns (yield assets). Any such differential in 

tax rates among assets can reduce economic efficiency by causing capital to be reallocated to assets wi th lower before-tax 

returns. 

Finally, if capital gains tax cuts reduce revenue, e c onomic 

efficiency losses result indirectly because either present or 

future tax rates must be increased to finance Federal spending 

programs. However, if cutting capi tal gains taxes induces enough 

unlocking of accrued gains that revenues increase, there is an 

efficiency gain since other taxes can be reduced. 

Prior to the 1978 tax changes, real effective tax rates on 

capital assets, defined as the percentage reduction due to taxes 

in the expected annual real before-tax rate of return over the 

life of an asset, were substantially above the tax rate on 

ordinary income for all taxpayers. This occurred even for growth 

assets because the capital gains exclusion and the benefit from 

deferring tax on accrued gains until realization did not offset 

the extra tax burden resulting from the taxation of inflationary 

gains. Since then, three changes -- the 1978 capital gains tax 

reduction, the decline in inflation, and the general reduction in 

marginal tax rates in the 1981 Ac t -- hav e reduced effective tax 

rates on capital assets. 

The reduction in effective tax rates has been more pronounced 

for growth assets . For example, suppose that inflation continues 

at a 4 percent rate in the 1980s, compared to an average rate of 

8 percent in the late 1970s. Consider a representative growth 

asset with an expected real before-tax rate of return of 4 

percent and an expected holding period of 6.5 years. For an 

investor with an "average" marginal tax rate (about 38 percent in 

1978 and 34 percent under 1984 law), the three changes mentioned 

above reduced the real effective tax rate from 44 percent on an 

asset purchased in 1978 to 21 percent on assets purchased in 1982 

or later years. Thus, on average, the real effective tax rate on 

growth assets is currently less than the statutory marginal tax 

rate, even after accounting for continued taxation of 

inflationary gains. Howeve r , the cu rrent 4 percent inflation 

rate is sufficiently h i gh to make the real effective tax rate 

higher than the nominal rate on realized gains. 

Consider next a representative yield asset which increases in 

nominal value at the rate of inflation and has an annual real 

cash flow return of 4 percent and an expected holding period of 

6.5 years. For the average i nvesto r described above, the real 

effective tax rate declined fr om 59 percent for assets purchased 

in 1978 to 40 percent for assets purchased in 1982 or in later 

years. The real effective tax r ate on yield assets remains above 

the statutory marginal tax rate be cause there remains a capital 

gains tax on purely inflationary gains. 

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The capital gains tax changes in 1978 also reduced the 

lock-in effect. Based on data on sales of capit~l assets by 

individuals in 1973 and 1977, the average tax price of 

realizations (the value of assets one would have to sell, gross of capital gains taxes, to finance the purchase of one dollar of 

an alternative asset) in both 1973 and 1977 was only slightly 

greater than 1.00. The tax price of realizations depends not 

only on the marginal tax rate on realized gains, but also on the 

ratio of gains to the total sales price of assets. The average 

tax price of realizations would have decreased by only 2 

percentage points, from 1.05 to 1.03, if the lower tax rates 

under the 1978 Act had been applied to capital assets sold in 

1977. Thus, on average, the disincentive to selling assets 

caused by capital gains taxes, as measured by the tax price of 

realizations, apparently was not large prior to 1978 and was not 

changed significantly by the 1978 Act. 

However, this disincentive to selling assets was reduced 

substantially in the highest income groups. For taxpayers with 

incomes over $200,000, the tax price of realizations would have 

declined by 14 percentage points -- from 1.32 to 1.18 -- if 

post-1978 law instead of 1977 law had been applied to 1977 

realized gains. These taxpayers not only confront high marginal 

tax rates, but also typically realize gains on assets with a high 

ratio of gains to sales price. 

Effects of Reduced Capital Gains Tax Rates on Saving, Economic 

Growth, and the Allocation of Resources Among Industries 

As mentioned above, the 1978 capital gains tax reduction 

increased after-tax r eturns to savers, but had differential 

effects on the cost of capital among industries. The overall 

effects on saving and capital formation were necessarily modest 

because the tax reduction was small as a fraction of the total 

taxation of capital income in the United States. Assets from 

which one might anticipate a significant amount of taxable 

capital gains represent less than one-third of the net worth of 

U.S. households. Moreover, even for these assets, a significant 

portion of the return to saving is in the form of dividends and 

rental income, rather than capital gains. 

A reduction in the capital gains tax has four primary 

consequences for the allocation of capital among industries. 

First, capital is allocated from household to business uses. 

This occurs because capital gains on owner-occupied housing are 

treated especially favorably under current law compared to gains 

on other assets. Because housing capital gains taxes were 

already so low under pre-1978 law, the housing sector received 

only slight benefits from further reductions in capital gains tax 

rates. Second, capital is allocated toward business activities 

in which the returns to investment tend to take the form of 

appreciation in value rather than immediate net cash flow. One 

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example is investment in "natural deferral" activities which are 

likely to encounter a gestation period during which there is 

little or no current revenue and a subsequent pay-out period of 

greater than average cash-flow; these activities include mining, 

energy resource development, othe r activities with long 

construction periods, and investments in development of new 

products and services. Third, capital may be allocated toward 

those industries and firms with low debt-equity ratios and low 

dividend payout ratios. This reallocation will occur to the 

extent that increases in demand for equities in general, and 

growth stocks in particular, result in reduced costs of capital for these industries and firms relative to those that rely more 

heavily on debt finance. Finally, capital in general is 

reallocated toward capital-intensive industries, since such 

industries expand the most when any capital income taxes are cut. 

In the report, a detailed sectoral model of the u.s. economy and tax system is used to simulate the long run effects of the 

1978 capital gains tax reductions on economic growth, capital 

formation, the allocation of capital among 19 major economic 

sectors, and the standard of living of households in 12 different 

income groups. The tax reduction is shown to generate an 

increase in the dollar amount of annual saving and investment of 

slightly over 1 percent. This higher level of investment 

increases the capital stock over time, leading gradually to 

modest (under 1 percent ) long- run increases in annual national 

income, producti vity, and the overall standard of living (defined 

to include the value of leisure time and the expected present value of future consumption). Consumption at first declines 

because a higher proportion of income is saved, but eventually 

increases because the rise in national income makes it possible 

to have both higher consumption and saving . Moreover, the 

temporary decline in consumption is associated with net economic 

gains to households in every time period and merely reflects 

voluntary decisions to save more. After 50 years, simulated 

annual consumption is 0.3 percent greater than levels projected 

under prior law. 

The capital gains tax reduction is shown to provide the 

largest benefit to taxpayers in the highest income group. Mo s t 

other groups also benefit, particularly the lowest income groups, 

because the induced increase in the capital stock raises 

productivity and real before-tax wages. These benefits are 

largest when, due to a permanent increase in realizations, no 

offsetting increases in marginal tax rates are required to 

prevent Federal revenue f r om capital gains taxes from declining. 

The reduction in the capital gains tax is also shown to alter 

the pattern of output in the economy and the allocation of 

capital among i ndustries. The largest increases in output occur 

in capital-intensive industries and their suppliers -- motor 

vehicles, mining (including petroleum and natural gas), metals 

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and machinery, petroleum and refining, and construction. At the 

other extreme, the capital gains tax reduction causes output to 

decline in certain previously tax-favored industries, notably 

real estate {including owner-occupied housing) and agriculture. 

These latter industries do not receive a significant cost 

reduction from the lowering of capital gains taxes. As a result, 

capital is bid away from these industries, their relative 

production costs rise, and output is lower than it would have 

been without the capital gains tax reduction. The movement of 

capital from previously tax-favored industries to other private 

sector activities increases the average productivity of the 

capital stock, raising national income and economic welfare. 

The resulting simulated changes in total saving, output, and 

the allocation of capital among industries are quite small 

compared to the changes that might result in the short run from 

shifts in overall monetary and fiscal policies or changes that 

might result in the long run from other factors, including other 

revisions of Federal tax policy. Therefore, these changes 

probably could not be detected in any statistical comparison of 

the actual path of the economy before and after 1978. The 

economic effects described in this r eport represent estimates of 

the effects attributable solely to the reduction in the taxation 

of capital gains, and not comparisons of the overall performance 

of the economy before and after 1978. 

Effects of Reduced Capital Gains Tax Rates on Emerqinq Industries 

and Venture Capital 

The capital gains tax reduction of 1978 also affected the 

performance of smaller, but important, sectors of the economy 

that are not separately identified in the model used to simulate 

the effects of lowering the capital gains tax. In this regard, 

there has been particular interest in the effect of reducing the 

capital gains tax on investment in new and emerging enterprises. 

The main reason that lower capital gains taxes might cause 

movement of capital from other sectors of the economy to new 

enterprises is that the return to investment in such enterprises 

is likely to be in a form that receives capital gains treatment. 

One area that has received particular attention is the group of enterprises financed through professional venture capital 

firms . Reduced taxation of capital gains is likely to increase 

the supply of funds available to venture capital firms from high 

income individuals. Moreover, reduced taxation of capital gains 

is likely to encourage entrepreneurs to establish new enterprises and thus expands the investment opportunities available to 

venture capitalists. In the 5 years following the 1978 capital 

gains tax cut, the total capitalization of private venture 

capital firms quadrupled, increasing from $3.5 billion in 1978 to 

$12.1 billion in 1983. 

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Still, venture capital firms account for only a very small 

fraction of the U.S. capital stock -- about 0.1 percent of total 

net worth and less than 1 percent of the market value of all u.s. 

non-financial corporations at the end of 1983 -- and thus receive 

only a small share of the tax benefits from reducing the capital gains tax. Moreover, a substantial share of the funding of 

private venture capital firms is supplied by investors not 

directly affected by changes in the tax treatment of capital 

gains . Over 60 percent of the increase in new supplies of funds 

to private venture capital firms between 1978 and 1981 was 

attributable to sources not affected by the 1978 capital gains reductions -- pension funds, insurance companies, endowments and 

foundations, and foreign investors. In fact, while new capital 

supplied by individuals and families -- the groups most affected 

by the reduction in capital gains taxes -- increased from $70 

million in 1978 to $201 million in 1981 and $412 million in 1983, 

the percentage of new venture capital funds supplied by this 

group actually declined from 32 percent in 1978 to 23 percent in 

1981 and 21 percent in 1983. 

Effect of Reduced Capital Gains Tax Rates on Federal Revenue 

Because capital gains taxes are imposed upon gains when 

realized rather than as accrued, there is an incentive to avoid 

the tax by postponing realizations. For taxpayers who wish to 

leave appreciated property to their heirs, this incentive to 

delay realization is strengthened by the ••step-up of basis" for 

gains transferred at death -- the basis of an inherited asset is 

its market value when acquired by the beneficiary rather than the 

cost basis of the decedent. Thus, gains transferred at death 

escape the Federal income tax entirely. Taxpayers may also 

transfer capital gains by gift, in which case the gain is not 

realized at the time of the gift, but the asset is subject to 

"carryover" of basis -- the basis of an asset transferred by gift 

is the cost basis of the donor. As a result of these 

opportunities to avoid or defer realizations, th~ existence of 

capital gains taxes deters some portfolio rearrangements that 

would have been advantageous if there were no tax consequences 

from realizing gains. 

Lowering capital gains tax rates has two effects on 

realizations. First, realizations that would have otherwise 

occurred at a later time are accelerated. Second, some gains 

that would otherwise be held until death and then transferred 

tax-free are realized during the taxpayer's lifetime. As a 

result of these two changes, there is both a one- time unlocking 

of past gains, and a smaller but permanent increase in annual 

realizations when capital gains tax rates are lowered. However, 

whether the increase in realizations is sufficiently large to 

offset the reduction in tax rates and cause revenues to increase 

cannot be determined on theoretical grounds. 

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The quantitative impacts of lower capital gains taxes on 

realizations of capital gains and on revenue from capital gains 

taxes were examined using two separate approaches. The first was 

a "cross-section'' analysis of how realizations of capital gains 

in any given year vary among a cross-section of taxpayers that 

face different marginal tax rates . From existing and new 

Treasury-sponsored econometric studies, estimates were derived of 

how much capital gains realizations would increase in the long 

run if the capital gains tax were lowered. The estimated 

response of realizations to lower tax rates was then used to 

simulate the long run effects on Federal revenue of the changes 

in capital gains taxes enacted in 1978 and 1981. 

The second approach was a ''time series" analysis of how 

aggregate realizations and capital gains tax revenue respond over 

time to changes in tax rates. Estimates were derived of the 

effects of the reductions in capital gains tax rates in the 1978 

and 1981 Acts on realizations and tax revenue over the years 

1979-1982. This analysis accounted for the fact that capital 

gains realizations would have increased over time even if tax 

policy had been unchanged; that is, a simple comparison of 

realized gains across years would be misleading since realized 

gains tend to grow over time. 

The estimates from these two statistical approaches provides 

somewhat conflicting evidence regarding the effect of the 

reductions in capital gains tax rates in the 1978 Act on Federal 

revenue from capital gains taxes. The cross-section analysis 

predicts a substantial long-run revenue increase of $2.1 billion 

at 1979 levels. The time-series estimates indicate a revenue 

increase of between $0.9-$1.1 billion in the first year after the 

tax cut, but significantly smaller increases or small reductions 

in Federal revenue in subsequent years. 

The analysis indicates that capital gain realizations also 

increased in response to the further reduction in capital gains 

taxes associated with the marginal tax rate cuts in the 1981 Act. 

The evidence is again mixed on how Federal revenue from capital 

gains taxes was affected by these further rate reductions. The 

best estimate from the cross-section studies implies that long 

run annual revenue from capital gains taxes, at 1979 levels, 

should have increased by about $1 . 6 billion when the 1981 tax law 

changes were fully phased in. However, time-series analysis of 

the data indicates that the reductions in capital gains tax rates 

in the 1981 Act resulted in relatively small revenue reductions 

in 1981 and 1982 on the order of $100-300 million. 

The findings suggest that long run annual revenue from 

capital gains taxes either increased or declined only slightly as 

a result of the capital gains tax reductions in the 1978 and 1981 

Acts. Nevertheless, even if revenue declined somewhat, it is 

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clear that the decline was much smaller than would be predicted 

by a static estimate that ignored induced increases in gains 

realizations. Moreover, the findings imply that any effort to 

raise substantial revenue by increasing capital gains tax rates, 

given the current parameters of the t ax law, is likely to be 

ineffective. 

Conclusions 

The analysis in this repo rt s upports a favorable evaluation 

of the 1978 capital gains tax reducti ons. The evidence presented 

indicates that these tax reducti ons resulted in a permanent 

increase in annual c apital gains r ealizations, and that Federal 

revenue from capital gain taxes increased substantially in the 

first year after the tax cut and i n the long run either increased 

or declined only slightly . Moreover, the 1978 capital gains tax 

reductions resulted in modest increases in economic growth, capital formation, productivi t y, and l ong run consumption levels. 

The greatest benefits of the t ax changes accrue to the highest 

income group where capital gains are concentrated, but other 

income groups also receive ne t benefits in the long run due to 

the increase in productivity associated with a larger capital 

stock. 

Prior to 1978, the combina tion of high tax rates and 

inflation resulted in extremely high real effective tax rates on 

the return to saving, including saving that gives rise to capital 

gains, despite the exclusion of 50 percent of long-term capital 

gains. Under these circumstances, the 1978 capital gains tax 

reduction not only increased the incentive for private saving, it 

was also one way of reducing the disparity between the tax 

treatment of capital gains and other types of income such as 

wages. However, since 1978, the rate of inflation has fallen 

significantly. Thus, under current circumstances, capital gains 

receive preferential treatment relative to ordinary income. 

Also, recent reductions in marginal tax rates, in combination 

with reduced inflation and the 1978 capital gains tax cuts, have 

substantially reduced real effective tax rates on appreciating 

assets. 

The results of thi s report suggest that, in considering 

further reductions in capital ga i ns taxes, one must weigh the 

benefits from increased incent i ves for private saving against the 

consequences of increasing the d i sparity in tax rates applied to 

different forms of income. Als o , reduc tions in capital gains tax 

rates at some point cause revenue from capital gains taxes to 

fall. Nevertheless, the results imply that increasing the tax 

rate on real capital gains above current levels in the context of 

the current tax system - - an unindexed, realizations-based system 

with step-up of basis for transfers at death and carryover basis 

for transfers by gift -- is unl ikely to result in significant 

increases in revenue from capital gains taxes. 

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TABLE OF CONTENTS 

Page 

Executive Summary . .. . ....... . ........ . .... . .. ... ............ i 

Table of Contents... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi 

List of Tables... . ............ . ... . .. . ...... .. . . ...... . ..... xv 

Chapter 1 --BACKGROUND INFORMATION.. . . . ............. .. ..... 1 

I. An Overview of Capital Gains Taxation in the 

United States............................ ... ...... . .. . . 1 

A. current Tax Provisions .. :......... ... ......... .... 1 

B. Distribution of Capital Gains by Income Group.. . . . 3 

c. Distribution of Capital Gains by Asset Type .. . .... 15 

D. Trends in Capital Gains Receipts .. . . . . . . ... .. . ... . 20 

II. The Legal Distinction Between Ordinary Income and 

Capital Gain................. . ... .. .... ... . . .... . ...... 22 

A. Introduction................ ... ....... . . . .. .... ... 22 

B. Holding Period........................ . ... . . . ... . . 24 

c . Definition of a Capital Asset .. ... . ............. . . 25 

D. Sale or Exchange. .. .......... . ..... . ... .. . ... ... . . 27 

E. Illustration of Problems caused by Capital Gain/ 

Ordinary Income Distinction .. ........ .. .. . ........ 27 

III. A History of the Capital Gains Taxation of Individual s . 29 

A. The Tax Treatment of Capital Gains from 1913 

to 1953 . .................... . ..... . ...... ... . . . . .. 31 

B. The Internal Revenue Code of 1954 and the Tax 

Treatment of Capital Gains from 1954 to 1978 ..... . 33 

C. The Taxation of Capital Gains Since the 

197 8 Revenue Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 

D . Summary . . . . . . . . . • • . . . . . . • . . . . . . . . . . . . . . • . . • • • • . . . . 3 9 

IV. An International Comparison of Capital Gains Taxation . . 39 

Footn otes to Chapter 1 ..... . .. . ......... . .....•. . ....• . 47 

Chapter 2 -- ECONOMIC INCENTIVES AND CAPITAL GAINS 

TAXATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 

I. A General Discussion of Economic Efficiency Losses .... . 52 

II. The Effects of Capital Gains Taxation and Inflation 

on saving Incentives and Asset Choices. ......... . ...... 57 

A. Int reduction.... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 

B. The Effective Tax Rate on Capital Gains ... .. .....• 58 

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C. Effects of the 1978 and 1981 Tax Changes .......... 63 

D. Ev idence from Sales of Capital Assets Files ....... 69 

III. The Effect of Capital Gains Tax ation on the Incentive 

to Sell Appreciated Assets . . .. .... ... .. . .... . .... ... ... 75 

A. Introducti on.... . ........ .. ................... .... 75 

B. Empirical Ev idence on the Effects of Taxing 

Sales of Appreciated Assets .. ....... . ....... . .. . . . 80 

c. Realization as a Productive Decision........... . .. 86 

IV. Summary .............................................. .. 87 

Footnotes to Chapte r 2...... .. . ... ... . ... .. .. .. . ....... 92 

Chapter 3 -- THE EFFECTS OF CAPITAL GAINS TAX REDUCTIONS 

ON SAVING, ECONOMIC GROWTH AND RESOURCE 

ALLOCATION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 

I. The Effects of Capital Gains Tax Reductions on Saving 

Incentives ............. . ... : ........................... 98 

A. Introduction.................... . .... . ............ 98 

B. Effe c ts on Expected After-Tax Returns ............. 99 

c. Effects on Sav ing and Capital Formation ........... 103 

D. Conclusions ....... . . . ............................. 107 

I I . The Effects of Cap i tal Gains Tax Reductions on 

Financial Markets and Capital Allocation . ... . . . .... .... 107 

A. General Discussion ... .. .. . ............ . . ...... .... 107 

B. Qualifications .......................... . . . .... . . . 109 

C. Conclusions ........................... .. .. ... . ... . 112 

III. General Equilibrium Model Estimates of the Effects of 

Capital Gains Tax Reductions on Capital Allocation, 

Economic Growth, and Welfa r e ........ . ......... . ........ 112 

A. Introduction ...................................... 112 

B. Simulation Results ...... .. . . ...................... 114 

C. Conclusions....... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 

IV. The Effects of Capital Gains Tax Reductions on 

Emerging and High-Technology Firms .. ................... 132 

A. Introduction .... . ................................. 132 

B. Effects on Risk-Taking and Natural Deferral 

Act i vi ties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 3 

c. Effects on Emerging Hi gh-Growth , High-Technology 

Firms ... . . ....... . ............... ..... ............ 134 

D. Effects on the Supply of Venture Capital . ... . ..... 139 

E. Conclusions .... . .. .. .. . .......... .. ............... 146 

Footnotes to Chapter 3 ........ ... .. .. ... ... . . .......... 148 

-xii-
Chapter 4 -- THE EFFECTS OF CA.PITAL GAINS TAX REDUCTIONS 

ON FEDERAL REVENUE. . . . • • • . • . . • . . • . • . . • . • . • . . • . • 151 

I. Introduction .... ... ........ .. .......................... 151 

A. Effects on Realizations and on the Income 

Tax Base .......................................... 151 

B. Historical Evidence on Realizations ........ .. .. ... 153 

c. Statistical Approaches ...... .. ............ ........ 157 

II. Evidence from Cross-Section Studies .... ..... ...... .. .. . 157 

A. Introduction ... .. ....................... . .... . .... 157 

B. Issues in Cross-Section Studies of Gains 

Realizations . . .. .... . ........ ... .. .. .. ............ 158 

C. Summary of the Results of the Panel Study ......... 162 

D. Simulated Revenue Effects of the 1978 and 1981 

Tax Changes....... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166 

III. Evidence from Time-Series Analysis ... ............... ... 175 

A. Introducti on ... .... ..... ........ ......... .. .... ... 175 

B. Projecting Revenue from Capital Gains Taxes with 

a Time-Series Model ... .... .................. ...... 175 

C. An Alternative Comparison Taking into Account 

the Effect of Capital Gains Tax Changes on the 

Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 7 9 

D. Summary and Evaluation .... . . . ........... . . ... ..... 185 

IV. Conclusions ... ...... ................................... 186 

Footnotes to Chapter 4 ..... .. ........ . ... . .... .. ....... 188 

Appendix A BRIEF DESCRIPTION OF THE TREASURY GENERAL 

EQUILIBRIUM MODEL . • • • • • • • • • • . • . • • • • • • • • • . • • • . • . 19 3 

I . Structure and Assumptions of the Model ................. 193 

II. The Effects of Changing the Capital Gains Tax in 

the Mode 1 . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 5 

Footnotes to the Appendix .............................. 199 

-xiii-
Table 1.1 

Table 1.2 

Table 1.3 

Table 1.4 

Table 1.5 

Table 1.6 

Table 1.7 

Table 1.8 

Table 1.9 

Table 1.10 

Table 1.11 

Table 1.12 

Table 1.13 

Table 1.14 

LIST OF TABLES 

Capital Gains in Adjusted Gross Income (AGI) as 

a Percentage of AGI by AGI Class, 1982... .... .. . 5 

Capital Gains in Adjusted Gross Income (AGI) 

as a Percentage of AGI by AGI Class, 1973....... 6 

Capital Gains in Adjusted Gross Income (AGI) 

as a Percentage of AGI by Permanent AGI Class, 

1973............................................. 8 

Permanent Capital Gains in Permanent Adjusted 

Gross Income (AGI) as a Percentage of Permanent 

AGI by Permanent AGI Class, 1971-1975........... 9 

Comparison of Nominal and Real Capital Gains on 

Sales of Selected Capital Assets by AGI 

Class, 1977.......... .... .. ..................... 11 

Percentage Distribution of Different Forms of 

Income from Capital by AGI Class, 1982 .......... 13 

Percentage of Returns Realizing Gains by 

Permanent AGI Class, 1971-1975 .................. 14 

Percentage Distribution ~f Gains and Losses on 

Sales of Capital Assets by Asset Type, 1973 ..... 16 

Percentage Distribution of Gains and Losses on 

Sales of Capital Assets by Asset Type, 1977 ..... 18 

Capital Gains Taxes Compared to Individual 

Income Tax Liability, 1970-1982 ................. 21 

Net Gains and Losses in Adjusted Gross Income, 

1973-1982....................................... 23 

Summary of Tax Treatment of Capital Gains, 

1913-1953....................................... 34 

Maximum Marginal Tax Rates on Long-Term 

Capital Gains, 1954-1978 ........................ 37 

International Comparison of Taxation of 

Individual Non-Business Capital Gains ..•.•...... 41 

- xv-
Table 2.1 Effects of Inflation and Holding Period on 

Effective Tax Rates on Growth Assets and Yield 

Assets for a Taxpayer in the 50 Percent Bracket 

with a 60 Percent Exclusion .. . ...... .. .. . ... . ... 62 

Table 2.2 Effects of Inflation and Tax Law Changes on 

Effective Tax Rates on Growth and Yield Assets 

for a Top Bracket Taxpayer ...................... 65 

Table 2.3 Effects of Inflation and Tax Law Changes on 

Effective Tax Rates on Growth and Yield Assets 

for an Average Recipient of Gains on Corporate 

Shares... . ..... .. ..... .. ............. . .... . ..... 67 

Table 2.4 Rea l Effec t ive Tax Ra t es Applied to Capital 

Gains Income, 1973 and 1977 Realizations ........ 72 

Table 2.5 Real Effective Tax Rates on Capital Gains Income 

Under Alternative Tax Rules, 1977 Realizations .. 73 

Table 2.6 Annual Rates of Return and Effecti ve Tax Rates 

on Corporate Shares by Holding Period, 1977 

Realizations..... . . ... ............... . ....... . .. 76 

Table 2.7 Annual Rates of Return and Effective Tax Rates 

on Corporate Shares by Income Class, 1977 

Realizations ................................. . .. 77 

Table 2.8 Tax Pr ice of Reali z ations for Long-Term Sales, 

1973 Reali zations .. . ..................... .... .. . 82 

Table 2.9 Tax Price of Reali z ations for Long-Term Sales 

Under 1977 Law, 1977 Realizations ..... .. . ..... . . 84 

Table 2.10 Tax Price of Realiza t ions for Long-Term Sales 

Under 1979 Law, 1977 Realizations ............... 85 

Table 2.11 Example of Optimal Holding Periods of Asset 

Table 3.1 

Table 3.2 

Table 3.3 

Held for Future Consumption Value ... ... ..... .. .. 88 

Household wealth by Asset Type, 1979 ........... . 100 

Initial Change in After-Tax Return on Capital 

Gains Assets Due to the 1978 Act by Asset 

Type . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 1 

Initial Change in After-Tax Return on Capital 

Gains Assets Due to the 1978 Act, by Asset Type 

with Estimated Gains at Death Excluded .......... 104 

-xvi-
Table 3 . 4 General Equilibrium Effects on National 

Aggregates of the 1978 Capital Gains Tax 

Reduction with an Additive Replacement Tax ..... . 117 

Table 3.5 Changes in Output, Capital Use, and Labor Use 

After 20 Years from 1978 Capital Gains Tax 

Reduction with Additive Replacement Tax ....... .. 119 

Table 3.6 Changes in Real Consumption and Welfare by 

Income Class from the 1978 Capital Gains Tax 

Reduction with an Additive Replacement Tax . . . . .. 121 

Table 3.7 Consumer Product Consumption Changes from the 

1978 Capital Gains Tax Reduction with an 

Additive Replacement Tax ......... . .. . ... . ... . ... 122 

Tabl e 3.4a General Equilibrium Effects on National 

Aggregates of the 1978 Capital Gains Tax 

Reduction Assuming No Revenue Cost ........ .. . ... 124 

Table 3.6a Changes in Real Consumption and Total Welfare 

by Income Class from the 1978 Capital Gains 

Tax Reduction Assuming No Revenue Cost ... ... . . .. 126 

Table 3.4b General Equilibrium Effects on National 

Aggregates of a Reduction in Capital Income 

Inclusion Rate s of 4.3 Percent with an Additive 

Replacement Tax ......... . ..... . ..... . .. . .... . .. . 128 

Table 3 . 5b Changes in Output, Capital Use, and Labor Use, 

by Industry After 20 Years from a Reduction in 

Capital Income Inclusion Rates of 4 . 3 Percent 

with an Additive Replacement Tax .. . ............ . 129 

Table 3.6b Changes in Real Consumption and Welfare by 

Income Class from a Reduction in Capital Income 

Inclusion Rates of 4.3 Percent with an Additive 

Replacement Tax . . . . ..... . . . . ... .. ..... . ....... . . 130 

Table 3.8 Equity Offerings as a Share of Corporate 

Primary Cash Offerings by Industry Groups .... ... 135 

Table 3.9 Relative Importance of Equity Finance for 

Selected Industries, by Size of Firms, 1976 .. . . . 13 7 

Table 3.10 Ratio of the Dollar Volume of New Equity to 

the Dol lar Volume of New Debt by Age of Firm .... 1 38 

Table 3.11 Venture Capital Investme n ts by Type of 

Investment ... . .. ..... .. ... . .. . . ... . . ... . .. ... ... 140 

-xvii-
Table 3.12 Average Share of External Capitalization of 

Small Technology-Based Firms by Type of Security 

and Type of Investor .................•......•... 141 

Table 3.13 Average Share of External Capitalization of 

Small Non-Technology-Based Firms by Type of 

Security and Type of Investor ................... 143 

Table 3.14 Sources of Committed Capital to Independent 

Private Venture Capital Funds . ... . .............. 145 

Table 4.1 Capital Gains Taxes Paid on Capital Gain Income 

for Returns with Net Capital, 1954-1982 ......... 154 

Table 4.2 Capital Gains by AGI Class, 1978-1982 ........... 155 

Table 4.3 Estimated Elasticities of Net Long-Term Capital 

Gains Realizations with Respect to Permanent 

Marginal Tax Rates on Long-Term Gains ........... 163 

Table 4.4 Comparison of Estimated Tax Elasticity for All 

Table 4.5 

Table 4.6 

Table 4.7 

Table 4.8 

Table 4.9 

Table 4.10 

Table 4.11 

Table 4.12 

Gains and Estimated Tax Elasticities for 

Subsets of Assets ....... ..........•.•......... .. 165 

Simulated Net Long-Term Capital Gains, Pre-1978 

Law and 1979 Levels .•......•.•. ......••...•..... 168 

Simulated Revenue from Capital Gains Taxes, 

1979 Levels ................. . ................... 169 

Simulated Effect of 1978 Capital Gains Cuts on 

Revenue from Capital Gains Taxes, 1979 Levels ... 170 

Simulated Net Long-Term Capital Gains under 

1984 Law, 1979 Levels ........................... 172 

Simulated Revenue from Capital Gains Taxes 

Under 1984 Law, 1979 Levels ............... .. .... 173 

Simulated Effect of 1981 Tax Rate Cuts on 

Revenue from Capital Gains Taxes, 1979 Levels ... 174 

Comparison of Actual and Projected Capital 

Gains, 1979-1982 ..........•......•.............. 177 

Comparison of Actual and Projected Revenue 

From Capital Gains Taxes, 1979-1982 ......•...... 178 

-xviii-
Table 4.13 Estimated Effects of Capital Gains Tax Rate 

Reductions on Value of Household Holdings of 

Corporate Stock, 1979- 1982 .. . ......... .. ........ 182 

Table 4.14 Comparison of Actual and Projected Capital 

Gains Taking into Account Estimated Effects of 

Capital Gains Tax Reductions on stock Values, 

1979-1982 .. . .... . . . . . ... . . ....... . .............. 183 

Table 4.15 Comparison of Actual and Projected Revenue 

From Capital Gains Taxes, Taking into Account 

Estimated Effects of Capital Gains Tax 

Reductions on Stock Values, 1979-1982 ....... . ... 184 

-xix-
Chapter 1 

BACKGROUND INFORMATION 

This chapter provides background information on the tax 

treatment of capital gains. The first section provides an 

overview of capital gains taxation in the United States. It 

includes: (a) a summary of the major provisions under current 

law pertaining to the taxation of capital gains received by 

individuals; (b) data on the distribution of capital gains by 

income class; (c) data on the distribution of capital gains by 

asset type; and (d) estimates of capital gains tax revenues in 

recent years. Section II discusses in more detail the legal 

definition of a capital gain, the problems created by the fact 

that economically similar transactions are taxed differently 

under current law, and the distinctions made in the tax law to 

address these problems. The third section reviews the history of capital gains taxation in the United States, and the final 

section briefly compares capital gains taxation among the OECD 

countries. 

I. An Overview of Capital Gains Taxation in the United States 

This section provides an overview of the taxation of capital 

gains in the United States. It contains a brief summary of major 

features of the tax law and how they were changed in 1978, 1981, 

1982, and 1984, and presents tables showing the distribution of 

both nominal and real capital gains by income class as compared 

to the distribution of both all income and other forms of capital 

income. It also examines the distribution by asset type of 

capital asset transactions, sales value, gross gains, and net 

gains. It then describes the growth over time of both capital 

gains in adjusted gross income and revenue from capital gains 

taxation, relative to total revenue from the individual income 

tax. 

A. Current Tax Provisions 

The discussion below of current law provisions briefly outlines general tax rules that apply to broad classes of 

transactions. It takes no account of the many exceptions to the 

general rules. Only the rules applicable to individuals are 

discussed. A more detailed, but also far from complete, 

discussion of tax law provisions relating to capital gains is 

provided in the second section of this chapter. 

A capital gain or loss is the increase or decrease in value 

realized upon the sale, exchange or other taxable disposition of 

a 11 capital asset 11 • • !/ Gain or loss is computed by subtracting the 

asset's basis (usually, but not always, its cost less any 
-2-

depreciation) from the net amount realized. "Capital assets" are 

essentially investment property (including property for personal 

use) or property used in a trade or business.2/ Gain or loss 

from the sale or exchange of property that is-not a "capital 

asset" is taxed as ordinary income or loss. 

In general, capital gains and losses from the ownership of 

"capital assets" are only taken into account for tax purposes 

when realized by sale, exchange, or other taxable disposition. 

Transfers of asset ownership by gift or bequest are not 

considered realization events, but gifts and bequests each have 

different consequences for the recipient. The recipient of a 

gift takes the basis of the donor for the computation of any 

capital gains from future realizations, and the lesser of fair 

market value or the basis of the donor for the computation of any 

capital losses from future realizations. In contrast, for 

property transferred at death by bequest or inheritance, the heir 

generally takes as his basis the asset's value on the decedent's 

date of death. Therefore, any unrealized gain or loss that had 

accrued during the decedent's lifetime is never subject to tax. 

Under current law, 40 percent of the net capital gain for a 

year is included in a taxpayer's adjusted gross income. "Net 

capital gain" is basically the long-term capital gains realized 

during the year reduced by the sum of (a) long-term capital 

losses for the year and (b) the amount by which short-term 

capital losses for the year exceed short-term capital gains for 

the year. The amount by which short-term capital gains exceed 

the sum of (a) short-term capital losses for the year and (b) the 

excess of long-term capital losses over long-term capital gains is taxed as ordinary in~ome. 

Since the maximum marginal tax rate was lowered from 70 

percent to 50 percent in the Economic Recovery Tax Act of 1981 

(the 1981 Act), the maximum tax rate on net capital gains for 

individuals is now 20 percent. Prior to the 1978 Revenue Act 

(the 1978 Act), 50 percent of net capital gains was included in 

adjusted gross income, and the excluded portion of long-term 

capital gains in excess of the greater of $10,000 of preferences 

or one half of regular tax liability was subject to the minimum 

tax of 15 percent applied to preference income. In addition, 

excluded capital gains offset income entitled to the benefits of 

the 50 percent maximum tax on personal service income. These 

provisions, combined with the 70 percent top rate under the 

personal income tax, theoretically confronted taxpayers with a 

tax rate as high as 49 percent on net recognized capital gains. 

Capital losses may be fully offset against capital gains. In 

addition, short-term losses (in excess of both short-term gains 

and long-term gains in excess of long-term losses) and 50 percent 

of long-term losses (in excess of both long-term gains and 

short-term gains in excess of short-term losses) may be deducted 

from ordinary income, up to a maximum deduction of $3,000. 
-3-

Losses in excess of the $3,000 limit may be carried forward for 

an unlimited number of years. 

There are special rules for the taxation of trade or business 

assets. In general, if there is a net gain on all such assets 

for the year, the gain or loss on each asset is treated as 

long-term capital gain, subject to the rules outlined above. If 

there is not a net gain on all such assets for the year, the gain 

or loss on each asset is ordinary income or loss. 

A sale of a capital asset is defined as a long-term 

transaction if the asset has been held for more than 6 months. 

The holding period required for a gain or loss to be defined as 

long term had been over 6 months prior to 1977, but was increased 

in the 1976 Tax Reform Act to over 9 months in 1977 and over 1 

year in 1978 and subsequent years. In the Deficit Reduction Act 

of 1984 (the 1984 Act), Congress reduced the holding period back 

to over 6 months for assets purchased between June 22, 1984 and 

January 1, 1988. 

Special treatment is accorded to a capital gain on the sale 

of a taxpayer's principal residence. Generally, recognition and 

taxation of the gain are deferred if another principal residence 

of equal or greater value is bought and occupied within 2 years 

before or after the sale. In addition, a person who is 55 years 

of age or older may exclude from adjusted gross income $125,000 

of capital gain resulting from the sale of his personal residence 

once in his lifetime. 

Finally, since the 1978 Act, capital gain has been subject to 

an alternative minimum tax. The base for the alternative minimum 

tax is computed by adding the excluded portion of capital gains 

(60 percent of net long-term gains) and certain other tax 

preferences to gross income less specified personal deductions. 

As modified in the Tax Equity and Fiscal Responsibility Act of 

1982 (the 1982 Act), the alternative minimum tax is imposed at a 

rate of 20 percent of alternative minimum taxable income in 

excess of $30,000 for unmarried individuals, $40,000 for married 

persons filing a joint return, and $20 , 000 for a married person filing a separate return. (Prior to the 1982 Act, the base was 

taxable income plus excluded capital gains plus excess itemized 

deductions.) If the alternative minimum tax so computed exceeds 

the taxpayer's regular tax, his tax liability is equal to the 

alternative minimum tax; otherwise, his tax liability is equal to 

the regular tax. Thus, unlike the add-on minimum tax under 

pre-1978 law, the present alternative minimum tax does not 

increase the maximum tax rate on net long-term capital gains. 

B. Distribution of Capital Gains by Income Group 

Income from the sale of capital assets is concentrated at the 

upper end of the income distribution. Taxpayers with the highest 

incomes receive a much larger share of total capital gains than 
--- -----------~ 

-4-

of total adjusted gross income (AGI). Furthermore, capital gains 

comprise a large proportion of taxpayers' AGI only among those at 

the highest income levels. 

Table 1.1 shows that reported long-term capital gains in AGI 

(among those taxpayers with net gains) accounted for slightly 

more than 2 percent of AGI on all tax returns filed for 1982.3/ 

However, capital gains accounted for 6.2 percent of AGI for - returns with AGI between $100,000 and $200,000, 12.9 percent of 

AGI for returns with AGI between $200,000 and $500,000, and 32.2 

percent of AGI for returns with AGI in excess of $500,000. 

The last two columns of Table 1.1 compare the cumulative 

distributions of AGI and capital gains. While taxpayers with AGI 

under $50,000 accounted for almost 80 percent of AGI, they 

received just over 30 percent of capital gains in AGI. The 

concentration of gains at the very top of the distribution is 

even more striking. For example, taxpayers with AGI over 

$100,000 received 8 percent of AGI, but almost 53 percent of 

capital gains in AGI. 

The data in Table 1.1 exaggerate to some extent the 

concentration of capital gains among taxpayers with persistently 

high incomes because an individual taxpayer's income in any one 

year can sometimes be significantly affected by the amount of 

gain realized. As gains realizations can vary greatly from year 

to year for any individual, at least part of the tendency for 

capital gains reported in a single year to be concentrated among 

taxpayers with high incomes in that year results from the fact 

that individuals with temporarily higher realized capital gains also have temporarily higher AGI. Therefore, the question of the 

extent to which capital gains are concentrated among those with a 

persistently high AGI -- rather than an AGI temporarily increased 

by large gains -- cannot be determined without examining gains 

realizations and AGI for individual taxpayers over a more 

extended time period. 

Tables 1.2-1.4 present data on the distribution of gains by 

AGI class using a 5 year panel study of taxpayers for the years 

1971-1975. These data show that capital gains are also very 

concentrated among taxpayers with the highest permanent, as well 

as current, AGI. Average capital gains over a 5 year period are 

also very concentrated among those with the highest permanent 

AGI. Thus, although using a single year's distribution of gains 

by AGI exaggerates to some extent the degree to which gains are 

concentrated among those with persistently, as opposed to 

temporarily, high levels of AGI, the data from the 5 year panel 

study generally confirm the distributional results shown in Table 

1 . 1 . 

Table 1.2 presents the same data as Table 1.1 for 1973. 

Because of the rise in nominal incomes (mostly due to inflation) 

between 1973 and 1982, taxpayers below any given level of AGI 
- 5-

Table 1.1 

Capital Gains in Adjusted Gross Income (AGI) 

as a Percentage of AGI by AGI Class, 1982 

Capital Capital Cumulative 

gains Total gains Eercentage of: 

AGI in AGI AGI as % I Capital 

($thou) ($bil) ($mil) of AGI AGI I gains 

5 or less 2,918 20,723 14.1 1.1 7.6 

5-10 834 127,637 0.7 8.0 9.7 

10-15 1,227 177,486 0.7 17.6 12.9 

15-20 944 182,642 0.5 27.5 15.4 

20-25 945 197,908 0.5 38.1 17.8 

25-30 1,253 209' 572 0. 6 49.5 21.1 

30-40 2,098 340,036 0.6 67.8 26.5 

40- 50 2,160 208,952 1.0 79.1 32 . 1 

50-75 3,523 179,566 2.0 88.8 41.3 

75- 100 2,282 59,748 3.8 92.0 47.2 

100-200 4,671 75,291 6.2 96.1 59.3 

200-500 5,156 39,974 12.9 98.2 72.7 

500+ 10,505 32,600 32 . 2 100.0 100.0 

Total 38,514 1,852,135 2.1 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: U.S. Internal Revenue Service, Statistics of Income- 1982 

Individual Income Tax Returns (Washington, D.C., 1984), 

pp . 44 and 48 . 
- 6-

Table 1.2 

Capital Gains in Adjusted Gross Income (AGI) 

as a Percentage of AGI by AGI Class, 1973 

AGI 

($thou) 

5 or less 

5-10 

10-15 

15-20 

20-30 

30-50 

50-100 

100-200 

200-500 

500-1,000 

1,000+ 

Total 

Capital 

gains 

in AGI 

($mil) 

315 

1,365 

1,201 

978 

1,482 

1,589 

1,638 

1,338 

821 

455 

416 

11,598 

Total 

AGI 

($mil) 

30,284 

110,370 

172,159 

136,043 

118,916 

52,588 

30,699 

10,513 

3,999 

1,102 

995 

667,668 

Capital 

gains 

as % 

of AGI 

1.0 

1.2 

o. 7 

0.7 

1.2 

3.0 

5.3 

12 . 7 

20.5 

41.3 

41.9 

1.7 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Cumulative 

percentage of: 

4.5 

21.1 

46 .8 

67.2 

85.0 

92.9 

97.5 

99.1 

99.7 

99.8 

100.0 

2.7 

14.5 

24.8 

33.3 

46.0 

59 . 7 

73 .9 

85.4 

92.5 

96.4 

100. 0 

August, 1985 

Source: 1973 Sales of Capital Assets Study , Five-Year Panel . 
-7-

accounted for a larger share of both AGI and capital gains in AGI 

in 1973 than in 1982. A comparison of the cumulative 

distributions of AGI and capital gains in AGI in 1973 and 1982 

shows a higher concentration of gains among those with relatively 

high current AGI in 1982 than in 1973. For example, in 1973 

taxpayers with AGI of $30,000 or more accounted for 54.0 percent 

of gains and 15.0 percent of AGI. By comparison, in 1982, 

taxpayers with AGI of $100,000 or more accounted for 52.8 percent 

of gains but only 8.0 percent of AGI. 

Table 1.3 shows the distributions of capital gains and AGI in 

1973 by permanent AGI class, where permanent AGI is defined as 

the taxpayer's average AGI for the years 1971-1975. In 1973, 

capital gains accounted for 1.7 percent of AGI for all returns in 

the sample. Capital gains accounted for 11.6 percent of AGI for 

taxpayers with permanent AGI between $100,000 and $200,000; 19.8 

percent of AGI for taxpayers with permanent AGI between $200,000 

and $500,000; 29.9 percent of AGI for taxpayers with permanent 

AGI between $500,000 and $1,000,000; and 19.6 percent of AGI for 

taxpayers with permanent AGI greater than $1,000,000. In 

comparison, the single year data reported in Table 1.2 show a 

greater tendency for capital gains to increase as a share of AGI, 

especially for taxpayers with AGI over $500,000. Table 1.2 shows 

that capital gains accounted for 12.7 percent of current (1973) 

AGI for taxpayers with AGI between $100,000 and $200,000; 20.5 

percent of AGI for taxpayers with AGI between $200,000 and 

$500,000; 41.3 percent of AGI for taxpayers with AGI between 

$500,000 and $1,000,000; and 41.9 percent of AGI for taxpayers 

with AGI greater than $1 million. 

Table 1.3 also shows that taxpayers with permanent AGI of 

$100,000 or more accounted for 2.1 percent of AGI and 18 . 5 

percent of capital gains in AGI in 1973. In comparison, Table 

1.2 shows that taxpayers with 1973 AGI of $100,000 or more 

accounted for 2.5 percent of AGI and 26.1 percent of gains in AGI 

in 1973. Thus, the data in Tables 1.2 and 1.3 illustrate that 

data on capital gains for a single year will tend to overstate 

the concentration of gains among taxpayers in the highest AGI 

categories. This is because high income groups, classified by 

single year income, will tend to include disproportionately more 

taxpayers with temporarily high incomes caused in part by large 

capital gains. The differences are especially pronounced for 

taxpayers with AGI of $500,000 or more . It remains the case, 

however, that taxpayers with the highest permanent AGI receive a 

much larger share of capital gains than of AGI, and that capital 

gains comprise a large share of AGI only for taxpayers at the 

highest permanent income leve l s . 

Table 1.4 shows the 1973 distribution of permanent capital 

gains by permanent AGI class, where both permanent gains and 

permanent AGI are defined as averages for the years 1971-1975 for 

each taxpayer filing returns in all 5 years. The distributional 

results shown in Table 1.4 are similar to those reported in Table 

485-125 0 - 85 - 2 
Permanent 

AGI 

($thou) 

5 or less 

5-10 

10-15 

15-20 

20- 30 

30- 50 

50- 100 

100- 200 

200-500 

500- 1,000 

1,000+ 

Total 

- 8-

Table 1. 3 

Capital Gains i n Adjusted Gross Income (AGI) 

as a Percentage of AGI 

by Permanent AGI Class, 1973 !I 

Capital 

gains 

in AGI 

($mil) 

534 

1,740 

912 

1,195 

2,241 

1,281 

1,545 

1,070 

701 

253 

125 

11,598 

Total 

AGI 

($mil) 

31,386 

120 ,579 

172 ,514 

140 , 104 

111 ' 994 

48 ,426 

28,413 

9,220 

3,545 

846 

640 

667 , 668 

Capital 

gains 

as % 

of AGI 

1.7 

1.4 

0. 5 

0.8 

2.0 

2.6 

5.4 

11.6 

19.8 

29.9 

19 .6 

1.7 

Cumulative 

percentage of: 

I Capital 

AGI 1 gains 

4.7 

22.8 

48 .6 

69.6 

86.4 

93 . 6 

97.9 

99.2 

99 .8 

99.9 

100.0 

4.6 

19.6 

27.5 

37.8 

57.1 

68.1 

81.5 

90.7 

96 . 7 

98.9 

100.0 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ Permanent AGI is defined as the taxpayer's average AGI for the - years 1971-75. 

Source: 1973 Sales of Capital Assets Study, Five- Year Panel 
-9-

Table 1.4 

Permanent Capital Gains in Permanent Adjusted Gross Income 

(AGI) as a Percentage of Permanent AGI by 

Permanent AGI Class, 1971-1975 1/ 

I 

Permanent I 

capital I 

Permanent 

AGI 

($thou) 

gains 

in AGI 

($mil) 

5 or less 520 

5-10 1,848 

10- 15 1,297 

15-20 1,263 

20-30 1,454 

30-50 973 

50-100 1,445 

100- 200 905 

200-500 752 

500-1,000 279 

1,000+ 195 

Total 10,931 

I 

I 

I 

!Permanent 

!capital 

Total I gains 

permanent! as% of 

AGI !permanent 

($mil) I AGI 

32,494 

120,397 

171,054 

139,557 

112,627 

46,970 

28,084 

8,992 

3,692 

890 

676 

665,431 

1.6 

1.5 

0 . 8 

0.9 

1.3 

2.1 

5. 1 

10.1 

20.4 

31.4 

28.8 

1.6 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Cumulative 

percentage of: 

I Permanent 

Permanent! capital 

AGI 1 gains 

4.9 

23.0 

48.7 

69.6 

86 .6 

93.6 

97.9 

99.2 

99.8 

99.9 

100.0 

4.8 

21.7 

33.5 

45.1 

58.4 

67.3 

80 . 5 

88.8 

95. 7 

98.2 

100.0 

August, 1985 

1/ Permanent capital gains are defined as the taxpayer's average 

realized capital gains in AGI for the years 1971-75, and 

permanent AGI is defined as the taxpayer's average AGI for the 

years 1971-75. 

Source: 1973 Sales of Capital Assets Study, Five-Year Panel. 
-10-

1.3. Permanent capital gains are 1.6 percent of permanent AGI 

for all taxpayers, but are 10.1 percent of permanent AGI for 

taxpayers with permanent AGI between $100,000 and $200,000; 20.4 

percent of permanent AGI for taxpayers with permanent AGI between 

$200,000 and $500,000; 31.4 percent of permanent AGI for 

taxpayers with permanent AGI between $500,000 and $1,000,000; and 

28.8 percent of permanent AGI for taxpayers with permanent AGI 

greater than $1,000,000. Taxpayers with the top 13.4 percent of 

permanent AGI (those with permanent AGI greater than $30,000) 

received 41.6 percent of permanent capital gains; taxpayers with 

the top 2.1 percent of permanent AGI (those with permanent AGI 

greater than $100,000) received 19.5 percent of permanent capital gains. 

Tables 1.1-1.4 report data on the distribution of nominal 

capital gains included in AGI. During a period of inflation, 

taxpayers reporting nominal capital gains on assets sold have not 

necessarily received a real increase in purchasing power during 

the period the asset was held. For example, if a taxpayer had 

purchased $1,000 of corporate sha r es in 1972 and then sold the 

shares for $1,100 in 1979, he would have received a nominal 

long-term gain of $100, of which 40 percent, or $40, would be 

included in AGI. If the nominal value of the shares had grown at 

the same rate as the GNP deflator over that time period, thus 

maintaining their real value, the shares would have been worth 

$1,628 in 1979 prices. Thus, the taxpayer in this example has 

suffered a real loss equal to $528 in 1979 prices, not a gain of 

$100, over the period the asset was held. The only taxpayers who 

realize real capital gains in any year are those for whom the 

rate of asset appreciation over the period the asset was held 

exceeded the inflation rate over the same time period. 

Table 1.5 compares real and nominal gains from sales of 

corporate shares and non-business real estate for a subset of 

returns included in the IRS data file compiled for the IRS study of sales of capital assets in 1977. Real gains are computed by 

increasing the basis of assets in proportion to the increase in 

the GNP deflator between the date the asset was purchased and the 

date it was sold. The returns used only included those with 

internally consistent reporting of holding periods, since 

accurate holding period data are necessary to compute real 

capital gains. 

Table 1.5 shows that nominal capital gains reported on both 

corporate shares and non- business real estate sold in 1977 

considerably overstate real increases in purchasing power during 

the period the assets were held. The $5.7 billion in nominal 

capital gains reported on sales of corporate shares represented 

an aggregate loss of $3.5 billion after adjustment for inflation. 

For non-business real estate, real capital gains were about 

one-fourth of the reported nominal gains of $3.6 billion. The 

table also shows that real gains are even more concentrated among 

high income taxpayers than are nominal gains. In 1977, for 
- 11-

Table 1.5 

Comparison of Nominal and Real Capital Gains 

on Sales of Selected Capital Assets 

by AGI Class, 1977 1/ 

Coq~orate shares Non-business real estate 

Nominal I Real Nominal I Real 

AGI class gains I gains gains I gains 

($thou) ($ mil) I ($ mil) ($ mil) I ($ mil) 

5 or less 239 -177 204 40 

5-10 132 -460 579 87 

10-15 -79 - 729 179 -15 

15-20 - 50 - 585 294 36 

20-30 -29 - 1,373 659 127 

30-50 860 - 1,169 691 276 

50-100 978 -843 525 183 

100-200 983 85 224 106 

200+ 2,646 1,763 215 101 

Total 5,684 - 3,488 3,570 939 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Data are from the 1977 IRS study of Sales of Capital Assets. 

In compiling the table, only records with internally 

consistent reporting of holding periods were used . 
-12-

example, total real gains on sales of corporate shares were 

negative for taxpayers in all groups with AGI less than $100,000, 

but were $85 million for taxpayers with AGI between $100,000 and 

$200,000 and $1,763 million for taxpayers with AGI greater than 

$200,000. Taxpayers with AGI in excess of $100,000 received 

almost 64 percent of the nominal gains on corporate shares, but 

were the only groups to realize j!¥ real gains on shares -- about 

$1.8 billion compared to $5.3 bi ~on of real losses for all 

groups with AGI less than $100,000. For non-business real 

estate, taxpayers with AGI in excess of $100,000 realized 12 

percent of nominal gains and 22 percent of real gains.i/ 

The data reported in Table 1.5 illustrate that low and middle 

income taxpayers paid a much higher effective tax rate on real 

realized gains than did upper income taxpayers, even though upper 

income taxpayers face higher statutory tax rates on nominal 

gains. This occurred because lower and middle income taxpayers 

had much larger nominal gains than real gains (indeed, real gains 

on corporate shares were negative for these groups), while for 

taxpayers with AGI over $200,000 real gains were two-thirds of 

nominal gains. 

Tables 1.1-1.5 generally compare the distribution of real and 

nominal capital gains with the distribution of AGI. Table 1.6 

compares the distribution of capital gains in AGI in 1982 with 

the distribution of other sources of income from capital reported 

on tax returns. The table shows that the distribution of capital gains is much more concentrated among high AGI groups than the 

distribution of either taxable interest income or dividends in 

AGI. For example, taxpayers with AGI greater than $100,000 

received 52.8 percent of capital gains in AGI, compared to 33.8 

percent of dividends and only 10.9 percent of taxable interest 

income; those with AGI over $500 ,000 received 27.3 percent of 

capital gains, 11.6 percent of dividends, and 2.4 percent of 

taxable interest income. 

Most taxpayers never realize any capital gains, but a large 

percentage of high income taxpayers realize capital gains every 

year. Table 1.7 presents data on the frequency of realizations 

by permanent AGI class for a sample of taxpayers who filed tax 

returns every year between 1971 and 1975. The table shows that 

76 percent of all returns had no realized gains during the years 

1971-1975, 20 percent of all returns had realized gains in some 

but not all years in that period, and only 4 percent of returns 

had realized gains every year. 

In contrast , the highest income taxpayers report capital gain 

income in most years. The percentage of taxpayers reporting 

gains in all five years rises as permanent AGI increases, while 

the percentage of taxpayers never reporting gains declines as 

permanent AGI increases. For example, the table shows that only 

1 percent of returns with permanent AGI greater than $500,000 
- 13-

Table 1.6 

Percentage Distribution of Different Forms 

of Income from Capital by AGI Class, 1982 

I Taxable 

!interest as Dividends as Capital gains 

AGI !percentage percentage of as percentage of 

($thou) I of AGI AGI AGI 

5 or less 4.6 3.0 7.6 

5-10 10.0 4.2 2.2 

10-15 11 .5 4.8 3.2 

15-20 9.8 5.1 2.5 

20-25 9.3 4.8 2.5 

25- 30 8.1 5.3 3.3 

30- 40 12.2 9. 3 5.4 

40- 50 8.3 8.5 5.6 

50- 75 10 . 4 13.6 9. 1 

75- 100 4. 7 7.6 5.9 

100- 200 5. 5 12 . 0 12 . 1 

200- 500 3.0 10 . 2 13.4 

500+ 2.4 11.6 27.3 

Total 100.0 100.0 100.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Derived from data reported in U.S. Internal Revenue 

Service, Statistics of Income- 1982, Individual 

Income Tax Returns (Washington, D.C., 1984), pp. 

44,45 and 47 . 
-14-

Table 1. 7 

Percentage of Returns Realizing Gains 

by Permanent AGI Class, 1971-1975 !I 

Permanent Gains never I Gains realized I Gains realized 

AGI realized lin some, but not! every year ($thou) (%) I all l':ears (%) I (%) 

Less than 0 50 49 1 

0 - 5 90 9 1 

5 - 10 83 14 3 

10 - 15 79 18 3 

15 - 20 69 27 4 

20 - 30 49 42 9 

30 - 50 28 51 21 

50 - 100 11 43 46 

100 - 200 4 42 54 

200 - 500 2 34 64 

500+ 1 26 73 

Total 76 20 4 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Results refer only to taxpayers who filed returns in all 

five years (1971-1975). Permanent AGI is defined as average 

AGI for the years 1971- 75. 
-15-

(the highest income group shown in the table) had no realized 

gains during the years 1971-75, 26 percent of these returns had 

realized gains in some but not all years, and 73 percent of these 

high permanent AGI returns had realized gains in every year 

between 1971 and 1975. 

In summary, capital gains reported on individual tax returns 

are highly concentrated among upper income taxpayers. Capital 

gains are much more concentrated at the top of the income 

distribution than is total income. Also, capital gains are more 

concentrated at high income levels than is other income from 

capital. The failure to adjust conventional measures of capital 

gain income for price level changes results in the overstatement 

of income reported from the sale of capital assets, but the 

understatement of the extent to which real capital gains income 

is concentrated among the highest income groups. Finally, in 

contrast to upper income taxpayers, most lower and middle income 

taxpayers do not report any capital gain income in most years. 

C. Distribution of Capital Gains By Asset Type 

Individuals realize capital gains and losses from the sale of 

a wide variety of different types of capital assets. Although 

corporate stock is the capital asset with the largest volume of 

transactions, gross sales value, gross gains, and gross losses, 

individuals also realize large amounts of gain from sales of real 

estate, business property, and other types of assets. 

Tables 1.8 and 1.9 show the percentage distribution by asset 

type of capital asset transactions, gross sales proceeds, gross 

gains, gross losses, and net gains (gross gains minus gross 

losses) from sales of capital assets in 1973 and 1977. In both 

years, sales of corporate stock accounted for the largest volume 

of transactions, gross sales value, gross gains, and gross 

losses, and the second largest volume of net gains (after 

personal residences) among single asset categories. For example, 

in 1977, corporate stock accounted for roughly 42 percent of 

capital asset transactions, 25 percent of gross sales value, 23 

percent of gross gains, 51 percent of gross losses, and 15 

percent of net gains. These figures understate the importance of 

corporate stock transactions relative to all capital asset 

transactions because some of the other major asset categories 

also include transactions in, or gains realized from, ownership 

of corporate stock. For example, capital gains distributions, 

prior year installment sales proceeds, share of capital gain or 

loss from partnerships and fiduciaries, and other assets, which 

include transactions not classified in the data, probably also 

include a large amount of sales of and/ or gains from corporate 

stock. If these four categories of "asset" are excluded from the 

total, corporate stock accounted for 62 percent of transactions, 

39 percent of gross sales value, 35 percent of gross gains, 72 

percent of gross losses, and 23 percent of net gains on 

individual income tax returns in 1977. 
-16-

Table 1.8 

Percentage Distribution of Gains and Losses 

on Sales of Capital Assets 

Type of 

asset 

Corporate stock 

Securities other than 

corporate stock 

Commodities, including 

futures contracts 

Capital gain distribution 

Share of capital gain or 

loss from partnerships 

and fiduciaries 

Capital gain distributions 

from small business 

corporations 

Liquidation distributions 

Lump-sum and other retire- ment plan distributions 

Sale or involuntary 

conversion of certain 

depreciable property 

Qualified gains on nonfarm 

depreciable business and 

personal property 

Qualified gains on other 

depreciable real property 

Qualified gains on farm- land with unharvested 

crop and livestock, 

except poultry, used in 

trade or business 

by Asset Type, 1973 !I 

No. of Gross 

trans- sales 

actions 2/ value 

53.8 28.7 

2.7 4.3 

1.4 4 . 7 

7.5 3/ 4.0 

5.7 2.3 

1.0 3.7 

0.3 3/ 0.1 

Gross 

gains 

26.1 

0.4 

2.5 

2.4 

7.7 

0.8 

2.6 

1.8 

6.7 

3.0 

3.8 

0. 3 

(continued on following page) 

Gross 

losses 

51.9 

2.9 

8.2 

0.8 

7.2 

* 

0.4 

* 

3.0 

Net 

gains 

14.8 

-0.8 

* 

3.1 

7.9 

1.1 

3.6 

2.6 

8.3 

4.3 

5.5 

0.4 
- 17-

Table 1.8 (Continued) 

No . of Gross 

Type of trans- sal es 

asset ac tions 2/ value ------------------------~------------~-

Standing timber 

All other farmland 

Personal residence 4/ 

Nonbusiness real estate 

Prior year installment 

sales proceeds 

Other types of assets ~/ 

0. 3 

0.1 

4.8 

4. 2 

7. 0 

11. 2 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

0. 3 

0 . 2 

15 . 1 

8 . 3 

17.8 

10.4 

Gross 

gains 

0.4 

0. 3 

10 .8 

8 . 1 

9.7 

12.7 

Gross 

losses 

* 

1. 3 

* 

24.3 

Ne t 

gains 

0. 6 

0.5 

15.5 

11.1 

14.0 

7. 6 

August, 1985 

1/ Dashes denote the category is not appli cable or data i s not available; 

asterisks indicate the amount is less than $0 . 05 billion. 

2/ Connotes sales, exchanges , involuntary conversions, and distributions 

of gain or loss from partnerships, fiduciaries, small business 

corporations, retirement plans, and enterprise liquidations. 

3/ Data are overstated to the extent a taxpayer reported more than one 

type of property included in this combi ned category. 

4/ The gain shown for sales of residences is the gross amount realized. 

Only a small part is taxable gain because of the deferral and exclusion 

provisions of the tax law relating to sales of residences. 

51 Other types of assets not elsewhere classified or transactions which 

were unclassified . 

Source: Data reported in Internal Revenue Servi ce, Statistics of 

Income--1973, Sales of Capital Assets Reported on 

Individual Income Tax Returns, (Washington, D.C. , 1980). 
- 18-

Table 1. 9 

Percentage Distribution of Gains and 

Losses on Sales of Capital Assets 

by Asset Type, 1977 

I No. of Gross 

Type of 

asset 

I trans- I sales Gross Gross 

lactions2/l value gains losses 

Corporate stock 

Securities other than 

corporate stock 

Commodities, including 

futures contracts 

Capital gain distributions 

Share of capital gain or 

loss from partnerships 

and fiduciaries 

Capital gain distributions 

from small business 

corporations 

Liquidation distributions 

Lump-sum and other retire- ment plan distributions 

Sale or involuntary conversion of certain 

depreciable property 

Qualified gains on non-farm 

depreciable business and 

personal property 

Qualified gains on other 

depreciable real property 

Qualified gains on farmland 

with unharvested crop and 

livestock, except poultry, 

used in trade or business 

42.1 

2.9 

1.3 

6.7 

3.6 

0.2 

0.2 

0.4 

6.0 3/ 

2.8 

1.3 

0.9 3/ 

24.8 22.8 

5.0 0.9 

7.6 2.8 

1.8 

8.1 

0.4 

1.6 

0.6 

2.7 5.0 

2.0 3.8 

4.2 5.7 

0.3 0.7 

(continued on following page) 

50.7 

2.6 

12.3 

0.3 

4.2 

* 

0.1 

3.3 

Net 

gains 

14.7 

0.4 

0.1 

2.3 

9.2 

0.6 

2.0 

0.7 

5.5 

4.9 

7.3 

0. 5 
-19-

Table 1.9 (Continued) 

No. of I Gross 

Type of I trans- I sales Gross Gross Net 

asset lactions2/l value gains losses gains 

Standing timber 0.4 0.3 1.0 * 1.3 

All other farmland * * * 0.1 

Oil and gas property * * 0.1 0.2 

Personal residence 4/ 6. 5 10.4 11.6 0.2 14.9 -

Nonbusiness real estate 3.2 6.6 7.7 1.3 9.5 

Prior-year installment 

sales proceeds ~/ 3. 3 23 . 0 6.6 0.1 8.5 

Other types of assets ~/ 18 . 0 13.1 18.8 25.0 17.1 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Dashes denote the category is not applicable or data is not available; 

asterisks indicate the amount is less than $0.05 billion. 

2/ Connotes sales, exchanges, involuntary conversions, and distributions 

of gain or loss from partnerships, fiduciaries, small business 

corporations, retirement plans, and enterprise liquidations. 

31 Data are overstated to the extent a taxpayer reported more than one 

type of property included in this combined category. 

4/ The gain shown for sales of residences is the gross amount realized. 

Only a small part is taxable gain because of the deferral and exclusion 

provisions of the tax law relating to sales of residences. 

51 Because of taxpayer reporting problems and data processing errors, 

prior-year installment sales are somewhat understated. 

6/ Other types of assets not elsewhere classified or transactions which 

were unidentified. 

Source: Data reported in Bertie Brame and Keith Gilmour, "Sales 

of Capital Assets, 1973-1980," in U.S. Internal Revenue 

Service, SOI Bulletin, Summer 1982, pp. 29-38. 
-20-

Other single asset categories that accounted for a 

significant volume of capital asset transactions and capital 

gains in 1977 were personal residences (10 percent of sales 

value, 12 percent of gross gains), non-business real estate (7 

percent of sales value, 8 percent of gro~s gains), commodities 

and futures contracts (8 percent of sales value, 3 percent of 

gross gains), and securities other than corporate stock (5 

percent of sales value, but less than 1 percent of gross gains). 

Because of the rollover provisions and the exclusion of some 

gains on personal residences for taxpayers age 55 or older, 

personal residences account for a much smaller fraction of the 

capital gains tax base than their share of net gains from capital 

asset sales. 

The data shown in Tables 1.8 and 1.9 reflect to some degree 

the particular economic conditions of the 1970s. During that 

decade, the stock market performed relatively poorly, bond prices 

generally declined, and real estate values increased at a greater 

rate than in other time periods. If these market trends are 

reversed in the 1980s, it is likely that the share of net gains 

accounted for by corporate stocks and other securities will be 

larger than the shares reported in Tables 1.8 and 1.9, while the 

share of net gains accounted for by real property, including 

business real property, non-business real estate, and personal 

residences, will be smaller. 

D. Trends in Capital Gains Receipts 

Capital gains taxes have accounted for slightly under 5 

percent of individual income tax receipts in the past decade. 

Table 1.10 shows that households who reported net capital gains 

in 1982 paid about $12.9 billion more in individual income taxes 

than they would have paid if their taxable capital gain had been 

zero and all other income had remained the same. Taxes on 

capital gain income amounted to 4.6 percent of individual income 

tax liability in 1982. 

Table 1.10 also shows that capital gains taxes, though 

varying from year to year, have remained at roughly the same 

share of individual income tax liability between 1970 and 1982. 

Capital gains tax liability increased from $3.1 billion in 1970 

to $5.7 billion in 1972, declined to about $4.5 billion during 

the 1974-75 recession, and then increased every year thereafter. 

The 1978 capital gains tax reduction lowered the fraction of 

individual net long-term capital gains included in AGI from 50 

percent to 40 percent. Despite this reduction in the inclusion 

percentage, total realized capital gains increased by a 

sufficient amount to result in an increase in net capital gains 

in AGI from $26.2 billion in 1978 to $31.1 billion in 1979. 

Capital gains in AGI increased further to $32.7 billion in 1980, 

$34.7 billion in 1981, and $38.5 billion in 1982. Taxes paid on 
-21-

Table 1.10 

Capi tal Gains Taxes Compared to Individual 

Income Tax Liability, 1970-1982 

I Total !Capital gains 

Net capi tal !Taxes paid on I individual I taxes as 

Year gain in AGI !I !capital gains lincome taxes I percentage 

($bil) I ($bil) I ($bil) I of t otal 

1970 10.7 3.1 83 .9 3.7 

1971 14.6 4. 4 85.4 5. 2 

1972 18.4 5. 7 93.6 6. 1 

1973 18.2 5.4 108.1 5.0 

1974 15 . 4 4.4 123.6 3.6 

1975 15.8 4.5 124. 5 3.6 

1976 20.2 6. 6 141.8 4. 7 

1977 23.4 8 . 1 159.8 5.1 

1978 26.2 9.3 188.2 4.9 

1979 31.1 11.7 214.5 5.5 

1980 32.7 12 .5 250.3 5.0 

1981 34.7 12.7 292.7 4.3 

1982 38 . 5 12.9 277 . 6 4.6 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ These figures include only returns with net gains and thus 

slightly overstate the contribution of the capital gains tax 

to total revenues by excluding returns with net losses that 

are deducted in computing taxable income. 
-22-

capital gains also increased fol l owing the 1978 tax reduction, 

rising from $9.3 billion in 1978 to $12.5 billion in 1980, $12.7 

billion in 1981, and $12.9 billion in 1982. Capital gains taxes 

as a percentage of individual income tax liability increased in 

the year after the 1978 capital gains tax cut, rising from 4.9 

percent in 1978 to 5.5 percent in 1979, but then fell back to 5.0 

percent in 1980, declined again to 4.3 percent in 1981 when the 

top rate on capital gains was reduced from 28 percent to 20 

percent (for gains realized after June 9, 1981 ) , and subsequently 

increased to 4.6 percent in 1982. 

The data in Table 1 . 10 slightly overstate the contribution of 

capital gains on individual returns to total Federal revenues 

because they only include returns with net gains. However, Table 

1.11 shows that net gains for returns with net gains far exceed 

net losses for returns with net losses. For example, in 1982, 

taxpayers reported $38.5 billion of net gains and $4.1 billion of 

net losses, for a total net capital gain in AGI, in excess of net 

losses in AGI, equal to $34.4 billion. Net gains were reported 

on approximately 7.1 million returns, while net losses were 

reported on 2.5 million returns. 

The effect of changes in Federal taxation of capital gains on 

capital gains realizations and on revenues from capital gains 

taxes will be discussed in detail in Chapter 4. 

II. The Lelal Distinction Between Ordinary Income and 

Capita Gain 

This section discusses in more detail the problems in 

determining when income attributable to an increase in an asset's 

value is to be regarded as a capital gain rather than ordinary 

income. The discussion reviews a variety of complex legal issues 

in a very general, summary fashion and does not purport to be a 

comprehensive discussion of all of the details of the substantial 

body of law dealing with capital gains. Rather, the intent of 

the discussion is to prov ide an ov erv iew of the types of legal 

issues that arise in defining a capital gain. 

A. Introduction 

The Federal income tax treats as taxable income most ''gain" 

recognized on the disposition of property. Gain is measured by 

subtracting the property's adjusted tax basis from the amount 

realized upon disposition (the sale price, in a sale). The 

adjusted tax basis is, essentially, the cost of the property to 

the owner. For example, if stock is purchased for 100, the owner 

has a basis in the stock of 100, so that if the stock were sold 

for 110, the gain would be 10 (110-100). In some instances, 
- 23-

Table 1.11 

Net Gains and Losses in Adjusted Gross Income, 1973-1982 

Returns with Returns with 

net gains net losses 

Number I Number I Net gain 

of I Net of I Net minus 

returns I gain returns I losses net loss 

Year (mil) I ($bil) (mil) I ($bil) ($bil) 

1973 6.4 18.2 2.3 1.5 16.7 

1974 5. 3 15 . 4 2.7 1.9 13.5 

1975 5 . 1 15.8 2.5 1.7 14 . 1 

1976 6.1 20.2 2.4 1.6 18.6 

1977 6.3 23.4 2.4 2.6 20.8 

1978 6 .6 26 . 2 2.1 3.0 23.2 

1979 6. 6 31.3 2.0 2.9 28.4 

1980 7. 0 32.7 2.0 3. 1 29. 7 

1981 7. 0 34.7 2.5 3.9 30.8 

1982 7.1 38.5 2.5 4 . 1 34.4 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Sources: Bertie Brame and Keith Gilmore, "Sales of Capital Assets, 

1973- 1980," in U.S. Internal Revenue Service, SOl 

Bulletin, (Summer, 1982), pp. 29-38 . U.S . Internal 

Revenue Service, Statistics of Income - 1981 Individual 

Tax Returns; and U.S. Internal Revenue Service, 

Statistics of Income - 1982 Individual Income Tax 

Returns. 
-24-

however, the original cost must be adjusted to take into account 

post-acquisition events pertaining to the property. For example, 

if a building is renovated, the cost of renovation is an 

additional cost of the building and increases the owner's basis. 

Similarly, if a property is depreciable, the depreciation 

deductions represent cost recovery to the owner and result in a 

decrease in the owner's basis. 

Gains and losses represent the increase or decrease in the 

value of property. Property can change in value every day. The 

tax law, however, generally does not tax gains or losses as they 

accrue daily or annually. Instead, taxation is deferred until 

the gain or loss is "realized'' when the owner's interest in the 

asset terminates. The two most common realization events are 

sales and exchanges. The gift of an asset is generally not a 

realization event. 

Some realizations are not recognized for tax purposes. The 

tax law contains a large number of nonrecognition rules. For 

example, under certain circumstances, a taxpayer that sells a 

personal residence may defer recognition of gain if the sales 

proceeds are reinvested in another personal residence. 

Similarly, gains and losses on certain ''like-kind" exchanges of 

property and on certain exchanges of property pursuant to a 

corporate or partnership reorganization are not recognized. 

Because gain, generally, is the increase in the value of 

property over its adjusted cost, gain is a measure of an increase 

in wealth. By the standard economic definition, all increases in 

wealth are income.S/ Current law, however, generally taxes 

long-term capital gain at a lower rate than ordinary income. The 

Code and the case law contain a remarkably complex collection of 

rules for determining whether an item of income is subject to the 

more favorable treatment provided for long-term capital gain. 

Under current law, a long-term capital gain is the gain 

realized on the sale or exchange of a capital asset held for more 

than six months.6/ Complexity arises in defining the terms 

"gain", "sale", wexchange", and "capital asset" in the preceding 

sentence and from a collection of exceptions to, additions to, 

and limitations on, these definitions. The following discussion 

reviews these key definitions, and considers the most significant 

of the exceptions, additions, and limitations. 

B. Holding Period 

In general, long-term capital gain treatment is restricted to 

gain on property that has been "held" for more than six months at 

the time of the taxable transaction. The law contains exceptions 

to the six-month rule. For example, cattle and horses held for 

certain purposes must be held for two years to qualify for 

long-term capital gain treatment. 
-25-

A holding period commences when the taxpayer first has the 

"benefits and burdens" of ownership. Because of the variety of 

interests which may be created in property, it can be difficult 

to determine when such benefits and burdens are first acquired. 

For example, a tenant in a building may gradually buy out his 

landlord in such a fashion as to make it difficult to determine 

when the benefits and burdens of ownership were transferred to 

the tenant. 

In some cases, the law suspends a taxpayer's holding period. 

For example, if a taxpayer makes a short sale with respect to 

stock already owned and uses such stock to cover the short sale, 

the taxpayer's holding period in the stock is suspended as of the 

time of the short sale. In other cases, the law includes in a 

taxpayer's holding period for a property a period during which 

such property was held by another person. For example, when 

property is transferred by gift, the donee's holding period 

includes the donor's holding period. In addition, the law on 

occasion includes in a taxpayer's holding period for one property 

a period during which the taxpayer held other property. For 

example, a taxpayer's holding period in stock received tax free 

in exchange for other stock as part of a corporate merger 

includes the holding period of the stock given up. 

C. Definition of a Capital Asset 

1. General Principles. The distinction between capital 

assets and other forms of property is the most important concept 

in the law relating to the taxation of capital gain. Under the 

Code, any property is a "capital asset" unless it is covered by 

one of the numerous exceptions. The theme running through the 

exceptions is that capital gain treatment is appropriate only for 

income resulting from the appreciation in value of investment 

property or property used in a trade or business. Thus, there 

are exceptions that deny capital gain treatment for income from 

personal efforts, income from property not attributable to 

appreciation (such as interest, dividends, royalties, and rent), 

and the ordinary profits of business operations. 

2. Capital Gain vs. Income From Personal Effort. In many 

common situations, either personal efforts become incorporated 

into a property, or a contract or other form of property 

represents the right to compensation for future services. The 

Code generally does not treat income resulting from personal 

efforts as capital gain. Consequently, certain forms of property 

which are produced by the taxpayer's personal efforts, such as 

copyrights, employment contracts and insurance agency agreements, 

are not capital assets in the taxpayer's hands.?/ . -

3. Ca ital Gain vs. Non-A reciation Income From 

Not only can 1ncome assoc1ate w1t serv1ces ecome property, 

frequently the right to income from property also becomes a 
-26-

separate item of property. One can sell the right to interest, 

dividends, royalties, or rent while retaining the underlying 

principal, stock, licensed property, or rental property. Capital 

gain treatment generally is considered appropriate only for 

profit on the appreciation of property and not for payments 

associated with property such as interest, dividends, royalties, and rent. Consequently, property interests that represent only 

the right to income from other property owned by the taxpayer are 

not capital assets. For example, under this rule, income from a 

sale of the right to receive a share of future rents is not 

capital gain if the seller retains the right to sell the 

underlying property . 

In contrast, income from a sale of future rents as part of 

the sale of the underlying property would be defined as capital 

gain since the taxpayer has sold the future rents with the 

property. Similarly, a taxpayer that sells a bond with coupons 

attached recognizes ordinary income as to accrued but unpaid 

interest on the coupons, as such interest represents income from 

property accrued while the property was owned by the taxpayer.8/ 

Because of the complexity and variety of business transactions~ 

complicated legal rules are r equired to determine whether a given 

property interest represents solely a right to income, rather 

than to the property itself. The law relating to the taxation of 

sales of mineral rights, for example, contains many rules for 

determining what sorts of interests in minerals are capital 

assets. 

4. Capital Gain vs. Business Income. Such assets as business 

inventory and property "held by the taxpayer primarily for sale 

to customers in the ordinary course of his trade or business" 

(property "held for sale'') are excluded from capital asset status 

because their sale generates the ordinary profits of the 

taxpayer's business. The distinction is that property used in a 

trade or business (such as an office building or a machine used 

in manufacturing) generally is treated as a capital asset, but 

property sold to generate profits in the ordinary course of the 

business (such as inventory) is not . 

This distinction requires rules to distinguish investment 

property (a capital asset) from property sold in the ordinary 

course of business. One rationale underlying the holding period 

requirement is a view that appreciation in the value of an 

investment occurs over time (over more than six months under the 

current holding period requirement), while short-term profit is 

more indicative of business profits. The "held for sale" rule 

also distinguishes between investment property and property 

regularly sold.~/ 

However, the law does not contain a clear or precise test of 

whether a property is held for sale, probably because of the 
-27-

elusiveness of the investment-business distinction in many common 

financial contexts. The key factor in determining whether a 

property is "held for sale" is the purpose of the taxpayer's 

holding. Frequently, a taxpayer has a mixed purpose for holding 

a property, yet the capital gain/ ordinary income distinction 

requires that all or none of the gain be capital gain. 

For example, land may be purchased with a view either to 

subdivide (a business purpose) or to hold in anticipation of 

appreciation (an investment purpose). If the land purchaser were 

to take a few steps towards subdividing, and then sell the entire 

property to realize an increase in value, there would be 

uncertainty as to whether the gain on the sale is capital gain or 

ordinary income. 

There is an additional type of property that is not permitted 

capital asset status because of its close relationship to 

ordinary business profits. On occasion, a business will acquire 

property to secure from risk a source of supplies or some other 

form of beneficial business relationship. This can be done, for 

example, by buying futures contracts (to protect against price 

fluctuations in supplies) or by investing in a supplier or a 

customer. In some cases property acquired to protect a source of 

supplies or a market for a business is viewed as being 

sufficiently related to the day-to-day profits of the business 

that, like inventory, it is denied capital asset status. 

D. Sale or Exchange 

Another important requirement for treating income as capital 

gain is that it must result from a "sale or exchange." The 

Congress and the courts have never articulated a policy basis for 

the restriction of capital gain treatment to sales or exchanges. 

Although there is no statutory definition of a "sale or 

exchange," the courts have held that a number of common 

transactions are not sales or exchanges. For example, the 

satisfaction of a legal claim is not a sale or exchange, so that 

any gain thereon is ordinary income. Under this rule, if a note 

from an individual is acquired at a discount and then the 

noteholder is paid in full by the individual, the noteholder has 

ordinary income.!Q/ 

E. Illustration of Problems Caused by Capital Gain/Ordinary 

Income Distinction 

The rules relating to capital gains create a class of 

favorably treated income -- capital gain -- and a class of 

disfavored losses -- losses on non-business capital assets. This 

creates a tension between transactions on either side of the 

capital gain/ ordinary income line that has resulted in a number 
-28-

of problems for the tax law. Particular problems have arisen 

from attempts to convert ordinary income to capital gain, and 

from the inconsistent treatment of related items. A good example 

of a conversion problem is the "collapsible corporation," which 

is discussed in the next paragraph. Examples of inconsistent 

treatment of related items are discussed after collapsible 

corporations. 

1. Converting Ordinary Income to Capital Gain -- The 

Collapsible Corporation. Often there is little practical 

difference between ownership of stock in a closely-held company 

and the underlying property used in the company's business. As a 

result, certain business property that is otherwise not a capital 

asset may be converted into the stock of a corporation, which 

generally is a capital asset, by merely incorporating the 

non-capital property. For example, suppose that a real estate 

developer forms a company to construct a building and then sells 

the stock after the building is completed. Most of the increase 

in the value of the stock would be attributable to the building, 

which would not be a capital asset in the developer's hands. The 

law contains intricate rules to prevent the use of corporations 

(known as "collapsible corporations") to convert ordinary income 

to capital gain in such cases. The real estate developer in the 

example likely would have ordinary income on the sale of stock 

under these rules. 

2. Inconsistent Treatment of Related Items -- The T-Bill 

Straddle. The 11 T-bill straddle" illustrates the problems that 

can ar1se from inconsistent treatment of related items as a 

result of the capital gain/ ordinary income distinction. Under 

the Code prior to the 1981 Act, a Treasury bill was not a capital 

asset, but a futures contract for Treasury bills was a capital 

asset. In a T-bill straddle, a taxpayer would construct a series 

of risk-free purchases and sales of Treasury bill futures 

contracts and Treasury bills which resulted in a net gain on the 

future contracts (a long-term capital gain) and an economically 

offsetting net loss on the Treasury bills (an ordinary loss). 

Although the T-bill straddle was subject to challenge by the IRS 

on several grounds, it appeared to offer the opportunity for 

substantial tax benefit even if the gain and loss were equal in 

amount, because of the inconsistent treatment of long-term 

capital gains and ordinary income.!!/ The 1981 Act removed the 

special exclusion of T-bills from capital asset status, thereby 

eliminating the source of the inconsistent treatment.~/ 

3. Inconsistent Treatment of Related Items -- Depreciation 

Recapture. Current law.allows a deduction against ordinary 

income for depreciation on certain assets used in earning income. 

Depreciation deductions result in a reduction in basis. 

Consequently, any depreciation deductions which reduce the basis 

of a depreciable asset below its fair market value present the 
-29-

possibility of offsetting a deduction against ordinary income 

with a long-term capital gain. This occurs because the property 

could be sold for a gain equal to the amount by which 

depreciation has reduced the basis below fair market value, and 

most gain recognized on depreciable assets is long-term capital 

gain. In most cases, this possibility of inconsistent treatment 

is prevented by "recapturing" such ''excess" depreciation when the 

asset is sold or exchanged. In general, the tax law requires 

that the amount of gain otherwise realized on the disposition of 

a depreciable asset (up to the amount of depreciation which has 

been claimed on that asset) be taxed as ordinary income. The 

principal exception to this rule is for real property which has 

been depreciated using straight-line rather than accelerated 

methods.!l/ 

4. Other Inconsistencf Problems. The T-bill straddle and 

depreciation recapture il ustrate the problems which arise from 

inconsistent treatment of related tax items as a result of the 

capital gain/ ordinary income distinction. The rules relating to 

depreciation recapture convert capital gain into ordinary income 

in order to compensate for deductions previously claimed. In 

other instances, the law taxes ordinary income in advance of the 

associated deductions. For example, if a corporation sells 

depreciable property to a wholly-owned subsidiary, all gain is 

ordinary income. This special rule prevents a related seller and 

purchaser from setting an artificially high sale price, thereby 

giving the purchaser a high cost basis in the sale property from 

which it can claim large depreciation deductions. If the related 

seller were treated as having capital gain on the sale, the tax 

thereon often would be less than the present value of the tax 

saving to the purchaser from the depreciation deductions. 

The problem of inconsistent treatment of related items caused 

by the capital gain/ ordinary income distinction in some instances 

results in the disallowance of deductions. For example, there 

are special rules that limit the deduction against ordinary 

income of "investment interest" incurred to carry capital assets. 

Similarly, the law limits the amount of long-term capital losses 

that individuals may use to offset ordinary income. 

III. A History of the Capital Gains Taxation of Individuals 

The method of taxing capital gains and allowing deductions 

for capital losses has been altered many times since the Federal 

individual income tax was imposed in 1913. In addition to the 

changes in the taxation of capital gains resulting from changes 

in the income taxation of so-called "ordinary income," numerous 

changes have been made that affect only capital gains income. 

The main items that have been altered are: 

(a) the extent to which capital losses may be deducted, 

either against capital gains or against other income; 
-30-

(b) the length of time an asset must be held for gain to 

qualify as a long-term capital gain; 

(c) the proportion of the gain or loss (or net gain or loss 

for the year) includable in income for tax purposes; and 

(d) the maximum marginal tax rate on any portion of capital 

gains or the maximum average tax rate on all capital 

gains of the individual. 

However, throughout the many tax changes, two features of the 

tax law have remained unchanged: 

(a) capital gains have never been completely excluded from 

income tax; and 

(b) with the exception of the special treatment of 

commodities futures contracts enacted in the 1981 Act and 

extended to commodity options and certain exchange-traded 

stock options in the 1984 Act, capital gains have only 

been taxed at the time the holder's interest in the asset 

terminates rather than as they accrue. 

Capital gains were separately defined in the tax law for the 

first time in 1922, and the basic definition of a capital gain, 

as described in the previous section, has remained essentially 

unchanged since that time. However, numerous exceptions to the 

general rules for defining a capital asset have been made. For 

example, sales of timber are treated as capital gains even though 

the sale may occur in the ordinary course of business. 

Similarly, royalty income for certain mineral properties is 

treated as long-term capital gain for tax purposes. 

Because certain capital gains receive preferential tax 

treatment, taxpayers have expended considerable political and 

legal effort to expand the definitions of eligible transactions 

and to convert ordinary income into capital gains. As a result, 

there have been innumerable changes in the scope of transactions 

eligible for capital gains. In addition, the definition of 

eligible capital gains and the details of special treatment to be 

received by such gains have been accorded considerable attention 

by tax professionals both inside and outside the government. 

This section is divided into four parts. The first part 

contains a brief outline of the taxation of capital gains from 

1913 to the enactment of the current tax statute, the Internal 

Revenue Code of 1954. The second part gives a more detailed 

presentation of the taxation of capital gains from the enactment 

of the Internal Revenue Code of 1954 until the Revenue Act of 

1978. The final part describes changes in the taxation of 

capital gains from 1978 through the present. A concluding 

section summarizes the discussion. 
-31-

A. The Tax Treatment of Capital Gains from 1913 to 1953 

1. 1913-1921. From the inception of the individual income 

tax in 1913 through 1921, capital assets were not explicitly 

defined, and realized gains on all assets were taxable in full as 

ordinary income. During ·this period, however, losses from the 

disposition of assets were subject to differing treatment. From 

1913 through 1915, losses were not deductible at all. In 1916 

and 1917, losses were only deductible to the extent of gains. 

From 1918 through 1921, losses were deductible in full against 

gains and other income. 

2. 1922-1933. Special treatment for certain capital gains 

was first introduced in 1922. Generally, if the holding period 

of the asset was two years or less, any gain was fully includable 

in income without any special tax treatment, and any loss was 

fully deductible from ordinary income. If the holding period 

exceeded two years, some long-term capital gains received special 

treatment. The entire amount of gains was includable in income 

subject to tax but, at the election of the taxpayer, long-term 

gains could be taxed under an alternative tax at a rate of 12.5 

percent. There was no netting rule for determining gains 

eligible for long-term treatment, as each item of gain or loss 

was taxed separately as long-term or short-term. During this 

period the top marginal tax rates ranged from 24 percent to 73 

percent while the rate on the first $4,000 of taxable income 

ranged from 0.5 percent to 4 percent. Consequently, the 

alternative rate was of value only to taxpayers with very 

substantial incomes.!!/ 

This treatment of long-term capital gains continued 

essentially unchanged from 1922 through 1933, but the treatment 

of losses differed. During 1922 and 1923, long-term capital 

losses were fully deductible against ordinary income. From 1924 

through 1933 long-term losses were not deductible but were 

eligible for a 12.5 percent credit against taxes, subject to the 

limit that the tax saving from the credit could not exceed the 

tax reduction which would have resulted if the loss had been 

fully deductible. 

3. 1934-1937. Between 1934 and 1937, the proportion of a 

capital gain that was includable in income , i.e., the inclusion 

ratio, was a decreasing function of the holding period. Five 

different holding periods were specified. For holding periods of 

1 year or less, 100 percent of gains was includable in income; 

for holding periods of 1 to 2 years, 80 percent; for holding 

periods of 2 to 5 years, 60 percent; for holding periods of 5 to 

10 years, 40 percent; and, finally, if the holding period was 

over 10 years, 30 percent of gains was includable in income. In 

1934 and 1935, the maximum marginal tax rate was 63 percent, and 

in 1936 and 1937, the maximum rate was 79 percent. Given these 

rates, the highest marginal tax rates for a capital gain from an 
-32-

asset held over 10 years was 18.9 percent in 1934 and 1935 and 

23.7 percent in 1936 and 1937. 

During this period, the inclusion ratio for a loss was the 

same as the inclusion ratio for a gain with a similar holding 

period. The taxpayer would compute each included gain and loss 

separately. Included losses were deductible to the extent of 

included capital gains plus $2,000. 

4. 1938-1941. Beginning in 1938, the number of different 

inclusion rat1os was reduced from five to three. For assets held 

18 months or less, gains were taxed as ordinary income. For 

holding periods over one and one-half but not over two years, 

two-thirds (66-2/ 3 percent) of the gain was includable in income. 

For holding periods over two years, one-half (50 percent) of the 

gain was includable in income. In both of the longer holding 

period situations, the taxpayer could elect an alternative tax of 

30 percent of the included gain, thus providing a maximum tax 

rate of 20 percent for gains with holding periods from one and 

one-half to two years, and a 15 percent rate for gains with 

longer holding periods. During this period, the maximum tax rate 

on ordinary income was between 79 percent and 81.1 percent. 

In 1938 and 1939, the inclusion rate for losses remained the 

same as the inclusion rate for gains with the same holding 

period. Included losses were deductible against gains and 

against $2,000 of ordinary income. In 1940 and 1941, short-term 

losses -- losses on assets held 18 months or less -- were 

deductible only against short-term gains, and any excess could be 

carried over only to the immediately succeeding year. Net 

long-term losses, determined on the basis of the applicable 

exclusion percentage, were deductible against other income or 

were creditable at a rate of 30 percent of the recognized loss; 

taxpayers were required to take whichever treatment was less 

beneficial. 

5. 1942-1953. In 1942, the differentiation of capital gains 

and losses by holding period was further simplified so that only 

two different categories of gains or losses were recognized --

those where the holding period was six months or less and those 

with a holding period of more than six months. The entire amount 

of so-called short-term gains was includable in income while only 

one-half (50 percent) of the amount of long-term capital gains 

was includable in income. Furthermore, long-term capital gains 

were, at the election of the tax payer, subject to an alternative 

tax at a flat rate of 25 percent from 1942 to 1951 and 26 percent 

in 1952 and 1953. During this period the maximum marginal tax 

rate on ordinary income varied from 86 percent to 94 percent. 

Beginning in 1942, the law contained a unified calculation of 

the effect of all capital transactions on taxable income that 

took into account gains and losses with different categories of 

holding periods. Long-term capital gains tax treatment was 
-33-

available only for net capital gains, which were defined as the 

excess of net long-term capital gains over net short-term capital 

losses. During this period, capital losses were generally 

deductible against gains and were deductible against ordinary 

income up to a maximum of $1,000. Excess losses could be carried 

forward for five years, and all losses which were carried forward 

were treated as short-term capital losses. 

Table 1.12 summarizes the tax treatment of capital gains 

between 1913 and 1953. It compares the top marginal tax rates on 

capital gains with the top marginal tax rate on other income. It 

also shows the asset holding periods required for taxation as a 

long-term gain, as well as the proportions of capital gains that 

were excludable from income for income tax purposes. 

B. The Internal Revenue Code of 1954 and the Tax Treatment of 

Capital Gains from 1954 to 1978 

The time span between the enactment of the Internal Revenue 

Code of 1954 and the Revenue Act of 1978 encompassed two distinct 

periods in capital gains taxation. Between 1954 and 1969, the 

prior tax treatment of capital gains continued essentially 

unchanged. Short-term gains were taxed as ordinary income. 

One-half of net capital gains was excluded from adjusted gross 

income, with the remainder nominally subject to tax at ordinary 

rates. An alternative tax of 25 percent on long-term gains 

remained available throughout the period. 

Beginning in 1969, Congress in various ways limited 

preferences available for net capital gains. Significant changes 

were made in both 1969 and 1976 that raised tax rates, especially 

the maximum possible tax rates on capital gains. 

1. Boldina Period. The Internal Revenue Code of 1954 

retained theefinition of long-term capital gains and losses as 

those where the holding period of the asset was over six months. 

That division between short-term and long-term transactions 

continued through 1976. The Tax Reform Act of 1976 increased the 

holding period required for long-term treatment to nine months in 

1977 and to one year beginning in 1978. 

2. Capital Losses. 

long-term capital gains 

1954 combined long-term 

net capital gains, that 

snort- term losses, were 

applicable to long-term 

For purposes of receiving special 

treatment, the Internal Revenue Code of 

and short-term gains and losses. Only 

is, net long-term gains in excess of net 

eligible for the lower tax rates 

capital gains. 

Capital losses were first offset against capital gains. Any 

excess losses were deductible against ordinary income to a 

limited extent. The maximum capital loss deduction against 

ordinary income was $1,000 between 1955 and 1976 and was then 

increased to $2,000 in 1977 and $3,000 in 1978 and thereafter. 
-34-

Table 1.12 

Summary of Tax Treatment of Capital Gains, 1913-1953 

Years 

1913-1921 

1922-1933 

1934-1937 

1938-1941 

1942-19S3 

Maximum I 

marginal I 

tax rate 1/l 

on capital I 

gains (%) I 

7-77 

12.S 

18.9-23.7 

1S 

25-26 

Maximum 

marginal 

tax rate 

on ordinary 

income (%) 

7- 77 

24-73 

63-79 

79-81.1 

86-94 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

I 

!Exclusion 

!ratio for 

I capital I 

I gains (%)I 

0 

0 

50 

0 

20 

40 

60 

70 

0 

33 

so 

0 

so 

Holding period 

required for 

exclusion ratio 

(years) 

n/a 

0-2 

2+ 

0-1 

1-2 

2-S 

S-10 

10+ 

0- 1.5 

1.5- 2 

2+ 

0-0.5 

0.5+ 

August, 1985 

1/ Tax rate which applies to a capital gain eligible for the maximum 

exclusion ratio. 
-35-

Until 1969, each dollar of excess long-term loss produced a 

dollar deduction against ordinary income. After 1969, each 

dollar of excess long-term loss produced only a 50 cent deduction 

against ordinary income, while each dollar of excess short-term 

loss produced a dollar of deduction against ordinary income. 

Between 1954 and 1963 excess losses above the $1,000 limit could 

only be carried forward for five years. After 1963, unused 

losses could be carried forward indefinitely. 

3. Alternative Tax. Before 1970, the alternative tax on 

capital gains effectively truncated the tax rate schedule by 

providing that, at the option of the taxpayer, all net capital 

gains could be taxed at 25 percent. This provision benefited 

only those high-income taxpayers with tax rates higher than 50 

percent. Beginning in 1972, only the first $50,000 of net 

capital gains was eligible for the alternative tax ; the remainder 

was taxed at one-half of ordina ry rates.~/ 

4. Minimum Tax on Tax Preference Income. Beginning in 1970, 

items of tax preference -- including the excluded portion of net 

capital gains -- were subject to the minimum tax. Between 1970 

and 1975, the minimum tax was 10 percent of total tax preferences 

less a $30,000 exclusion and less the amount of regular income 

tax liability. Regular taxes not used to offset minimum taxes 

could be carried forward for seven years. 

Allowing for the fact that each dollar of gain generated a 50 

cent tax preference which was reduced by the tax on the included 

gain, the extra tax from the minimum tax for a taxpayer in the 

highest bracket (70 percent) was 1.97625 percent in 1970, 1.75 

percent in 1971, and 1.5 percent between 1972 and 1975.~/ 

In 1976, the minimum tax rate was raised to 15 percent; the 

exclusion was lowered to the larger of $10,000 or one-half of 

regular tax liability, and the car r yforward of ordinary tax 

offsets was eliminated. As a result of these changes, the extra 

tax on net capital gains due to the minimum tax for a top-bracket 

taxpayer was raised to 4.875 percent. · 

5. Maximum Tax on Personal Service Income. Beginning in 

1970, the maximum tax rate on earned income was lower than the 

maximum rate on other income. While the highest marginal tax 

rate on other income remained at 70 percent, the highest tax rate 

on earned income was 60 percent in 1971 and 50 percent in 1972 

and thereafter. 

Capital gains were not eligible for the maximum tax, but tax 

preferences, including the excluded portion of net capital gains, 

reduced the amount of earned income subject to the maximum tax by 

an equal amount. Each dollar of net capital gain produced 50 

cents of tax preference and reduced the amount of income eligible 

for maximum tax treatment by 50 cents. This interaction, called 
-36-

"poisoning the maximum tax,'' effectively raised the marginal rate 

of tax on affected long-term capital gains. In 1971, this 

poisoning could have raised the tax rate on an affected long-term 

capital gain by 5 percentage points. Between 1972 and 1978, the 

maximum effect was 10 percentage points. 

Because of several interactions in the calculation of the 

maximum tax, the effect on capital gains varied widely depending 

on the sources of a particular taxpayer's income. The 

interactions tended to reduce the effects of the poisoning of the 

maximum tax and, under typical conditions, the net effect of 

poisoning was only about one-half to two-thirds of the maximum 

possible effect. 

From 1971 to 1975, only preferences in excess of $30,000 

poisoned the maximum tax. Under the changes enacted in 1976, 

preferences from the very first dollar poisoned the maximum tax. 

However, between 1971 and 1975, preferences considered for 

poisoning were the larger of the current year's preferences or 

the average of preferences in the five years ending with the 

cu rrent year. Thus, a very large gain poisoned the maximum tax 

for a total of five years -- the year in which the gain was 

realized and in each of the next four years. 

6. Maximum Rates on Long-Term Ca~ital Gains. Table 1.13 

summarizes the maximum possible marg~nal tax rates on long-term 

capital gains from 1954 through 1978. The table shows the rates 

under each combination of provisions which might have affected 

the taxation of long-term capital gains. It should be noted that 

extremely complicated cases involving several combinations of tax 

provisions did not affect large numbers of taxpayers, nor did 

they affect large amounts of capital gains income. 

In any given year, the highest possible marginal tax rate on 

an additional dollar of long-term capital gain occurred in 

situations where the long-term capital gain -- considered as the 

marginal income -- offset an existing s hort-term loss. In such 

situations, shown in the last row of Table 1.13, the applicable 

marginal rate is the statutory rate on ordinary income. 

c. The Taxation of Capital Gains Since the 1978 Revenue Act 

The 1978 Act included some fundamental changes in the 

taxation of capital gains realized after October 31, 1978.17/ 

The major change was that the inclusion ratio for net capital 

gains fell below 50 percent for the first time since 1942, as it 

was lowered from 50 percent to 40 percent. In addition, the 1978 

Act repealed the alternative tax under which, at the option of 

the taxpayer, the first $50,000 of net gains was taxed at a 25 

percent rate. The excluded portion of net capital gains was 

removed from the list of items of tax preference under the add-on 

minimum tax, and the poisoning effect of the capital gains 

exclusion under the maximum tax on personal service income was 
Table 1.13 

Maximum Marginal Tax Rates on Long-Term Capital Gains, 1954-1978 (%) !I 

~- I 

Taxes Imposed 11954-631 1964 11965-671 1968 I 1969 I 1970 I 1971 I 1972 11973- 751 1976-78 

Alternative or Ordinary Tax 

Alternative or ordinary tax, plus 

minimum tax 

Alternative or ordinary tax, plus 

minumum tax, plus maximum tax 

Alternative or ordinary tax, plus 

minimum tax; plus maximum tax, 

plus future maximum tax 

25.0 

25.0 

25.0 

25 .0 

Alternative or ordinary tax, plus 25.0 

minimum tax, plus maximum tax, plus 

future maximum tax , if there are 

sufficient foreign tax credits to 

eliminate the value of tax offsets 

under the minimum tax 

Ordinary tax, if extra long-term 

gain offsets short-term loss 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

91.0 

25.0 

25.0 

25.0 

25.0 

35 . 0 

77.0 

25.0 

25 .0 

25.0 

25.0 

25 . 0 

70.0 

26 . 9 

26.9 

26.9 

26.9 

26 . 9 

75 . 3 

27 . 5 

27.5 

27 . 5 

27.5 

27.5 

77 .o 

30 . 2 32.5 

32.2 34.4 

22.2 30.8 

41.5 47.6 

45.6 52.3 

71.8 70.0 

35 . 0 

36 . 5 

45.5 

53.2 

58.5 

70.0 

35.0 

36.5 

45.5 

52.7 

58.0 

70.0 

35.0 

39.9 

49.1 

49.1 

52.5 

70.0 

August, 1985 

1/ Due to interactions, the combined maximum rates from the various tax provisions are often lower than the sum 

of rates for the individual provisions. The tax rates include the effects of the temporary surtaxes in 1968 

through 1980: 1968, 7.5%; 1969, 10%; and 1970, 2.5% . In 1970, the surtax had the effect of reducing the 

minimum ta.x . Tax rates listed for 1978 were effective through October 31, 1978. 

I 

w 

....., 

I 
-38-

eliminated. In combination, these four changes reduced the 

maximum possible rate of tax on a taxpayer's net long-term 

capital gain from as much as 52.5 percent to 28 percent (the 

product of the 40 percent inclusion rate and the 70 percent 

maximum ordinary income tax rate) . Net long-term capital losses 

were still subject to a 50 percent exclusion rate. 

In order to prevent certain high-income tax filers from 

paying little or no income tax, a new alternative minimum tax was 

enacted. For purposes of the alternati ve minimum tax, the 

excluded portion of net capital gains and certain itemi zed 

deductions in excess of 60 percent of adjusted gross income were 

considered to be items of tax preference and added to gross 

income less deductions to compute alternati ve minimum taxable 

income. This alternative base was subject to tax at rates 

ranging from zero percent on the first $20,000 to 25 percent on 

amounts in excess of $100,000 . The alternative minimum tax so 

calculated was payable only if it exceeded the sum of ordinary 

tax plus any add-on minimum tax. Under the alternative minimum 

tax, the maximum marginal rate on any capital ga i n was 25 

percent. Thus , while certain capital gains might be subject to 

tax under the alternative minimum tax, the alternative minimum 

tax did not increase the maximum possible marginal rate at which 

long-term capital gains could be taxed under the ordinary 

individual income tax. 

The 1981 Act reduced the maximum marginal tax rate on 

ordinary income to 50 percent for 198 2 and subsequent years. As 

a result, the maximum tax rate on long-term capital gains 

declined to 20 percent (the product of the 40 percent inclusion 

rate and the 50 percent maximum ordinary income tax rate). Under 

a special provision in the 1981 Act, the lower maximum tax rate 

for capital gains was effective for capital gains realized after 

June 9, 1981. The 1981 Act also lowered the highest alternative 

minimum tax rate from 25 percent to 20 percent (at $60,000 of 

alternati ve minimum taxable income). 

In addition, special tax rules for regulated futures 

contracts were imposed in the 1981 Act. Regulated futures 

contracts provide that the holde r may withdraw any profit on the 

contract on a daily basis without closing the contract and must 

deposit cash for any loss on the contract on a daily basis. 

Under the new tax rules, a holder of a regulated futures contract 

generally is taxed at year end on the accrued gain or loss on the 

contract as of the end of the year. The gain or loss on such 

contracts is treated as 60 percent long-term and 40 percent 

short-term, resulting in a 32 percent maximum tax rate. These 

"mark-to-market" rules are a unique case of a tax on gain as it 

accrues prior to the time the holder's interest in the asset is 

terminated. The Technical Corrections Act of 1982 expanded 

mark-to-market accounting to certain forward contracts in foreign 

currency that do not provide f or the wi thdrawal of accrued 
-39-

profit. The 1984 Act further expanded mark-to-market accounting 

and the 32 percent maximum tax rate to certain exchange-traded 

stock options held by investors, to all listed options held by 

options market makers , and to commodity options. 

The 1982 Act made substantial changes in the alternative 

minimum tax. The base was expanded to be adjusted gross income 

plus all tax preferences (still including excluded capital gains) 

less certain itemized deductions . The tax is imposed at a rate 

of 20 percent on alternative minimum taxable income in excess of 

$30,000 for unmarried individuals, $40,000 for married persons 

filing a joint return, and $20,000 for a married person filing a 

separate return. Changes were also made in the ability to use 

tax credits against the alternati ve minimum tax. The changes in 

the 1982 Act do not affect the maximum rate on net capital gains, 

which remains at 20 percent. 

Finally, the 1984 Act reduced the holding period for 

determining a long-term gain to over six months for assets 

acquired after June 22, 1984 and before January 1, 1988. 

D. Summary 

This section has reviewed the history of capital gains tax 

provisions applicable to individuals since the imposition of the 

Federal income tax in 1913. During that period, major aspects of 

the capital gains tax -- the percentage of long-term gains 

included in taxable income, the holding period (or, in some 

years, periods) for determining what gains are subject to the 

preferential rate (or rates), the loss offset provisions, and 

special provisions either to limit the maximum tax rate on 

long-term capital gains or to impose extra taxes on otherwise 

untaxed capital gain income -- have been changed frequently. In 

addition, there have been numerous changes, not reviewed here, 

including special provisions relating to what property can be 

classified as a capital asset, recapture rules for depreciable 

assets, rollover of realized gains, and the definition of a 

realization event. 

The frequent changes in the tax treatment of capital gains 

have reflected change s in emphasis and philosophy, as well as 

changes t hat represented adjustments to other changes in the tax 

law, such as changes in marginal tax rates . At times , Congress 

has sought to encourage investment and reduce impediments to 

asset sales, to encourage the holding of assets for longer 

periods, to simplify the tax law, to increase the tax burden on 

high income individuals, and to minimize the effectiveness of tax 

avoidance strategies. The conflict among these objectives has 

contributed to the frequent changes in the tax law. 

IV. An International Comparison of Capital Gains Taxation 

This section presents a comparison of the levels of capital 

gains taxation in 10 OECD countries. The tax rate on capital 

gains depends both on the treatment of capital gains relative to 

485-125 0 - 85 - 3 
-40-

"ordinary" income, and on the level of income taxation generally. 

This summary will focus primarily on the former question. 

Table 1.14 summarizes the principal features of the taxation 

of personal, non-business capital gains in 10 OECD countries. 

While there are substantial indi v idual differences, the 10 

countries tend to fall into 3 groups. One group includes the 

United States, Canada, and Sweden. While generally giving 

preferred treatment to capital gains compared to ordinary income, 

the countries in this group impose significant and roughly 

comparable taxes on realized capital gains. For example, Canada 

has a 50 percent exclusion compared to a 60 percent exclusion in 

the U.S. but, unlike the U.S., has no holding period limitation. 

Swedish taxation of long-term gains from stock has an inclusion 

rate similar to the United States, but with a longer holding 

period requirement. Movable property other than stock is treated 

more leniently in Sweden than in the United States as gains on 

such property are tax exempt after 5 years. In periods of low 

inflation, Swedish taxation of real estate gains is higher than 

in the United States, but the indexation of basis in Sweden 

probably has reversed that relationship in most of the recent 

past. 

The second group of countries, which includes West Germany, 

Japan, the Netherlands, Italy, and Australia, tax personal 

non-business capital gains, particularly from the sale of 

securities, very lightly. In some of these countries, such as 

West Germany and the Netherlands, the concept of capital gains is 

not used in the tax system. This means that if gains are not 

business related they tend to be exempt from tax.~/ 

Because of recent legislation, taxation of capital gains in 

the United Kingdom and France now appears to fall between the 

first two groups. In France, where capital gains taxation used 

to be low, the legislative changes effective in 1978 mean that a 

significant amount of the gains from shares will be subject to a 

tax of 15 percent, although there is a substantial threshold. 

The top marginal personal tax rate on ordinary investment income 

is 60 percent. In the case of the United Kingdom, the maximum 

tax rate on gains is 30 percent, compared to a top tax rate of 75 

percent on ordinary investment income. There is no holding 

period limitation. The United Kingdom introduced indexation of 

basis in 1982, with the result that taxation of capital gains 

accrued in future years will be significantly lower than in the 

United States. 

Several of the countries that virtually exempt long-term 

portfolio gains do not extend this exemption to sales by holders 

of a "significant" percentage of a company's stock. For example, 

in west Germany half of the capital gains realized by a holder of 

more than a 25 percent share of a fir m' s capital are included in 
Country 

United States 

Canada 

Sweden 

- 41-

Table 1.14 

International Comparison of Taxation 

of Individual Non-Business Capital Gains 1/ 

Rules for taxation of individual 

non-business capital gains 

Net long term capital gains (held longer than 6 

months) receive a 60 percent exclusion, with net short 

term gains fully taxed. 

Net short term losses plus 50 percent of long term 

losses are deductible against other income up to an 

annual limit of $3,000, with indefinite carry forward; 

special treatment provided for losses in stock of 

"small business corporations". 

Gains on a principal residence are deferred if 

reinvested within 2 years; a one-time exemption of the 

first $125,000 of gain is provided for taxpayers of 

age 55 .or older. 

All net gains receive a 50 percent exclusion, and an 

exemption for the first $1,000 of investment income 

can be applied to taxable capital gains. 

50 percent of net losses are deductible from taxable 

income up to $2,000, with one year carry back and 

indefinite carry forward; 50 percent of losses on the 

sale of shares in non- public Canadian corporations are 

deductible without limit . 

Gains on a principal residence are tax exempt. 

Long term gains from equities (held longer than 2 

years) receive a 60 percent exclusion, while short 

term gains are taxed. 

Gains on movable property other than equities are 

exempt after a 5 year holding period, with varying 

rates between 2 and 5 years. 

Losses are deductible only against gains, with a 6 

year carry forward. 

Gains on a principal residence are taxable, with a 

variety of relief provisions. 

Long term gains on other real property receive a 25 

percent exclusion and indexing of basis for inflation . 

(continued on following page) 
Country 

Vest Germany 

Japan 

-42-

Table 1.14 (continued) 

Rules for taxation of individual 

non- business capital gains 

Gains are generally tax-exempt. 

Speculative gains (on real property held less than 2 

years and other property held less t han 6 months) are 

fully taxed after a DM1000 exemption . 

Significant holdings (ownership of more than 25 

percent of share capital in the 5 years before a sale) 

generally receive a 50 percent exclusion, but sales of 

less than 1 percent of the total capital stock per 

year are tax exempt. 

Losses are deductible against taxable gains only in 

the year incurred . 

Gains from securities sales are generally tax exempt. 

Speculative gains (from more than 50 transactions per 

year involving more than 200,000 shares) are taxable . 

Sales of controlling interests (holdings of 50 percent 

or more in the 3 years before a sale) are taxable if 

10 percent or more is sold in one year or 25 percent 

or more is sold over 3 years. 

Gains which are taxable and long-term (held more than 

5 years) receive a 50 percent exclusion, while short 

term gains are fully taxed, subject to a 500,000 yen 

exemption which is stacked first against short-term 

gains. 

Losses from taxable categor ies of gain are deductible 

from ordinary income and may be carried forward for 3 

years . 

Gains on a principal residence are exempt up to 30,000 

yen. 

Gains on other real property are subject to a penalty 

tax equal to to the greater of 40 percent of the gain 

or 110 percent of the tax assessed if the gain were 

included in income. 

(continued on following page) 
Country 

Netherlands 

Italy 

Australia 

-43-

Table 1.14 (continued) 

Rules for taxation of individual 

non-business capital gains 

Gains are generally tax exempt. 

Speculative gains are fully taxed, but provisions 

appear to be of limited application . 

Gains from sales of significant interests (family 

holdings of at least one third of share capital during 

the five years before a sale, with the taxpayer having 

at least 7 percent) are includable in income, with the 

option of a flat 20 percent tax rate . 

Gains on a principal residence are tax exempt . 

Gains are generally tax exempt . 

Speculative gains are taxed at ordinary rates but 

provisions appear to have limited application, other 

than requiring a two year holding period for 

collectibles and a five year holding period for real 

property holding companies. 

Gains on a principal residence are tax exempt. 

A separate real property appreciation tax is assessed, 

with the rate depending on the amount of appreciation 

and varying from 3 percent to 30 percent for gains in 

excess of 200 percent of basis; some indexing for 

inflation is allowed. 

All long-term gains (held more than 12 months) are tax 

exempt , while short-term gains are fully taxed. 

Gains on a principal residence are tax exempt. 

United Kingdom All gains above a LSOOO exemption are taxed at a flat 

30 percent rate, with indexing of basis beginning in 

1982. 

Losses are deductible against gains but not against 

other income, and can be carried forward indefinitely. 

Gains on a principal residence are tax exempt. 

(continued on following page) 
Country 

France 

-44-

Table 1.14 (continued) 

Rules for taxation of individual 

non-business capital gains 

Habitual stock operations (annual sales which exceed 

160 percent of holdings on the previous December 31) 

are fully taxed if such gains exceed other income, and 

otherwise can be taxed at a 30 percent rate at the 

taxpayer's election. 

Gains on substantial transactions (annual sales of 

more than FF150,000) are taxed at a 15 percent rate. 

Sales of significant interests (holdings of 25 percent 

or more in the 5 years before a sale) are taxed at a 

15 percent rate. 

Losses are deductible from gains only in the year 

incurred. 

Gains on a principal residence are tax exempt. 

Gains from other real property held less than 2 years 

are fully taxed but are exempt if held 20 years, with 

some indexing for inflation between 2 and 20 years; 

various exclusions apply, including the first FF6,000 

of taxable gains, and all gains if total property 

holdings are less than FF400,000. 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ No special treatment is provided for gains on principal residences 

or gains from real property other than principal residences unless 

otherwise noted. 
-45-

income, with a threshold of sa les of 1 percent in a year. 

Similarly, France imposes a 15 percen t tax on gains from sales by 

holders of more than 25 percent of a firm's outstanding stock. 

Some countries, including Japan, France, Sweden, and Italy 

single out capital gains realized from real estate for special, 

generally less favorable, treatment. In fact, Japan imposes tax 

rates on capital gains from real estate which exceed those on 

ordinary income. 

Although the second group of countries has clearly lower 

taxation of personal capital gains than the u.s. , there are other 

features of their tax systems that may moderate somewhat the 

apparent disparity in treatment. For example , some countries 

seem to have more expansive definitions of business i nc ome than 

does the United States.19/ In addition, countries that exempt 

capital gains from securities seem to provide fewer opportunities 

for tax free liquidations and distributions than does the United 

States. The corporate liquidation provisions of the u.s. 

Internal Revenue Code provi de that if a corporation adopts a plan 

of liquidation and sells its assets wi thin 12 months, then 

capital gains from the sales are not taxable at the corporate 

level and the liquidating distribution to the shareholder is 

regarded as a purchase of his stock and not as a dividend. In 

West Germany, for example, gain on the sal e of assets in a 

liquidation is, at the corporate level, taxed at the rate on 

distributed income, and the liquidating distribution to 

shareholders is treated as a dividend (with integration credits) . This treatment of liquidations may, however, simply mean that 

o ther types of corporate reorganizations are used instead, e.g., 

purchase by acquiring firms of the corporation's shares instead 

of direct purchase of its property. 

It might be supposed that countries with low taxes on capital 

gains have correspondingly higher taxes on wealth because 

policymakers may regard capital gains and we?lth taxes as close 

substitutes. However, this is not the case. The United States 

and Canada have relatively hi gh taxes on wealth as a percentage of GOP in the form of taxes on real property. Revenues from 

property and wealth taxes are relatively modest in Japan , France, 

Italy , the Netherlands, and even in West Germany , despite the 

fact that West Germany has a relatively broad-based tax on 

personal wealth. 

Very few countries provide separate data on tax revenues 

derived from the taxation of capital gains. The only comparison 

available for OECD members is that col lections from personal 

capital gains in 1978 amounted to 0 . 5 percent of GOP in the 

United States and 0 . 2 percent of GDP in the United Kingdom. 

Total collections are , of course , inadequate measures of the 

real costs imposed by capital gains taxes since they depend on 

the level of accrued gains compared to other forms of capital 

income in each country. Still, they do provide some indication 
-46-

that capital gains taxes are a small share of gross product even 

in countries that tax capital gains relatively heavily. 

Moreover, capital gains taxes also account for a relatively small 

share of total capital income taxes -- about 8 percent in the 

United States and less than 3 percent in the United Kingdom. 

Thus, a comparison of capital gains taxation can only be a small 

part of a comprehensive comparison of the taxation of capital 

income. 

The preceding discussion has concerned taxation of capital 

gains at the personal level. The pattern among countries of 

taxation of corporate level gains is less clear.20/ West Germany 

and Japan make no distinction between capital gains and other 

business income at the corporate level. However, West Germany 

offers significant opportunities for the deferral of tax when 

equipment is sold and the proceeds reinvested. Canada, which 

includes 50 percent of a corporate gain in income, and the United 

Kingdom, which taxes corporate gains at a flat 30 percent rate, 

have similar rollover provisions. In France, gains from assets 

held less than 2 years are taxed at normal rates and long-term 

gains are taxed at a 15 percent rate with a further 35 percent 

tax on distribution. The United States gives corporations the 

option of a 28 percent tax on long-term gains. As noted earlier, 

opportunities for tax-free liquidations seem more significant in 

the United States than in some other countries. Because of the 

difficulty in evaluating the significance of rollover provisions, 

firm judgments on the degree of corporate level taxation of 

capital gains in the United States compared to other countries 

are impossible; however, U.S. taxation seems clearly higher than 

in Canada and probably lower than in Japan. 
-47-

FOOTNOTES TO CHAPTER 1 

1/ The problems involved in defining a "capital asset" are 

aiscussed in the second section of this chapter. 

2/ Unless indicated otherwise, the report (i) deals solely with ~taxpayer with only net gains, (ii) uses the term "capital gain" 

in place of the term "net capital gain," as that term is used in 

the Internal Revenue Code (the "Code"), (iii) uses the term 

"ordinary income" to include a "net short-term capital gain," as 

that term is used i n the Code, and (iv) uses the term "capital 

asset" to include "property used in the trade or business, " as 

that term is used i n section 1231(b) of the Code . 

3/ Capital gains data used in this report are based solely on 

Information reported by taxpayers on their Federal tax returns . However, taxpayers may understate capital gains income by failing 

to report gains, by understating the sales price or by 

overstating basis, or by misstating facts so as to reduce the 

amount of income includable in adjusted gross lncome. The 

Internal Revenue Service estimates that in 1981 individual 

taxpayers voluntarily reported only 59.4 percent of all capital 

gains (compared to over 75 percent i n 1973). See U.S. Department 

of the Treasury, Internal Revenue Service, Income Tax Compliance 

Research: Estimates for 1973-1981, Washington, D. C., u.s. Government Printing Office, July, 1983 . 

4/ Feldstein and Slemrod, using 1973 data, present similar 

results which show that nominal gains greatly overstate real 

gains and that real gains on sales of corporate shares were 

positive only for groups with AGI over $100,000. See Martin S. 

Feldstein and Joel Slemrod, "Inflation and the Excess Taxation of 

Gains on Corporate Stock," National Tax Journal, June, 1978. 

5/ An increase in the nominal value of an asset does not 

represent an increase in wealth if the asset's value increased 

less than the increase in the general price level during the 

period in which the wealth change is measured. Thus, the income 

resul ting from a change in the value of an asset in any year is 

equal to the asset's value at the end of the year minus the 

purchase price in end of year dollars; that is, the purchase 

price multiplied by one plus the rate of inflation during the 

year. If the rate of inflation during the year exceeds the 

increase in the nominal value of the asset, the wealth change is 

negative. 

/ Current law requires a taxpaye r to hold any asset more than 6 

months to obtain long-term capital gain treatment on its sale or 

exchange. The history of changes in the holding period for 

determining when a gain or loss is "long-term" is reviewed in the 

next section of this chapter. 
-48-

21 There is a significant statutory exception to the general 

rule described in the text. Section 1235 grants capital gain 

treatment to sales of patents by individuals under a variety of 

circumstances in which such treatment might otherwise not be 

available, including sales by the individuals who created the 

patent. 

8/ General tax rules suggest that the sale of a coupon with 

accrued but unpaid interest by a taxpayer with no other interest 

in the bond could be capital gain if otherwise qualified. 

Special rules enacted in the 1982 Act, however, convert a portion 

of the gain of such a "stripped" coupon to ordinary income. 

9/ However, not all property regularly sold is considered "held 

Ior sale." For example, a trader on a public stock exchange does 

not hold stock "for sale to customers in the ordinary course of 

his trade or business" since he sells in the market and not "to 

customers." 

10/ The Code, however, confers sale or exchange status on 

certain transactions. For example, amounts received by a holder 

of corporate indebtedness on retirement of the indebtedness are 

treated as received in exchange for the indebtedness. The 

Deficit Reduction Act of 1984 provided that for bonds issued 

after July 18, 1984, the appropriate portion of the gain on the 

disposition of bonds acquired at a market discount from the 

stated redemption price is to be treated as interest income. 

This provision was enacted to prevent certain tax shelter 

transactions in which taxpayers acquired market discount bonds 

using borrowed funds to take advantage of the ability to defer 

tax liability on ordinary income and convert ordinary income to 

capital gain. 

11/ An individual taxpayer with offsetting gain and loss of 100 

could have includable income of only 40 on the gain recognized on 

the Treasury bill futures (due to the 60 percent exclusion for 

long-term capital gain) and yet would have an ordinary deduction 

of 100 for the loss on the Treasury bills. 

12/ The mark-to-market rules for regulated futures contracts, 

aiso adopted in the 1981 Act as discussed below, would have 

independently eliminated those T-bill straddles that used 

regulated futures contracts. 

13/ It should be noted that even if "excess depreciation" is 

taxed as a capital gain on sale instead of being recaptured as 

ordinary income, the tax law still may discourage "churning•• of 

assets. Churning will result in a net tax benefit only if the 

present value of tax benefits from additional future depreciation 

deductions resulting from the increase in basis exceeds the 

immediate capital gains tax paid when the asset is sold. For an 

elaboration of this point, see Gerard M. Brannon and Emil M. 
-49-

Sunley, "The Recapture of Excess Tax Depreciation on the Sale of 

Real Estate ," National Tax Journal, December, 1976. 

!il During this entire period, the individual income tax appl i ed 

to a small fraction of the population, and only a small fraction 

of income was subject to tax. Between 1918 and 1920 , taxable 

individual income tax returns only covered an average of 9.5 

percent of the U. S . population. Between 1921 and 1929, the 

comparable figure was 5.2 percent of the population. Similarly, 

in 1918, taxable income was only 13 percent of personal income; 

in 1926, taxable income was only 14 percent of personal income. 

Furthermore, most taxpayers had -- by today's standards --very 

low incomes . In 1920, 7.3 million tax returns were filed. 

Returns with less than $2,000 of income represented 37 percent of 

all returns and included 17 percent of income . Returns with 

incomes of less than $3,000 represented 72 percent of total 

returns and 43 percent of income. Finally, 91 percent of returns 

(with 64 percent of income) had incomes below $5,000 . The top 

tax rate of 77 percent applied to taxable income over $1,000,000 . 

There were only about 30 such returns. 

15/ In 1970 and 1971, all gains were eligible for the 

aTternative tax, but the alternative tax rate was 29.5 percent in 

1970 and 32 . 5 percent in 1971 . 

16/ The computation for 1970 is affected by the 2.5 percent 

surtax which applied to ordinary or alternative taxes. 

17/ The reduced inclusion rate for long-term capital gains 

enacted in the 1978 Revenue Act applied to sales, exchanges, and 

installment payments after October 31, 1978. However, the 

changes in the minimum tax provisions and the elimination of the 

alternative tax on capital gains did not take effect until 1979. 

18/ See, for example, the country summaries in Cahiers De Droit 

Fiscal International, volume LXI B, The Definition of Capital 

Gains in Various Countries, Proceedings of the 1976 Jerusalem 

Conference . 

19/ See, for example, the "General Report" by Yaakov Neeman in 

the Conference volume referred to in footnote 18 . 

20/ In 1978, U.S. revenues from the taxation of corporate 

capital gains amounted to 27 percent of the tax revenues from 

gains at the personal level. 
-51-

Chapter 2 

ECONOMIC INCENTIVES AND CAPITAL GAINS TAXATION 

In general, the cost of government spending programs is 

measured by the market value of resources purchased by the 

Federal government, and thereby diverted from private use. In 

addition to these direct costs, detailed in the Federal budget, 

the method of raising revenue to finance Federal activities can 

impose additional costs on the economy by distorting economic 

decisions within the private sector. The level of these 

additional costs -- sometimes referred to as the "excess burden" 

or "deadweight loss•• of taxation -- can be influenced by altering 

the tax structure used to finance any level of government 

activity.!/ 

This chapter discusses the economi c distortions that result 

from the taxation of capital gains in the context of the current 

U.S. income tax. These distortions relate to private sector 

decisions that affect productivity and economic growth -- decisions to save or to consume, decisions to sell or t o hold 

assets with accumulated gains, and decisions on how to allocate 

wealth among alternative financial claims and productive assets. 

This chapter desc r ibes and measures these distortions, and shows 

how they have been altered by recent legislation. 

The first section of the chapter briefly reviews the concept 

of economic efficiency and indicates generally how taxes that 

drive a wedge between prices paid by buyers and prices received 

by sellers reduce the efficiency of resource use. Three economic 

choices distorted by a tax on capital gains are described: 

(a) the choice between present and future consumption; (b ) the 

choice among types of financial claims and among productive 

assets; and (c) the decision to sell assets with accrued gains or 

losses. The ways that changes in the capital gains tax alter 

these economic disto rtions are then discussed. 

The second section focuses on the effects of the capital 

gains tax on the incentive to save and on the choice among 

different forms of saving. The magnitudes of these incentive 

effects depend on the holding period and on the future inflation 

rates expected by today's potential buyers of financial claims 

and physical assets. It is shown how the real effective tax rate 

on returns in the form of asset value appreciation varies with 

the rate of inflation, the gross-of-tax real rate of return, the 

holding period of the asset, and the nominal tax rate on realized 

capital gains. This effective tax rate is also compared to the 

tax rate imposed on returns to sav ing received in the form of 

cash flow income. Empirical e vidence is presented which shows 

the average effective tax rate imposed on gains realized in 1973 

and in 1977. These data are used to indicate how the average 
-52-

effective rate would have been reduced if the 1978 and 1981 law 

changes had been in effect in 1977, and if the rate of inflation 

had been lower. 

Section III discusses the inefficiency resulting from the 

fact that the capital gains tax is normally triggered by a 

decision to sell assets. A measure of the "price" of an asset 

purchased with the proceeds of the sale of another asset is 

calculated; this price depends on the number of years the asset 

sold has been held, the average real rate of appreciation of the 

asset, the rate of inflation, and the rate of tax on realized 

capital gains. Data are then presented showing how capital gains 

taxes affected the price of asset sales in 1973 and 1977 for 

different classes of taxpayers, and how this price would have 

been reduced if the 1978 and 1981 changes had been in effect in 

1977. 

The final section of the chapter briefly summarizes the 

findings and describes their implications for tax policy. 

I. A General Discussion of Economic Efficiency Losses 

Efficiency is generally defined as a condition in which it is 

impossible to improve the welfare of one individual without 

reducing or leaving unchanged the welfare of other individuals in 

the economy. It follows that economic efficiency is reduced by 

laws and institutions that prevent people from engaging in 

mutually beneficial exchanges, or that impose impediments to 

those exchanges which are unrelated to any real costs from the 

activity involved. 

Economists have demonstrated that, under generally plausible 

assumptions, competitive markets give rise to an efficient 

allocation of resources in the absence of external economies or 

diseconomies. In other words, efficiency results if all the 

costs and benefits of any market transaction are ''internalized" 

in prices facing market participants. Externalities generally 

result when property rights are difficult to define, so that 

someone can use a scarce resource without paying a price (for 

example, a firm that pollutes the environment) or a producer is 

prevented from claiming property rights in generalized benefits 

he produces (for example, the increase in knowledge from research 

activities, when the producer cannot claim full property rights 

to the new knowledge). 

The discussion of economic efficiency conditions and of the 

weight that should be given to efficiency considerations in 

public policy choices has been a major activity of the economics 

profession in recent decades and need not be reviewed in detail 

here. The general thrust of this discussion, however, is worth 

noting. In an economic system placing a high value on free 

choice and consumer sovereignty, blocking or impeding voluntary 
-53-

exchanges or limiting competition causes a loss of economic 

efficiency by preventing transactions from which both parties 

gain. In the absence of significant externalities, economic 

efficiency is reduced by disallowing such transactions or by 

imposing costs that make the price paid by buyers differ from the 

price received by sellers. 

Most taxes impose efficiency losses on the private sector 

because they impose a wedge between the price paid by a buyer and 

the price received by a seller in a market transaction . The 

efficiency loss results because, in the absence of the tax, there 

exists a price lower than the price paid by the buyer and higher 

than the price received by the seller at which a sale would 

benefit both parties. Marginal buyers and sellers -- those with 

relatively small net gains from the transaction -- are inhibited 

from making the transaction by the presence of the tax. If the 

tax wedge is large, the efficiency losses from excluding these 

marginal buyers and sellers can be quite large. 

All taxes imposed on the returns from market activity can 

give rise to efficiency losses. For example, an excise tax on 

one commodity can impose an efficiency cost by discouraging the 

production and consumption of the taxed good and reallocating 

resources to goods with a lower value when measured at prices 

reflecting real social benefits. 

A general sales tax imposed at equal rates on all goods 

reduces efficiency by distorting the choice between market and 

non-market activities. In the long run, people can acquire 

scarce resources in two ways -- by selling their labor or capital 

services on the market and using the resulting money income to 

purchase goods that others sell, or by producing goods and 

services for themselves outside of markets. By taxing the former 

and not the latter, a general sales tax drives a wedge between 

the relative returns from non-market and market activities. In 

other words, a general sales tax distorts the choice between 

labor and leisure, if the latter is defined broadly to include 

all uses of time other than work for monetary compensation. 

A broad-based income tax 2/ also distorts the choice between 

labor and leisure, and in addition distorts the choice between 

current and future consumption by driving a wedge between the 

price paid by users of capital services and the return to saving. 

The present value of tax liability can be reduced by advancing 

consumption from the future to the present, either by borrowing 

or by reducing saving. 

In theory, a lump sum tax on all individuals would not create 

distortions because it would be impossible to avoid such a tax by 

altering economic behavior. However, it is impractical to design 

a completely distortion-free tax system based on any measure of 

an individual's welfare because overall well-being can in 

practice only be estimated from the subset of activities that 
-54-

give rise to monetary transactions. In addition, a tax system 

that assesses relatively higher tax burdens on the more affluent 

members of society is consistent with generally accepted views of 

fairness. Some economic distortions might be regarded as the 

cost of an equitable tax system . Finally, focusing only on the 

distortions of taxes ignore~ the large benefits from financing 

certain public activities -- those that either cannot be handled 

efficiently by private markets or those that would be 

underfinanced in terms of broader social policy objectives. 

Notwithstanding these qualifications, it is important to 

consider changes in the tax structure that might increase 

economic efficiency. In particular, changes in the capital gains 

tax affect the specific distortions resulting from the taxation 

of capital gains, as well as the distortions imposed by the U. S . 

income tax generally, to the extent that tax rates must change in 

the long run to offset the revenue consequences of changes in 

capital gains taxation. The discussion below reviews specific 

distortions caused by the capital gains tax and how these 

distortions were affected by provisions of the Revenue Act of 

1978 (the 1978 Act) and the Economic Recovery Tax Act of 1981 

(the 1981 Act). 

The specific rules governing capital gains taxation are one 

part of a complex income tax system. The efficiency effects of 

changes in the capital gains tax must be evaluated in the context 

of the entire U.S. income tax system; they are not independent of 

the tax rules applied to other forms of market income. The 

analysis in this report views capital gains taxes as one portion 

of the U.S. personal income tax and regards the other parts of 

the tax structure as fixed. Any more general discussion of tax 

reform would have to consider changes in the entire system of 

taxing capital income. In particular, it is important to note 

that conceptually ideal rules for taxing realized capital gains 

as part of an ideal tax system 3/ might not be appropriate in the 

context of the existing tax structure. 

The current U. S. income tax has the following five 

distinctive features that are especially relevant for an analysis 

of changes in the tax treatment of realized capital gains. 

(a) The income tax has a graduated rate structure , with a 

maximum rate of 50 percent (70 percent prior to the 198 1 

Act). 

(b) Most income from work effort is fully included in the 

tax base , but most fringe benefits are excluded. 

(c) Income from saving is partially taxed . Some forms of 

returns to saving are taxed at the same rates as labor 

income (for example, most personal interest income and 

dividends in excess of the $100 exclusion), while other 

forms of returns to saving are completely untaxed (for 
-55-

example, income accumulated within IRAs, Keogh Plans, 

and employer-contributed pension funds, interest on 

state and local bonds, and imputed rent from investment 

in owner-occupied housing and other consumer durables). 

Returns to saving in the form of asset appreciation are 

taxed only upon realization and then at a reduced rate. 

(d) The effective tax rate imposed on the real return to 

saving rises during a period of inflation because the 

tax rules do not take into account the decline in the 

real value of the princ i pal amount invested. 

(e) Interest payments are deductible in computing income 

subject to tax. The deductibility of interest, combined 

with the graduated rate structure and the existence of 

tax prefe r red assets, allows some taxpayers in high tax 

brackets to earn arbitrage profits by incurring fully 

deductible debt to purchase partially taxed or untaxed 

assets.!/ 

Under this complex tax structure, the taxation of capital 

income varies with the characteristics of both taxpayers and 

assets. Changes in the tax treatment of realized capital gains 

alter existing distortions of three specific economic choices. 

First, any tax on capital gains distorts the choice between 

present and future consumption by subjecting to tax an important 

component of the return to saving. Reducing the tax rate on 

realized capital gains would reduce the tax bias against saving 

by lowering the overall tax wedge imposed on income from capital. 

Second, the taxation of capital gains at rates below those 

applied to most forms of cash flow capital income favors those 

economic activities where returns typically accrue in the form of 

an increase in the capitalized value of future cash receipts, 

rather than as an immediate cash flow yield to capital. These 

"natural deferral" activities include mining , energy resource 

development, other activities with long construction periods, and 

investments in the development of new products and services. 

Reducing the capital gains tax without lowering tax rates on 

other income would increase the tax bias that favors these 

activities, compared to other capital investments.5/ In 

addition, by favoring asset appreciation over cash-flow earnings, 

the capital gains preference may encourage corporations to retain 

profits rather t han to d i stribute them. However, the issue of 

how capital gains taxes and dividend taxes affect corporate 

financial policy has not yet been fully resolved.~/ 

Third, the taxation of capital gains upon realization rather 

than as accrued discourages the sale of appreciated assets, and 

encourages taxpayers to sell assets that have declined in 

(nominal) value. In particular, when assets increase in value 

more rapidly or more slowly than expected or when a taxpayer's 
-56-

personal circumstances change unexpectedly, the taxpayer's 

perception of his optimal portfolio also changes. In that case, 

a capital gains tax triggered by an asset sale distorts the 

decision to retain or sell assets. If an asset has an 

accumulated gain, the tax discourages transactions that, in the 

absence of the tax, would have been mutually beneficial. If the 

asset has an accumulated loss, the tax encourages sales that 

otherwise might not be perceived as beneficial to the buyer and 

seller. Finally, in those cases where recognition of gain is 

linked either to change in management (for example, the sale of a 

small business) or to a specific production decision (for 

example, cutting down more trees), the taxation of gains upon re~lization could reduce productive efficiency. Lowering the 

capital gains tax reduces this tax bias against the realization 

of gain on appreciated assets. 

Thus, under our current tax structure, reducing the capital 

gains tax would increase efficiency in two ways -- by reducing 

the distortion between present and future consumption and by 

removing an impediment to sales of appreciated assets (and 

removing a subsidy to sales of assets with accrued losses ). At 

the same time, reducing the capital gains tax would decrease 

efficiency by increasing the distortion in choices among assets, 

encouraging savers to purchase assets that yield a return in the 

form of price appreciation and thereby increasing the tax bias 

that favors investment in "natural deferral" activities. 

Finally, it is worth commenting briefly on the relationship 

between the capital gains tax and risk taking. One can view the 

total return to a particular investment or financial claim as 

a combination of a flow of payments (such as interest, 

dividends, or rent) and an increase in the market value of an 

asset. The latter results either from a change in the future 

expected net earnings from the asset, or from a change in the 

rate at which such earnings are discounted. Under current law, 

the favorable tax treatment of appreciation of capital assets, 

relative to cash flow returns, may encourage risk taking if 

capital gains are associated with risky assets. 

In fact, discussions of capital gains taxation often presume 

a close relationship between asset value appreciation and the 

risk component of return to investment. It is certainly true 

that a large component of the return to suppliers of capital in 

particularly risky industries and new ventures accrues in the 

form of asset value appreciation because firms engaged in such 

investments are understandably unwilling to commit themselves to 

high fixed interest rates or high dividend payout ratios. At the 

same time, there are many ways to structure relatively low risk 

investments so that the returns to the suppliers of capital 

accrue in the form of asset value appreciation rather than 

periodic cash payments. The most common example is the retention 

of earnings by mature corporations. Annual earnings per share 

are only partially distributed to shareholders, with the 
-57-

undistributed portion reinvested to increase share values. Thus, 

a certain component of capital gains from corporate stock may be 

viewed as anticipated on average as a result of corporate 

financial policy, rather than as an unexpected windfall. 

Similarly, in some "natural deferral'' industries (for example, 

timber growing), a substantial share of the reward for ''waiting" 

accrues in the form of predictable growth in asset values rather 

than as a flow of revenues. 

In general, the proportion of return that accrues in the form 

of capital gains is correlated only in a very loose way with the 

riskiness of an asset. For this reason, special treatment of 

capital gains, relative to other forms of returns to saving, is a 

fairly poorly targeted method of offsetting any bias against risk 

taking that might result from taxing the returns to saving in a 

tax system with progressive rates and without complete loss 

offsets.l/ 

II. The Effects of Capital Gains Taxation and Inflation On 

Saving Incentives and Asset Choices 

A. Introduction 

This section discusses the effects of capital gains taxation 

on the incentive to save and on the incentive to purchase assets 

that provide returns in the form of appreciation rather than cash 

flow; the interaction between inflation and capital gains 

taxation is stressed. Potential investors are considered to be 

facing three choices -- current consumption, purchase of an asset 

that appreciates in value in anticipation of a future stream of 

cash returns, and purchase of an asset that immediately yields a 

periodic flow of cash returns in the form of dividends, rental 

payments or interest income. The latter two assets will be 

labeled ''growth assets" and "yield assets", respectively, for the 

remainder of the discussion; assets which offer both annual cash 

returns and potential appreciation can be viewed as linear 

combinations of these two polar cases. 

A tax on the return from holding assets distorts the choice 

between current and future consumption because the net return 

received by any saver is less than the social return from capital 

investment, i.e., the increased future consumption opportunities 

for the entire society. The tax creates an economic inefficiency 

because net social welfare could be improved by shifting 

resources from current to future consumption. 

The bias in favor of current consumption which results from 

taxes on the returns to saving is exacerbated under the u.s. 

income tax because the net income from saving is measured 

improperly when the price level is changing. During a period of 

inflation, nominal capital gains and interest income reported for 

tax purposes overstate real income because they fail to account 
-58-

for the decline in the real purchasing power of the investor's 

principal. Thus, during a period of inflation , the effective tax 

rate imposed on the real return to saving is considerably higher 

than the nominal tax rate . 

While the capital gains tax, like all income taxes, 

encourages current consumption relative to saving, it also is not 

neutral among alternative forms of saving. Since the tax is 

imposed upon gains as realized rather than as accrued, growth 

assets are taxed preferentially relative to yield assets. Yield 

assets are taxed annually at the taxpayer's statutory marginal 

tax rate; in contrast, the return from growth assets is allowed 

to accumulate tax-free until the asset is sold and is then taxed 

at a preferential rate. 

These two different distortions of individual behavior make 

it important to identify the particular efficiency effects 

associated with different methods of reducing capital income 

taxation. For example, increasing the fraction of capital gains 

excluded from taxable income reduces the tax bias that favors 

consumption over saving but increases the tax bias that favors 

growth assets over yield assets. A reduction in the tax rate on 

all forms of capital income by, for example, reducing the top 

marginal tax rate from 70 to 50 percent, reduces the tax bias 

against saving without increasing the tax bias in favor of growth 

assets over yield assets. 

The remainder of this section provides measures of the 

effective tax rates on growth and yield assets. In the 

calculations presented below, growth assets are defined as assets 

for which the entire return is in the form of appreciation in 

value, while yield assets are defined as assets for which the 

entire real return is in the form of annual monetary payments and 

the nominal value of the asset increases in proportion to the 

general price level. First, it is shown how the effective tax 

rates on growth assets and yield assets vary with the holding 

period, the rate of inflation, the exclusion rate for capital 

gains, and the marginal tax rate. Then, illustrative 

calculations are presented showing the effects on the effective 

tax rates on the two different types of assets of the 1978 

capital gains tax changes, the reduction in the top marginal rate 

in 1981, and the recent decline in the rate of inflation . Finally, empirical evidence from special IRS studies on sales of 

capital assets is used to show the effective tax rates paid on 

the gains from corporate shares and from non-business real estate 

sold in 1973 and 1977, and to show how 1977 effective tax rates 

would have fallen if the 1978 law changes had been in effect. 

B. The Effective Tax Rate on Capital Gains 

The effective tax rate on the return to holding an asset with 

a positive before-tax rate of return is defined as: 
-59-

t = ( g - n) / g . . . ( 1) 

where t is the effective tax rate, g is the before-tax rate of 

return, and n is the after-tax rate of return. 

Suppose an investor purchases an asset that earns no net cash 

returns, but appreciates in value at a rate of g per year. 

Assuming an initial purchase price of one dollar, the nominal 

value (V) of the asset after k years is: 

v = (1 + g)k ... (2) 

If the asset is sold after k years, the investor must pay a 

capital gains tax (per dollar of initial investment) of: 

T = am ( (1 + g )k- 1) (3) 

where a is the percentage of net capital gains included in 

taxable income (50 percent prior to 1978 and 40 percent under 

current law), and m is the taxpayer's marginal tax rate. 

In the absence of inflation, the real after-tax rate of 

return, n, is the annual growth rate at which one dollar 

increases in value to the amount realized after k years, net of 

capital gains tax. Thus, the real after-tax rate of return, 

absent inflation, is obtained from the equation: 

(1 + n)k = (1 + g)k- T ••• (4) 

Substituting ( 3) into (4), and solving for n yields: 

n = ( ( 1 + g ) k ( 1 - am) + am) 1/ k - 1 . . • ( 5 ) 

Equation (5) shows that the after-tax real rate of return 

depends on the before-tax rate of return, the holding period , the 

marginal tax rate, and the inclusion rate of net capital gains in 

taxable income. For any before-tax return, the after-tax return 

increases, and the effective tax rate is thus lower, the longer 

the holding period and the lower the tax rate on realized gains. 

The effective tax rate is lower for longer holding periods 

because gains are allowed to accumulate tax free. The longer the 

asset is held, the greater the benefit from deferring the tax on 

accumulated gains. 

For yield assets, the effective tax rate is m, the taxpayer's 

marginal rate, and the real after-tax return is simply : 

n = g(1- m) ... (6) 

If there were no capital gains exclusion (a=l) and the growth 

asset were sold within the first year (k=l), then the effective 

tax rate on growth assets would be the same as the effective tax 
-60-

rate on yield assets. That is, Equation (5) reduces to Equation 

(6) when a=1 and k=1. 

Inflation significantly increases the real effective tax rate 

on the returns from capital assets. Under current law, the 

computation of taxable income on the returns from a capital asset 

fails to take into account the change in the value of money 

between the time of purchase and the time of sale of the asset. 

If, for example, an asset is purchased for one dollar and later 

sold for two dollars, there is a capital gain of one dollar under 

current tax rules. However, if all prices had doubled over that 

time period, the real increase in purchasing power from holding 

the asset would be zero. In effect, the one dollar invested when 

the asset was purchased is equivalent to two dollars at the price 

level prevailing at the time of sale, but a capital gains tax 

must still be paid. 

More generally, the capital gains tax, T, can be expressed 

as : 

T = am [ ( 1 + g ) k ( 1 + p ) k - 1 ] ( 7 ) 

where p is the (assumed constant) annual rate of inflation. The 

first term in brackets in Equation (7) represents the value in 

nominal dollars of one dollar invested k years earlier. The 

nominal value of the asset after k years depends on both the 

annual growth rate in real value, g, and the annual rate of 

increase in the price level, p. The tax is imposed on the 

difference between the value at the time of sale, in current 

prices, and the value at the time of purchase, in prices 

prevailing k years earlier. 

In the presence of inflation, the after-tax real yield is the 

annual growth rate at whi c h 1 dollar invested in year 1 will 

increase in value to the amount realized after k years, net of 

capital gains taxes, where both before-tax proceeds and taxes 

paid are expressed in year 1 dollars. Thus, the real after-tax 

rate of return is computed from the equation: 

(1 + n)k = (1 + g)k - (T/ (1 + p)k) (8) 

Substituting (7) into (8), the net rate of return is equal 

to: 

n = ((1 + g)k(1- am)+ am/ (1 + p)k) 1/ k- 1 ... (9) 

Equation (8) shows that the net rate of return depends on the 

before-tax rate of return (g), the holding period (k), the 

percentage of capital gains included in taxable income (a), the 

taxpayer's marginal tax rate (m), and the rate of inflation (p). 

For any given real before-tax re t urn, the after-tax rate of 

return is greater for longer holding periods and smaller for 

larger values of the percentage of capital gains included in 
-61-

taxab le income, the marginal tax rate, and the rate of in f lation . Thu s , the real effec t ive tax rate falls with increases in the 

ho l di ng period, bu t rises with increases in t he rate of 

infl ation . 

For yield assets, the real effective tax rate also increases 

with the rate of inflation because the nominal appreciation in 

the value of the asset needed to maintain the real value of the 

i nve s to r 's wealth is subject to the capital gains tax upon sale . The expression for the after-tax rate of return for a y i e l d asset 

is: 

n = [(1 + g(1- m))k- am(1- (1/ (1 + p)k))) 1/ k- 1 . . . ( 10) 

The second term in the brackets in Equation (10) repr e sents 

the reduction in the after-tax yield caused by taxation of 

nomina l appreciation that just compensates for inflation . If 

there were no tax on nominal appreciation (a=O) or no infl ation 

(p=O) , Equation (10) reduces to Equation (6) and the real 

effective tax rate is equal to the marginal tax rate, m. 

Table 2 . 1 illustrates how changes in the holding peri od and 

the rate of inflation alter the effective tax rates on the 

returns to growth and yield assets . The calculations assume a 60 

percent exclusion, a 50 percent margina l tax rate, and a r eal 

be f or e -tax rate of return on growth assets of 4 percent . Th e 

nominal before-tax rate of return is higher for those case s with 

highe r inflation. It is assumed that the real before-tax return 

on yield assets adjusts to keep after-tax returns equalized on 

both growth assets and yield assets for a top-bracket investor . Thus , the table shows how alternative assumptions about expected 

inflation rates and holding periods affect the relative 

befor e-tax returns , or the relative cost of capital, between 

activi t ies where t he return is in the form of annual cash f low 

and activities in which the return is in the form of 

appreciation . 

Table 2.1 demonstrates that the effective tax rate on growth 

assets increases with inflation, but declines with increases i n 

the holding period because of the benefits of tax deferral. For 

a n a s s et held one year and one day, the effective tax rate is 20 

pe r cent wi th no i n flation (40 percent of the 50 percent ma rgi nal 

tax r ate), 29.8 percent with a 2 percent inflation rate , 43.8 

percent with a 5 percent inflation rate, 57.0 percent with an 8 

percent inflation rate , and 73.6 percent with a 12 percent 

infla tion rate. For longer holding periods, the real eff ective 

tax rate is lower and is relatively less sensitive to changes in 

the rate of inflation . For example,-rGr assets held 20 years, 

t he e ffective tax rate rises from 14 . 9 percent with no inflation 

to 27 . 3 percent with 12 percent inflation . 

The examples in Table 2.1 illustrate the ambiguity in 

determining "the" effective tax rate on the return on 
-62-

Table 2.1 

Effects of Inflation and Holding Period on Effective Tax Rates 

on Growth Assets and Yield Assets for a Taxpayer in the 

50 Percent Bracket with a 60 Percent Exclusion 1/ 

I 

I 

Holding! Annual 

period !inflation 

(years)! rate(%) 

1 

10 

20 

0 

2 

5 

8 

12 

0 

2 

5 

8 

12 

0 

2 

5 

8 

12 

I !Annual reall 

I Annual !before-tax 

I real I return on 

!after-tax I yield 

!return (%)1 asset (%) 

3.2 

2.8 

2.2 

1. 7 

1.1 

3. 3 

3.0 

2.7 

2.5 

2.2 

3.4 

3. 2 

3.1 

3.0 

2.9 

6.4 

6.4 

6. 4 

6. 4 

6.4 

6.6 

6.6 

6.6 

6.6 

6. 6 

6.8 

6.8 

6 .8 

6.8 

6.8 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Effective tax rate (%) 

Growth I Yield 

asset I asset 

20.0 

29.8 

43 .8 

57.0 

73.6 

17.4 

24 . 2 

32 . 2 

38.2 

43.9 

14.9 

19.3 

23.4 

25.7 

27.3 

50.0 

56 . 1 

64.9 

73.1 

83.5 

50.0 

54.1 

58 . 9 

62 .6 

66 .0 

50. 0 

52.6 

55.0 

56.4 

57.3 

August, 1985 

1/ The annual real before-tax rate of return on growth assets is 

4 percent. The annual real after-tax return is the same on 

both assets. The calculations assume the growth asset has no 

cash flow returns and the real market value of the yield 

asset remains unchanged. 
-63-

appreciating assets. For assets held for a long period of time , the effective tax rate can be extremely low when the inflation 

rate is zero; moreover, it does not rise dramatically with 

moderate increases in the rate of inflation . On the other hand, 

the effective tax rate on the return to appreciating assets can 

be extremely high if the taxpayer expects to sell the asset 

within a short period of time and if a significant portion of the 

increase in nominal value is expected to result from inflation 

rather than from real appreciation. 

In contrast, the effective tax rate on yield assets does not 

vary as much with the holding period because the portion of the 

tax imposed on the real return is assessed every year. For an 

inflation rate of 8 percent, the effective tax rate on yield 

assets is 73.1 percent for a 1 year holding period and 56.4 

percent for a 20 year holding period; in contrast, the effective 

tax rate on growth assets declines from 57.0 percent to 25 . 7 

percent for the same increase in holding period. As the holding 

period increases, the required before-tax return on yield assets, 

relative to growth assets, increases. In contrast, the relative 

before-tax returns on the two assets are not altered by changes 

in the rate of inflation. For a holding period of one year , the 

effective tax rate on yield assets rises from 50 . 0 percent in the 

absence of inflation to 83.5 percent at an inflation rate of 12 

percent, while the required before-tax return remains at 6.4 

percent when growt h assets earn a 4 percent before-tax return . For a holding period of 20 years, the effective tax rate on yield 

assets varies from 50.0 percent with no inflation to 57 . 3 percent 

at an inflation rate of 12 percent . The required before-tax 

return, for a 20 year holding period, is 6.8 percent at all 

inflation rates when the before-tax return on growth assets is 4 

percent. 

c. Effects of the 1978 and 1981 Tax Change s 

The 1978 Act substantially reduced the effective tax rate on 

the return from appreciating assets by lowering the capital gains 

inclusion rate from 50 percent to 40 percent, removing capital 

gains from the base of the add-on minimum tax, and eliminating 

the requirement that taxpayers offset the untaxed portion of 

capital gains against income entitled to the benefits of the 

maximum tax on personal service income. However, the 1978 Act 

did not reduce the maximum marginal tax rate on ordinary income . The 1978 Act did lower marginal tax rates for many taxpayers by 

increasing exemptions, widening brackets, and reducing some 

statutory rates; however, most, and in many cases all, of the 

effect of this rate reduction was offset by bracket creep between 

1977 and 1981 . 

In contrast, the 1981 Act lowered the marginal tax rate 

applied to all forms of income. In particular, rates were 

significantly reduced in the highest income bracket, where the 
-64-

rate applied to fully taxed income from capital was reduced from 

70 percent to 50 percent. 

The decline in inflation that began in late 1981 has also 

substantially reduced real effecti ve tax rates on the return to 

saving. Between 1976 and 1981, the average annual rate of 

inflation, as measured by the GNP deflator, was 7.9 percent. In 

contrast, the GNP deflator increased at an annual rate of 4.4 

percent in 1982, 3 . 8 percent in 1983, and 3.7 percent in 1984. 

Tables 2.2 and 2.3 show how the 1978 and 1981 tax changes and 

the decline in anticipated rates of inflation have raised the 

expected real after-tax rate of return to savers, and lowered 

real effective tax rates on the returns from different types of 

assets. In the examples illustrated in the two tables, the 

expected real before-tax yield on growth assets is taken to be 4 

percent. The examples also assume that both growth and yield 

assets are held for 6.5 years. This holding period assumption 

corresponds to the average holding period, weighted by dollar 

volume of sales, of corporate shares sold in 1977. 

The holding period assumption used to estimate effective tax 

rates represents a lower bound number, and therefore overstates 

average effective tax rates, because the computation of the 

average holding period does not take account of assets that are 

not sold during the lifetime of the purchaser. For growth assets 

held until death, the effective tax rate is zero because of the 

step-up in basis at death. Moreover, the average holding period 

for corporate shares is considerably shorter than the average 

holding period for other assets for which data are available. 

Table 2 . 2 shows the effect of changes in tax laws and the 

decline in expected inflation on the effective tax rate on the 

return on growth and yield assets for the highest bracket 

taxpayer under the assumption that after-tax returns on the two 

asset types are equalized for taxpayers in the highest tax 

bracket . (Calculations for an alternative and less extreme 

assumption -- that after-tax returns are equalized for an average 

investor-- are presented in Table 2.3). At an 8 percent 

inflation rate, the change in capital gains taxation in the 1978 

law reduced the effective tax rate on growth assets for a top 

bracket taxpayer from ·117.6 percent to 63.5 percent. The 

extremely high real effective tax rates under both 1977 and 1979 

law result from the fact that inflation accounts for two-thirds 

of the 12 percent nominal before-tax return on assets. However, 

the 1978 capital gains tax reduction by itself cut the effective 

tax rate almost in half and increased the anticipated real 

after-tax return corresponding to a 4 percent before-tax real 

return from -0.7 percent in 1977 to 1.5 percent in 1979. The 

reduction in the top bracket rate from 70 percent to 50 percent 

in t he 1981 Act further increased the real expected return to 2.2 

percent, and lowered the effective tax rate to 44.4 percent . At 
Assumed 

I 

I 

I 

-65-

Tabl e 2.2 

Effects of Inflation and Tax Law Changes 

on Effective Tax Rates on Growth and Yield Assets 

for a Top Bracket Taxpayer ll 

I Annual I 

I real I 

Marginal Annual I before- taxi 

I Annual tax rate (%) real I return I 

Effective 

tax rate (%) 

tax I inflation Capital! Ordinary after-tax I yield !Growth Yield 

structure I rate (%) gains I income return (%)1 asset (%) I asset asset 

Late 1970s inflation 21 

-

1977 law 8.0 49.0 70.0 -0.7 7.2 117.6 109.8 

1979 law 8.0 28 .0 70 .0 1.5 9.9 63.5 85.2 

1984 law 8.0 20.0 50.0 2.2 6.5 44.4 66.0 

Expected mid-1980s inflation 21 

-

1977 law 4. 0 49.0 70 . 0 0.6 7.2 85.7 92.0 

1979 law 4.0 28.0 70 . 0 2.1 9.9 47.0 78 . 5 

1984 law 4.0 20 . 0 50.0 2.7 6.5 33.1 59.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ The real before- tax r ate of return on growth assets is 4 percent per year, 

compounded annually, and the holding period for both growth and yield assets 

is 6.5 years. The holding period is the sales-weighted average holding 

period for corporate shares sold in 1977, computed from IRS data on sales of 

capital assets in 1977. 

2/ The annual rate of increase in the GNP deflator averaged 7.9 percent between 

1976 and 1981, that then declined to 4.4 percent in 1982 (between 1981 IV 

and 1982 IV), 3 .8 percent in 1983, and 3.7 percent in 1984. 
-66-

an 8 percent rate of inflation, the effective tax rate under both 

1979 law and current law is slightly below the statutory tax rate 

(70 percent in 1979, 50 percent in 1981). 

The required return from an asset yielding cash flow returns 

was 7 . 2 percent in 1977. The effective tax rate at an 8 percent 

rate of inflation was 109.8 percent.8/ The 1978 capital gains 

tax cut lowered the tax rate on yiela assets to 85 . 2 percent, but 

substantially widened the disparity in the tax treatment of the 

two types of assets. The before-tax return on yield assets 

required to produce the same after-tax return as that received on 

a growth asset with a 4 percent before-tax return increased from 

7.2 percent to 9.9 percent. The reduction in the top bracket 

rate to 50 percent, on the other hand, lowered the effective tax 

rate ·on yield assets to 66.0 percent, at an 8 percent rate of 

inflation, and reduced the required before-tax return to 6.5 

percent. The combination of the two changes lowered the required 

before-tax return on yield assets, relative to growth assets. 

The decline in the inflation rate from around 8 percent to 

about 4 percent, taken by itself, had a smaller effect on 

expected real after-tax yields than the reductions in capital 

gains taxation and the top marginal rate. If 1977 law had 

remained in effect, the decline in inflation would have increased 

the expected real after-tax return from -0.7 percent to 0.6 

percent. The effective tax rate on growth assets would have 

declined from 117.6 percent to 85.7 percent and the effective tax 

rate on yield assets would have declined from 109.8 percent to 

92.0 percent. 

The last row of Table 2.2 shows the after-tax return and the 

effective tax rates under current law for both yield assets and 

growth assets, at a 4 percent rate of inflation. The combination 

of the tax reductions since 1978 and the reduction in the 

expected rate of inflation lowered the estimated effective tax 

rate on growth assets from 117 . 6 percent to 33.1 percent and on 

yield assets from 109.8 percent to 59.0 percent for a top bracket 

taxpayer. 

In contrast to the top bracket taxpayer depicted in Table 

2.2, Table 2.3 shows similar data for an average recipient of 

capital gains on corporate shares . The average marginal tax rate 

on fully taxable income, weighted by sales, for taxpayers 

reporting long-term sales of corporate shares in 1977 was 39.9 

percent. These same taxpayers faced an average marginal rate of 

20.0 percent on capital gains realizations in 1977, because of 

the exclusion of 50 percent of realized long-term capital gains 

from the income tax under 1977 law.9/ The increase in the 

exclusion rate in 1978 to 60 percent, coupled with the removal of 

capital gains from the add-on minimum tax, lowered the average 

marginal tax rate that would have applied to 1977 long-term 

realizations to 14.8 percent in 1979. The marginal tax rate on 

ordinary income declined slightly to 37.0 percent for taxpayers 
-67-

Table 2.3 

Effects of Inflation and Tax Law Changes 

on Effective Tax Rates on Growth and Yield Assets for an 

Average Recipient of Gains on Corporate Shares 1/ 

I I I Annual real! 

I I Marginal tax I Annual before-tax I Effective 

Assumed I Annual I rate (%) I real return on al tax rate (%) 

tax I inflation !Capital !Ordinary !after-tax yield I Growth I Yield 

structure rate (%) income return(%) asset(%) asset asset 

Late 1970s inflation 

1977 law 8.0 20.0 39 .9 2.2 5.4 44.4 59.1 

1979 law 8.0 14.8 37.0 2.7 5.5 32.5 50.8 

1984 law 8.0 13.1 32 . 7 2.9 5.2 28.6 45.4 

ExEected mid-1980s inflation 

1977 law 4.0 20.0 39.9 2.7 5.4 33.1 50 . 7 

1979 law 4.0 14.8 37.0 3.0 3.0 24.3 44.8 

1984 law 4.0 13.1 32.7 3.1 5.2 21.4 39.9 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Marginal tax rates in 1977 and 1979 are computed from the 1977 Sales of Capital 

Assets File and represent the gain- weighted average of the marginal tax rate on 

a dollar of fully taxed income for taxpayers selling corporate shares in 1977. 

The average marginal tax rate for ordinary income under 1982 law is computed by 

multiplying 37.0 by the ratio of marginal tax rates for families with twice 

median income in 1984 under the 1981 Economic Recovery Tax Act (38 percent) and 

the 1980 marginal tax rate of the same group under the old tax law (43 

percent). The marginal tax rate on capital gains under 1982 law is 40 percent 

of the marginal tax rate on ordinary income. 

Source: Economic Report of the President 1982, p. 120. 
-68-

with long-term sales. The marginal tax rate on capital gains is 

40 percent of the marginal tax rate on ordinary income under both 

1979 law and 1984 law. 

For 1984, the average marginal tax rate on ordinary income 

for the average recipient of capital gains on corporate shares is 

estimated to decline to 32.7 percent. This decline reflects the 

net effect of the three year marginal tax rate cut and bracket 

creep from estimated inflation between 1980 and 1984. 

Table 2.3 shows that, at an 8 percent inflation rate, the 

1978 capital gains tax cut reduced the average effective tax rate 

on growth assets from 44.4 percent to 32.5 percent and increased 

the expected after-tax return from 2.2 percent to 2.7 percent. 

This reduced the effective tax rate on growth assets to slightly 

below the average statutory marginal tax rate for realizers of 

gains. The 1981 Act further lowered the effective tax rate on 

growth assets from 32.5 percent to 28.6 percent and increased the 

after-tax return to 2.9 percent. 

The reduction in inflation from around 8 percent to about 4 

percent lowered the effective ta x rate on growth assets from 44.4 

percent to 33.1 percent and also increased the after-tax return 

corresponding to a real before- tax return of 4 percent from 2.2 

percent to 2.7 percent. The combination of the 1978 and 1981 tax 

changes and the reduction in inflation in the early 1980s reduced 

the effective tax rate on growth assets from 44.4 percent to 21.4 

percent -- a cut in the tax rate of over 50 percent -- and 

increased the estimated expected after-tax return from 2.2 

percent to 3.1 percent. 

The 1978 capital gains tax reduction increased the required 

before-tax return on yield assets, when the return on growth 

assets is held at 4 percent, from 5.4 percent to 5.5 percent. 

The subsequent cut in marginal tax rates, however, reduced the 

required before-tax return on yield assets to 5.2 percent . Thus, 

while the 1978 capital gains tax increased the relative tax 

advantage for growth assets, the 1981 cut in marginal tax rates 

provided a relative gain for yield assets. The combination of 

the two changes lowered the cost of capital on yield assets 

relative to growth assets. 

In summary, the anticipated real effective tax rates facing 

prospective buyers of capital assets -- especially those assets 

that provide returns in the form of appreciation in value rather 

than annual cash payments -- have declined substantially between 

the late 1970s and the early 1980s because of both tax policy 

changes and the slowdown in the rate of inflation. Based on 

reasonable assumptions about average expected before-tax returns, 

the expected tax rates on appreciating assets have been reduced 

by more than half for the re pr e s e ntative buyer of appreciating 

assets, and have fallen to j ust ov er one-fourth the pre-1978 rate 

for savers who then faced the top marginal tax rate on capital 
- 69-

gains. Although the effective rate facing any single investor 

var1es greatly with the anticipated pre-tax rate of return and 

the pl anned holding period, the real effective tax rate is now 

below the statutory marginal tax rate applied to ordinary income 

for assets with average rates of return . At the same time, the 

relative tax advantage of growth assets compared to yield assets -- measured as a lower required before-tax return -- first 

widened as a result of the capital gains cuts in the 1978 Act, 

but then narrowed to less than the pre-1978 advantage as a result 

of the reduction in marginal tax rates in the 1981 Act . 

D. Ev i dence fr om Sales of Capital Assets Files 

Tables 2.2 and 2.3 show hypothetical effective tax rates 

confronting investors in the late 1970s and early 1980s, given 

reasonable assumptions about expected rates of inflation and 

expected real before-tax returns. An alternative approach to 

measuring the taxation of the returns to saving is to measure the 

effective tax rate actually paid on the income from date of 

purchase to date of sale generated by assets sold in recent 

years . 

It should be emphasized that current saving behavior depends 

on expected future after- tax returns, and not directly on the 

fraction of real returns that were taxed away in the past. At 

any particular time , the capital gains tax is collected on the 

accumulation from past investments. Current capital gains tax 

rates only affect current saving decisions to the extent savers 

expect those rates to remain in effect at the time when assets 

purchased today are sold. Thus, the most relevant calculations 

of the effect of capital gains taxation on incentives to hold 

growth and yield assets are calculations such as those presented 

in Tables 2.2 and 2.3 that estimate how capital gains taxes 

affect expected future returns. Nonetheless, it is also useful 

to estimate the effective tax rate on appreciation from past 

asset purchases for assets sold in recent years, and how that 

effective tax rate, ex post, would have been reduced if those 

gains had been taxed at the lower rates prevailing after the 1978 

Act . 

These data provide a useful supplement to the ex ante data in 

Tables 2 . 2 and 2.3 for two reasons. First, they provide 

additional information because they are based on real before-tax 

returns actually earned by a sample of taxpayers who sold assets 

in recent years. To the extent that rates of return on assets 

sold differ from those earned on all assets, estimated effective 

tax rates will also differ. Second, the data on actual sales 

reported on taxpayers' returns enable one to estimate roughly how 

real effective tax rates on growth assets have differed in the 

past among taxpayers in differ ent income groups . 

The IRS studies on Sales of Capital Assets for 1973 and 1977 

provide detailed data on purcha ses and sales of different types 
-70-

of capital assets, including date of purchase, date of sale, type 

of asset , purchase price, and sales price. From these data, it 

is possible to compute the real before-tax rate of return, g, for 

any capital asset sold in 1973 and 1977 from the equation: 

V = (1 + g)k (1 + p)kB . .. (11) 

or 

g = (V/(1 + p)kB) 1/ k- 1 ... (11a) 

where B is the purchase price of the asset, V is the sales price 

(before capital gains tax), pis the average annual percentage 

rate of increase in the GNP deflator between the date of purchase 

and the date of sale of the asset, and k is the number of years 

between purchase and sale. 

The real after-tax rate of return is computed from the 

equation : 

(V- T) = (1 + n)k(1 + p)kB ... (12) 

or 

n = ((V- T) / (1 + p)kB) 1/ k- 1 ... (12a) 

where T is the additional capital gains tax paid attributable to 

the sale of the asset and n is the real after-tax rate of return . The term (V-T) thus represents the net (after-tax) proceeds from 

the sale. 

The capital gains tax attributable to the sale, T, is 

computed by simulating the individual tax model developed by the 

Office of Tax Analysis, using the tax calculators applicable for 

1973 tax law, 1977 tax law, and 1979 tax l aw . For each taxpayer , the model computes the last dollar marginal tax rate for an 

additional dollar of long-term capital gain. This marginal tax 

rate on long-term gai ns (or reduced capital losses) for each 

taxpayer is then u sed to compute the additional tax liability 

att ributable to any sale in the asset class. 

The effective tax rate for any asset c l ass is then compu ted 

from the equation: 

t = (g - n)/ g 

where the before and after-tax rates of return, g and n, are 

weighted averages of the rates of return from all capital assets 

in the asset class. In computing the average rates of return, 

each transaction is weighted by its gross sales value. Note 

that , with infl ation, a negative real before-tax return can 

accompany a positive nominal before-tax return . Such cases 

represent an extreme case of overtaxation, where positive capital 

ga i ns taxes are paid even though the real rate of return is 

negative. !.Q/ 
-71-

Table 2.4 shows the effective tax rates applied to real 

before-tax rates of return on corporate shares and non-business 

real estate sold in 1973 and 1977. The effective marginal tax 

rate at which net losses can be deducted is less than the 

effective tax rate on gains for two reasons. First, and more 

important, inflation raises the ratio of taxes to real gains, and 

lowers the ratio of (negative) taxes to real losses because 

nominal gains are greater than real gains and nominal losses are 

less than real losses. Second, some taxpayers have insufficient 

gains against which to offset all capital losses.!!/ 

Aggregating across sales, net taxes per dollar of net real 

gain on all sales are greater than taxes per dollar of real gain 

on sales with positive gains because the additional tax per 

dollar of additional real gain is greater than the reduction in 

tax per dollar of real loss. Thus, in Table 2.4, the effective 

tax rate on all gains and losses for both corporate shares and 

non-business real estate is greater than the effective tax rate 

on returns with gains only.12/ For non-business real estate, 

very few returns showed losses; therefore, the effective tax 

rate on all returns is only slightly greater than the effective 

tax rate on returns with gains only. 

Table 2.4 shows that the capital gains tax changes in the 

1978 Act would have reduced the real effective tax rate on the 

income from corporate shares sold in 1977 from 29.4 percent to 

19.8 percent, and on non-business real estate from 27.8 percent 

to 18.3 percent. 

Table 2.5 compares the effective tax rates on assets sold in 

1977 to the effective tax rates that would have resulted under 

alternative tax rules. Calculations are performed for all 

rea l ized gains and losses, and for realized gains and losses on 

assets held for 25 years or more. In each category, the first 

two rows of Table 2 . 5 show the effective tax rates under the 

rules for taxing capital gains in 1977 and 1979. ·The third row 

estimates what the effective tax rate would have been, given 1977 

realizations, if nominal capital gains were taxed at the same 

rate as ordinary income. The fourth row shows the effective tax 

rate if capital gains were taxed at the same rate as ordinary 

income, with a basis adjustment for inflation . In computing the 

tax rates shown in the third and fourth rows, it is assumed that 

the taxpayer confronts the same last dollar marginal tax rate on 

ordinary income as he would under 1977 law . Finally, the fifth 

row shows the last dollar marginal tax rate applied to ordinary 

income . 

Table 2 . 5 shows that the effective tax rate on both corporate 

shares and non-business real estate sold in 1977 was 

signi f icantly below the marginal tax rate confronted by the same 

taxpayers on ordinary income under both 1977 and 1979 rules for 

taxing capital gains. The tax rates on corporate shares and 

485-125 0 - 85 - 4 
-72-

Table 2.4 

Real Effective Tax Rates Applied to Capital Gains Income, 

1973 and 1977 Realizations (%) !I 

1973 1977 realizations 

Assets realizations 1977 law I 1979 law 

Coq~ora te shares 

All gains and losses 23.7 29.4 19.8 

Returns with gains only 16.7 23.4 16.4 

Returns with l osses only 8.2 10.1 9.1 

Non-business real estate 

All gains and losses 21.1 27.8 18.3 

Returns with gains only 19 .6 25.6 16 . 9 

Returns with losses only 1.8 2.6 2.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

11 Calculations include long- term nominal gains and losses only 

(assets held over 6 months if sold in 1973 and over 9 months if 

sold in 1977). In computing average tax rates, transactions 

are weighted by dollar volume of sales. 

Source: Computations from 1977 Sales of Capital Assets files. 
- 73-

Table 2.5 

Real Effective Tax Rates on Capital Gains Income Under 

Alternative Tax Rules, 1977 Realizations (%) 1/ 

Assumed tax 

structure 

All realized gains and losses 

1977 tax law 

1979 tax law 

Full inclusion, 

no basis adjustment 

Full inclusion, 

basis adjustment 

Last dollar marginal 

tax rate, 1977 law 

Assets held 25 years or more 

1977 tax law 

1979 tax law 

Full inclusion, 

no basis adjustment 

Full inclusion, 

basis adjustment 

Last dollar marginal 

tax rate, 1977 law 

Corporate 

shares 

29.4 

19.8 

54.9 

35 . 4 

39 . 9 

27.3 

11.7 

37 . 1 

26 . 4 

61.5 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Non-business 

real estate 

27.8 

18 .3 

48 .5 

30 . 1 

30 . 5 

26.2 

14.8 

49.1 

23.6 

39.5 

August, 1985 

1/ Calculations include long-term nominal gains only (assets held 

over 9 months) . In computing average tax rates, transactions 

are weighted by dollar volume of sales. 

Source: Computations from 1977 Sales of Capital Assets files . 
-74-

non-business real estate held 25 years or more were lower than 

the effective tax rate on the return from all corporate shares 

and non-business real estate because the benefits from deferral 

of tax are greater for assets with longer holding periods and 

because assets held a longer time prior to 1977 were subject to 

less inflation. 

Full inclusion of gains on all corporate shares and 

non-business real estate, without a basis adjustment for 

inflation, would raise the effective tax rate on the income from 

appreciation of both assets above the rate applied to ordinary 

income. The high effective tax rates that would apply if a full 

inclusion rule had been applied to all 1977 realizations -- 54.9 

percent for corporate shares and 48.5 percent for non-business 

real estate -- result because a large portion of the gain from 

the sale of assets reflects changes in the general price level 

rather than a change in the real value of the asset. The 

taxation of inflationary gains more than offsets the benefits 

from deferral of tax on all gains, real and inflationary, until 

realization. The real effective tax rate would be reduced to 

35.4 percent for corporate shares and 30.1 percent for 

non-business real estate if taxpayers were allowed to adjust the 

cost basis of assets for inflation. With a basis adjustment, the 

computed effective tax rates are slightly below the marginal tax 

rate on ordinary income, reflecting the benefit from deferral. 

Finally, it is interesting to note that taxpayers realizing 

gains on corporate shares held 25 years or more are generally in 

a very high tax bracket. The marginal tax rate, weighted by sales, on an additional dollar of income for these realizers of 

very long-term gains on corporate shares is 61.5 percent, 

compared to 39.9 percent for all recipients of gains (and losses) 

on shares. However, even though the statutory marginal tax rate 

is higher for sellers of shares held 25 years or more, the 

effective tax rate applied to income from those shares was lower 

than the effective tax rate applied to income from all corporate 

shares. This comparison illustrates the importance of deferral 

for assets with long holding periods. 

The effective tax rates shown in Tables 2.4 and 2.5 for 1977 

and 1979 law are lower than the effective tax rates from current 

investments estimated in Table 2.3. Compared to the case of 4 

percent inflation in Table 2.3 -- an inflation rate roughly 

comparable to the inflation during the holding period of assets 

sold in 1977 (though lower than the inflation rate during the 

late 1970s) -- the effective tax rate on corporate shares was 

29.4 percent rather than 33.1 percent under 1977 law and 19.8 

percent rather than 24.3 percent under 1979 law. The major 

reason for this difference is that the before-tax real yield on 

actual realizations, weighted by dollar value of sales, was much 

higher than the anticipated 4 per cent real yield assumed for 

current asset purchases. In other words, long-term capital asset 

sales reported for tax purposes show higher rates of return than 

the long-term historical trends on all asset accruals. 
-75-

Table 2.6 provides a more detailed breakdown of the annual 

rates of return and effective tax rates on corporat~ shares sold 

in 1977. The weighted average (by sales) annual before-tax 

nominal rate of return on these assets was 16.3 percent. This 

nominal return resulted from an average before-tax real return of 

9.7 percent and an average inflation rate of 6.0 percent over the 

period the shares were held. The before-tax real rate of return 

was over 10 percent for shares held less than three years, but 

was only 6.1 percent for shares held 25 years or more. The 

effective tax rate for shares held for a long period of time was 

lower than the effective tax rate for all shares (21.7 percent 

for shares held 10 to 25 years and 18.6 percent for shares held 

25 years or more compared to 29.4 percent for all shares). The 

lower effective tax rate on long-held shares reflects the 

benefits to taxpayers from deferring the payment of tax until 

realization. Had the 1978 Act changes been in effect for 1977 

sales, th~ effective tax rates would have been 19.8 percent for 

all corporate shares and 11.7 percent for shares held more than 

25 years (see Table 2.5). 

Finally, Table 2.7 shows the rates of return and effective 

tax rates by income class for 1977 corporate share realizations. 

It is interesting to note that the effective tax rate for the 

highest income class (27.3 percent for over $200,000 AGI) was 

slightly below the effective tax rate for all income classes 

(29.4 percent) . The higher statutory marginal tax rate imposed 

on taxable income in the highest income class was offset by the 

fact that these taxpayers generally sold shares with much higher 

before-tax rates of return. In particular, the nominal rate of 

return on shares sold in 1977 by taxpayers with AGI over $200,000 

was roughly twice as large as the before-tax rate of return on 

all shares sold. Thus, for the highest income taxpayers, a much 

higher fraction of the before-tax nominal return was accounted 

for by real gains, rather than by inflationary gains, than for 

taxpayers as a whole. 

III. The Effect of Capital Gains Taxation on the Incentive to 

Sell Appreciated Assets 

A. Introduction 

As previously noted, the capital gains tax is imposed when 

the gain on an asset is recognized or realized, rather than as 

gains accrue. In addition, the basis of inherited assets is the 

market value at the time acquired by the beneficiary, not the 

original purchase price paid by the decedent. As a result, for 

most assets, the capital gains tax can be permanently avoided if 

the asset is never sold. The opportunity to avoid the capital 

gains tax makes it profitable to re frain from some asset sales, 

even if the prospective seller expects to receive a higher rate 

of return from an alternative investment. 
Holding 

period 

(lears) 

0.75-1 

1-2 

2-3 

3-4 

4-5 

5-10 

10- 25 

25 + 

Total 

- 76-

Table 2. 6 

Annual Rates of Return and Effective Tax Rates on Corporate 

Shares by Holding Period, 1977 Realizations 

Annual I Annual Annual I Annual I 

before-tax I before-tax after-tax I after- tax !Effective 

nominal rate !real rate of !nominal rate I real rate of ltax rate 

of return (%) I return (%) I of return (%)1 return (%2 I (%) 

16.4 10.2 12.7 6 . 7 34.7 

20 .8 14.2 16.1 9.8 31.3 

26.1 17.9 21.2 13 .3 25 . 9 

19.3 10.8 16.1 7.9 27.2 

10.7 3.2 9.0 1.6 49.2 

11.2 4.5 9.8 3.2 29.5 

11.6 6. 5 10.1 5.1 21.7 

10.2 6.1 9.0 5 . 0 18.6 

16.3 9.7 13.3 6. 8 29.4 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Computations from 1977 Sales of Capital Assets File. 
-77-

Table 2.7 

Annual Rates of Return and Effective Tax Rates 

on Corporate Shares by Income Class, 1977 Realizations 

Adj usted I Annual I Annual Annual I Annual I 

gross I before- tax I before- tax after-tax I after-tax !Effective 

i ncome I nominal rate !real rate of I nominal ratel real rate of I tax 

($thou) I of return (%) I return (%) lof return (%)1 return (%) I rate (%) 

0- 5 7. 5 1. 0 7 . 5 1. 0 3 . 1 

5-10 5. 7 -0 .6 5.4 -0.9 1/ 

-

10-15 10 . 2 4.0 9.4 3. 2 19.9 

15-20 12.5 5. 9 11.5 4.9 16 . 9 

20-30 9.9 3.4 8 . 6 2.2 34 . 6 

30-50 10 . 3 3. 9 8.7 2. 5 36.0 

50- 100 16.0 9. 4 12.7 6.3 33 .3 

100-200 23.5 16. 5 18.1 11 .5 30.7 

200 + 33.0 25.8 25 . 5 18.7 27 .3 

Total 16.3 9. 7 13.3 6.8 29 . 4 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ In this case, a positive tax was imposed on a negative real rate of return . 

Source : Computations from 1977 Sales of Capital Assets File . 
-78-

This "lock-in" effect associated with the capital gains tax 

as structured under existing law was a major reason cited for 

reducing the capital gains inclusion rate during the debates on 

the Revenue Act of 1978. Some proponents of the 1978 changes 

argued that the unlocking of past gains from a lowering of rates 

would be so great that Federal tax revenues would actually 

increase . 

It is important not to confuse the lock-in effect with any 

disincentive to saving resulting from the taxation of income from 

capital. The lock-in effect results purely from the fact that 

the tax is imposed upon recognition by sale or exchange , rather 

than when the income is accrued, and depends on the amount of 

capital gains tax as a fraction of the sales price of the asset. 

In contrast, as noted in the previous section, the capital gains 

tax affects the incentive to save by altering the prospective 

after-tax rate of return to the buyer of an asset. The expected 

present value of the tax on an anticipated future sale, not the 

tax actually paid when the asset is sold, influences the decision 

to save by altering the expected return to this particular form 

of saving. Thus, the tax rate that influences saving is not 

measured as a percentage of the gain or the sales price, but 

rather is measured as a percentage reduction in the expected rate 

of return over the entire planned holding period of the asset. 

For assets held for many years, a large tax upon realization, 

computed as a share of the gain, may in fact only reduce the rate 

of return over the life of the asset by a small amount. 

The relationship between such tax impediments to the sale of 

appreciated assets and any possible inefficiency in the 

allocation of saving among types of capital assets is not well 

established. For capital to be allocated efficiently among uses, 

prospective yields on alternative investments must be equalized . The tax on capital gains realizations does cause some asset 

holders to be "locked in" to existing investments. However, for 

marginal returns in a market to be equalized, it is not necessary 

for all participants to have no impediments to exchange. Rates 

of return on alternative investments can be driven to equality if 

there are a sufficient number of market participants, with a 

sufficient amount of wealth, who are not ''locked-in" to 

particular investments by the tax system. Since the allocation 

of new saving among investments, the allocation of saving by 

tax-exempt institutions such as pension funds, and the allocation 

of a large share of saving by taxable investors not held in the 

form of assets with unrealized appreciation are all not impeded 

by the tax on realized gains, it is unlikely that the capital 

gains tax prevents enough movement of funds among assets to keep 

expected after-tax yields on alternative assets from being 

equalized. The fact that prospective yields among alternative 

investments are differentially taxed indeed leads to an 

inefficiency in the allocation of the capital stock because the 

assets with the highest expected after- tax returns are not always 

those with the highest before-tax returns. However, the 

''lock-in" effect does not necessarily worsen this misallocation. 
-79-

Rather, the inefficiency or misallocation associated with the '' lock-in" effect is of a different type. Si nce the taxation of 

gains upon realization impedes some sales that might otherwise 

take place, the capital stock may be allocated inefficiently 

among individuals. That is, even if society as a whole is 

holding the right total amount of all assets, the total expected 

return from the capital stock, and thus the total e conomic 

welfare of asset holders, would be greater if ownership rights to 

particular assets could be reallocated among individuals. 

The ineffi c iency which occurs when ownership rights are 

misallocated among individuals can take several forms. At the 

very least, tax impediments to asset sales prevent people f rom 

holding the assets they most prefer. For example, suppose a 

taxpayer wishes to sell asset A in order to purchase asset B at 

prevailing market prices, but is impeded from doing so by the 

capital gains tax. In this case, he is prevented from holding 

the asset that he believes would yield the highest after-tax 

return , if asset B could be purchased with the before-tax 

proceeds from the sale of asset A. Since asset prices reflect 

the market's expectation of future earnings, the taxpayer's wish 

to sell A in order to purchase B reflects the fact that his 

expectation of relative future returns from the two assets is 

different from the expectations of other shareholders. The 

taxpayer may be right or wrong in his perception, and his loss or 

gain from the transaction may be offset by the gain or loss for 

the investor who would have sold B to purchase A. Nonetheless, 

in an ex ante sense, total welfare could be reduced when 

individuals are impeded from holding the assets they most prefer . 

Moreover, the lock-in effect might result in a loss of 

productivity in those cases where the ownership and management of 

an asset or enterprise are not clearly separable. For example, 

an individual starting a new company often owns a significant 

fraction of the company's shares. If this individual is 

relatively more skilled at starting new enterprises than at 

managing a large ongoing organi zation, net productivity may 

increase if he sells his shares in the organization once it 

attains a certain size . A capital gains tax imposed at the time 

of sale might prevent the organization from "going public'', and 

thus prevent the efficiencies that would otherwise result from a 

reallocation of management personnel. 

Another example of this type of inefficiency is caused by the 

impositi on of a capital gains tax on the sale of a personal 

residence. Individuals clearly have different preferences for 

residing in a particular structure. Thus, any tax that deters an 

individual from changing his personal residence when changed 

ci r cumstances would otherwise cause him to move could lower the 

total value of the s t ock of housing . Special provisions of t he 

tax law that allow rollover of the sale of personal residences 

and a $125,000 exemption from cap i t al gains tax for taxpayers of 

age 55 or older prevent the capital gains tax from imposing a 

severe "lock-in'' effect on homeowners. 
-80-

Finally, it should be noted that some asset portfolio 

rearrangements desired by private inve stors are motivated by tax 

considerations rather than productivity concerns. Under the 

current tax system, there is a tendency for taxpayers in high tax 

brackets to seek to hold tax-preferred assets, thus driving down 

the before-tax yields on such assets relative to heavily taxed 

assets. Thus, for any given supplies of different types of 

assets, investors as a whole maximize after-tax returns when 

fully taxed assets are held by investors in low tax brackets and 

tax-preferred assets are held by investors in high tax . brackets.13/ The taxation of capital gains upon realization may 

impede the-movement toward an optimal allocation of assets among 

households - - from a tax minimization point of view -- by 

discouraging the sales of some assets by investors whose marginal 

tax brackets have changed. To the extent that "lock-in" prevents 

wealth holders from fully exploiting the opportunities in the tax 

system, it may increase Federal revenues in ways that would not 

be observed merely by looking at total realizations of capital 

gains. 

The next two parts of this section discuss two separate 

aspects of the effects of the capital gains tax on the decision 

to sell assets -- the effect of the capital gains tax on the 

decision to sell currently productive assets, and the effect of 

the capital gains tax in those situations in which payment of the 

tax is triggered by a termination of the production process. 

B. Empirical Evidence on the Effects of Taxing Sales of 

Appreciated Assets 

Suppose an individual sells an asset, A. The proceeds from the 

sale of one unit (such as a share of stock) of A are equal to the 

price per unit minus the capital gains tax. If the price is V 

dollars per unit, and the capital gains tax paid when the asset 

is sold is T, the individual can purchase an additional (V-T) 

dollars of an alternative asset, B, for the sale of a unit of the 

asset worth V dollars.l4/ Alternatively , to purchase one dollar 

of asset B, the indiviaual will have to sell V/ (V-T) dollars of 

asset A. Define the ratio V/ (V-T) as the tax price of 

realizations -- the value of an asset A that must be sold to 

finance the purchase of one dollar of an alternative asset. 

More generally, the tax price of realizations can be 

expressed as: 

P = (1 + i)n/ ((1 + i)n(1- am) +am) . . . ( 13 ) 

In Equation (13), Pis the tax price of realizations for a 

given asset, i is the annual nominal yield over the period the 

asset was held, n is the number of years the asset was held, a is 

the percentage of capital gains included in taxable income, and m 

is the taxpayer's marginal tax rate . If i is positive (the asset 

has increased in value), the tax price of realizations is greater 
-81-

than one and increases as the values of i, n, a, and m increase. 

If i is negative, the tax price of realizations is less than one 

and is smaller for larger values of n, a, m, and the absolute 

value of i, where a is interpreted as the fraction of the loss in 

asset value that can be deducted against other taxable income. 

A tax price of realizations greater than one indicates a tax 

barrier to asset sales; a tax price less than one implies a tax 

subsidy to asset sales . However , the tax price of realizations 

at any point in time does not fully describe how the capital 

gains tax affects the incentive to sell an appreciated asset . For example, suppose an individual owns an asset that has 

increased in value at 10 percent per year since the date of 

purcna se, and is expected to continue to increase at the same 

rate. The tax price of realizations will increase every year the 

asset is held, because the ratio of the tax base (the value of 

the asset in excess of the purchase price) to the total value of 

the asset will continually increase as the asset's nominal value 

rises . Thi s increase in the tax price will continue until the 

owner dies, at which point the tax basis of the asset becomes the 

value at death and the owner's beneficiary faces a tax price of 

realizations equal to one. 

The tax price of realizations as defined above is a good 

measure of the lock-in effect of the capital gains tax if the 

asset need not be sold to produce a stream of future income and 

if the individual is able to borrow against the future earnings 

from the asset, or has enough other sources of funds, to finance 

any large immediate consumption requirements.l5/ If the 

individual is seeking to maximize the presen t-aiscounted value of 

yields from his portfolio, then he will balance any reduction in 

the amount available for investment caused by the capital gains 

tax against any prospective increase in the rate of return on 

alternative assets. The tax price of realizations is a measure 

of the sacrifice in principal associated with switching to other 

a ssets. 

Tables 2.8-2.10 illustrate the tax price of realizations for 

taxpayers who realized long- term c apital gains and losses in 1973 

and 1977. Table 2 . 8 shows the tax price of realizations by 

income class for selected capital assets in 1973, weighted by the 

value of assets sold. On average, the tax price was 1 . 041 for 

a ll capital assets under then prevailing tax law, a modest 

disincentive to selling assets to finance purchases of other 

assets. The tax price for sales of corporate shares was 1 . 066, 

slightly higher than the tax price for all assets. The tax price 

for other securities was 1.000 because on average these 

securities did not increase in value over the period they were 

held. 

The tax price of realizations on all capital assets in 1973 

was substantially above 1.05 only for taxpayers with income in 

excess of $100,000. For these taxpayers, the disincentive to 

selling assets was significant. Moreover, since these data only 
-82-

Table 2.8 

Tax Price of Realizations for 

Long-Term Sales, 1973 Realizations 

Income Asset tl~e 

class Corporate I Other I Non-business All capital ($thou~ shares !securities! real estate Timber assets 

0-5 1.001 0.991 1.008 1.007 1.005 

5-10 1.009 0. 995 1.015 1.017 1.010 

10-15 1.017 0.984 1.034 1.060 1.017 

15-20 1.020 1.003 1.029 1.097 1.018 

20-30 1.024 1.001 1.046 1.087 1.024 

30- 50 1.033 0.998 1.082 1.293 1.037 

50-100 1.056 1.001 1.089 1.187 1.051 

100-200 1.104 1.003 1.110 1.317 1.075 

200 + 1.231 1.002 1.185 1.349 1.168 

Total 1.066 1.000 1.062 1. 156 1.041 

Office of the Secretary of the Treasury August, 1985 Office of Tax Analysis 

1/ The tax price is calculated as the ratio of before-tax proceeds from - asset sales to after-tax proceeds from asset sales. 

Source: Computations from 1973 Sales of Capital Assets File. 
-83-

show assets that were in fact sold, they presumably understate 

the tax price from potential realizations for those assets for 

which sales were contemplated. Taxpayers with income in excess 

of $200,000 faced an average tax price of realizations of 1.168 

for all capital assets and 1.231 for corporate shares. Thus, 

these taxpayers faced an excise tax of 18.8 percent ( .231/ 1.231) 

of the value of corporate shares sold. 

Table 2.9 shows the same data for 1977. The average tax 

price of realizations for all assets and for corporate shares was 

slightly higher in 1977 than in 1973. However, the tax price for 

corporate shares in the highest income class was significantly 

higher, rising from 1.231 in 1973 to 1 . 320 in 1977. The tax 

price is high in the upper income classes because these taxpayers 

face higher marginal tax brackets, generally earn above-average 

returns, and generally hold assets for longer periods of time so 

that larger gains are accumulated. Therefore, high income 

taxpayers on average are selling assets for which the taxable 

gain is a relatively large fraction of the sales price . 

Table 2 . 10 shows how the tax price of realizations on longterm sales of capital assets would have been reduced if 1979 law 

were in effect for 1977 realizations. On average, the tax price 

of realizations would have fallen from 1 . 053 to 1.032, a decline 

of only 2.1 percentage points. However, the tax price of 

realizations for taxpayers with incomes over $200,000 would have 

fallen by almost 10 percentage points (from 1 . 227 to 1.131) for 

al l assets and by 14 percentage points (from 1.320 to 1.180) for 

corporate shares. In summary, the average reduction in the 

lock-in effect -- as measured by the tax price of realizations --

due to the 1978 Act was small. However, the reduction in the tax 

price of realizations, particularly for corporate shares, was 

significant for taxpayers with very high incomes. Thus, the 1978 

Act appears to have provided a substantial reduction in the 

disincentive to the realization of gains by taxpayers in the 

highest tax brackets. 

Tables 2.8-2 . 10 show only data for long-term sales because 

the 1978 Act did not affect directly the taxation of short-term 

capital gains and losses. It is worth noting, however, that the 

tax price of realizations for short-term gains and losses is 

generally quite close to one. Even though short-term 

transactions do not receive preferential capital gains rates, the 

tax price of realizations is low because the ratio of gain or 

loss to the sale price of the asset is generally small for assets 

held one year or less. Therefore, the taxation of short term 

gains and losses, even though imposed at higher rates than the 

taxation of (and offset for) long-te rm gains and losses, imposes 

a very small distortion on the incentive to realize such gains 

and losses. 
- 84-

Table 2.9 

Tax Price of Realizations for 

Long-Term Sales Under 

1977 Law, 1977 Realizations 11 

-

Income Asset All 

class Corporate Other capital ($thou) shares securities Timber assets 

0-5 1. 000 1.006 1.009 1. 000 1.005 

5-10 1.006 1.000 1.039 1.076 1.013 

10-15 1.014 1.002 1.026 1.092 1.022 

15-20 1. 012 1.015 1. 046 1.002 1.021 

20-30 1.016 1.006 1.063 1.138 1.024 

30-50 1.035 1.007 1.117 1. 241 1. 045 

50-100 1.073 1.027 1.187 1.289 1.082 

100-200 1.128 1.014 1.205 1.341 1.115 

200 + 1.320 1.015 1.290 1.293 1.227 

Total 1.093 1.014 1.096 1.187 1.053 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ The tax price is calculated as the ratio of before-tax proceeds from - asset sales to after-tax proceeds from asset sales. 

Source: Computations from 1977 Sales of Capital Assets File. 
-85-

Table 2.10 

Tax Price of Realizations for 

Long- Term Sales Under 1979 Law, 

1977 Realizations 1/ 

-

Income Asset type 

class Corporate Other I Non- business 

($thou) shares securities I real estate 

0- 5 0 . 999 1.004 

5-10 1. 003 1.000 

10-15 1. 008 1.002 

15-20 1. 008 1.014 

20-30 1. 009 1.004 

30-50 1.017 1.005 

50- 100 1. 045 1.016 

100-200 1.080 1.010 

200 + 1.180 1.010 

Total 1. 054 1.009 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

1.009 

1.015 

1. 018 

1.029 

1.041 

1.066 

1.110 

1.129 

1.170 

1.057 

All 

capital 

Timber assets 

1.000 1.002 

1.021 1.006 

1.062 1.013 

1.001 1.013 

1.098 1.015 

1.155 1.025 

1.184 1.051 

1. 222 1.073 

1.185 1.131 

1.119 1. 032 

August, 1985 

11 The tax price is calculated as the ratio of before-tax proceeds from 

asset sales to after-tax proceeds from asset sales. 

Source: Computations from 1973 Sales of Capital Assets File. 
-86-

C. Realization as a Productive Decision 

The tax price of realizations, as defined above, is not a 

good measure of the tax impediment to realizing gains if the 

asset produces consumption value to some member of society only 

when realized. An example of such an asset is a tree grown to 

produce logs (but not a fruit tree). The tree produces a current 

economic service, in the form of housing services, paper products, or firewood, only after it is cut. Therefore, there 

must be a realization event, and a capital gains tax paid, within 

some finite time period if the asset is to be put to its most 

productive use. In this case, the issue is when, rather than 

whether, to realize a gain. ----

For example, suppose a tree grown for lumber production is 

growing at the rate i. If the relative price of lumber is 

unchanged, the tree's value is expected to increase by (l+i) 

times its prior year value. The change in the capital gains tax 

liability if the tree is cut down after n+l years rather than n 

years is 

am ((1+i)n+l- 1) -am ((1 + i) n- 1) ... (14) 

Thus, deferring realization increases the capital gains tax 

liability by the ratio 

((1 + i) n+1 - 1)/((1 + i)n- 1) ... (15) 

The tax liability grows at a faster rate than does value when 

realization is deferred because the initial cost of the asset is 

not in the tax base. Deferral raises the tax price of 

realizations. Thus, if a tax were imposed only on the sale of 

the tree, and hot on other assets, the tax on realizations would 

shorten the holding period and produce a negative lock-in effect. 

Suppose more generally that the same income tax rates were 

imposed both on the proceeds of the sale of the tree and on 

capital income generally. Suppose also that the economic value 

of the tree increases rapidly in the early years after planting, 

but eventually begins to exhibit diminishing returns. Net income 

to the investor will be maximized if the tree is cut down when 

the rate of increase in value is equal to the opportunity cost of 

deferring realization -- the foregone net interest earnings on 

alternative assets. A tax imposed at the same rate on the 

capital gain from the sale of the tree and on cash flow capital 

income generally will delay realization; equal rate taxation will 

reduce the opportunity cost of deferral, the after-tax interest 

on other assets, by more than it reduces the growth rate of 

after-tax proceeds from the sale of the tree. Thus, there will 

be a ''lock-in" effect from capital income taxation generally. 

The intuition behind this result is that a tax imposed at equal 

rates on the gain from tree growing and on cash flow capital 
-87-

income favors tree growing where tax is deferred until the 

capital income is realized . Since the major element of "capital" 

invested in trees is deferred realization, the tax system, by 

providing a preference for "capital" invested in tree-growing, 

will cause tree production to be more capital-intensive; that is, 

tree-growing will involve a longer holding period than it would 

in the absence of any capital income taxes. 

If a capital gains preference is introduced -- that is, the 

rate of tax on realization of capital gains is lowered -- and 

standing timber is defined as a capital asset, then the optimal 

holding period becomes even longer, because the growth rate of 

the after-tax proceeds increases while the opportunity cost is 

unchanged. Therefore, a capital gains preference, in this case, 

delays realization, although a lowering of the tax rate on both 

capital gains and ordinary income would cause realization to 

occur sooner.l6/ In this case, a longer holding period means 

that more "caPital-intensive" methods are used to produce timber. 

Table 2.11 illustrates these relationships between capital 

gains taxation, ordinary income tax rates, and the return to 

investors from delaying realization of an asset held for its 

future consumption value. In Table 2.11, the consumption value 

from selling the asset is assumed to grow at a declining rate -- it increases by 20.5 percent in the first year, 19.5 percent in 

the second year, and 1 percent less per year thereafter. The 

interest rate is 10 percent. In the absence of any taxes (the 

"base case'' in the table), the optimal holding period is 11 

years; in earlier years, the increase in value from waiting 

exceeds the interest rate of 10 percent, while in later years the 

value of the asset grows less than the interest rate. Case 1 

illustrates the growth in after-tax proceeds from sale if an 

income tax of 50 percent is imposed on both the gain on the asset -- the difference between the sales price (consumption value) and 

the purchase price ($100) -- and on the yield from alternative 

assets. The growth in sales proceeds from delaying realizations 

declines, but by less than the yield on alternative assets which 

falls to 5 percent. The optimal holding period increases to 15 

years. Case 2 illustrates the effect of allowing capital gains 

treatment for the asset, with 40 percent of capital gains 

included in taxable income. If the tax rate on alternative 

assets remains at 50 percent, the discount rate will be unchanged 

at 5 percent. The holding period increases from 15 to 16 years 

as a result of the capital gains preference. 

IV. SuJIUilary 

All taxes imposed on market rewards result in some efficiency 

costs for the economy by distorting price signals faced by 

individuals and firms. When people respond to these distorted 

price signals, inefficiencies in a wide variety of economic 
-88-

Table 2.11 

Example of Optimal Holding Periods of Asset Held 

for Future Consumption Value !I 

Base Case Case 1 I Case 2 -=pr_o_c_e_e~ds~~~~-----IProceeds 

Consumption 

Year value 

0 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

100.00 

120.50 

144.00 

170 . 64 

200.50 

233.58 

269.79 

308.90 

350.61 

394 . 43 

439.79 

485.97 

532.14 

577.37 

620.67 

661.02 

697.37 

728.75 

. 205 

.195 

.185 

.175 

.165 

.155 

.145 

.135 

.125 

.115 

.105 

.095 

.085 

.075 

.065 

.055 

. 045 

from I I from Marginal 

sale sale ield 

100.00 

110.25 

122.00 

135.32 

150.25 

166.79 

184 .90 

204.45 

225 .31 

247.22 

269.90 

292.99 

316.07 

338.69 

360 .34 

380.51 

398.69 

414.38 

.103 

.107 

.109 

.110 

.110 

.109 

.106 

.102 

.097 

.092 

.086 

.079 

.072 

.064 

.056 

.048 

.039 

100.00 

116.40 

135.20 

156.51 

180.40 

206.86 

235.83 

267 .12 

300.49 

335 .54 

371.83 

408.78 

445.71 

481.90 

516.54 

548 .82 

577.90 

603.00 

.164 

.162 

.158 

.153 

.147 

.140 

.133 

.125 

.117 

.108 

.099 

.090 

.081 

. 072 

.062 

. 053 

.043 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ The interest rate is 0.10 . In the Base Case, the tax rate and the 

discount rate are 0, and the optimal holding period is 11 years. In 

Case 1, the tax rate is 0.5, the discount rate is 0.05, capital gains 

are fully included in income, and the optimal holding period is 15 

years. In Case 2, the tax rate is 0.5 , the discount rate is 0. 05, 40 

percent of capital gains are included in income, and the optimal 

holding period is 16 years. 
-89-

choices result, and it is likely that the amount of work effort 

and the size of the capital stock are diminished. Some 

distortions imposed by taxation are inevitable, however, if 

public services are to be financed by taxes based on some measure 

of ability to pay. 

Under the U.S. income tax, the effective tax rate on real 

income from property varies greatly among different types of 

capital and different methods of finance . This can result in 

significant inefficiency in the allocation of the existing 

capital stock. In addition, any tax on the return to saving 

favors current consumption over saving for future consumption 

because the social return from investment, as measured by the 

before-tax return from an additional dollar of capital, exceeds 

the after-tax return from saving received by households. This 

can lead to lower than optimal rates of saving and capital 

accumulation. 

Reducing the tax on realized capital gains has several 

potential consequences for the efficiency of resource use in the 

U.S. economy. First, it may increase efficiency by reducing the 

bias against saving that is one feature of an income tax. 

Second, it may reduce efficiency by increasing the tax disparity 

among types of assets, favoring those with returns in the form of 

appreciation ("growth assets") relative to those providing 

immediate cash returns ("yield assets"). Third, it increases 

efficiency by reducing an impediment to the sale of appreciated 

assets that results because the income from appreciation is taxed 

only when realized, not as accrued, and because gains transferred 

at death permanently escape taxation under the current u.s. 

income tax. Finally, changes in the tax rate imposed on capital 

gains realizations can affect the efficiency of the economy by 

altering the tax rates that must be imposed on income generally 

to maintain the same total revenue. 

Changes in the capital gains tax alter incentives for saving 

by changing the real after-tax rates of return on growth and 

yield assets. The effective tax rate on the real return to 

saving, expressed as the percentage reduction due to capital 

income taxation in the before-tax annual rate of return , measures 

how much the tax system alters the rewards to saving. Under 

current tax rules, this effective tax rate varies greatly among 

assets, depending on the rate of inflation , the before-tax return 

on the asset, and the number of years the asset is held. 

This chapter presented two alternative sets of computations 

of the effective tax rates on growth and yield assets and how 

they were altered by recent legislative changes. The first set 

of computations provided measures of the taxation of a 

representative growth asset, defined as an asset with an expected 

real rate of return of 4 percent and an expected holding period 

of 6.5 years (the average for all stocks sold in 1977); the 

calculations were performed for the case where the marginal 
-90-

investor was a top bracket taxpayer and the case where the 

marg i nal investor had a marginal tax rate equal to the avera ge 

marginal tax rate for all investors selling corporate shares in 

1977. When the marginal investor was a top bracket taxpayer, the 

estimated real effective tax rate on growth assets was 118 

percent in 1977, assuming an 8 percent expected rate of 

inflation. The reduction in capital gains taxes in 1978, the 

further reduction in marginal tax rates in the 1981 Act, and the 

decline in inflation rates (to an assumed 4 percent for the early 

1980s) reduced this estimated effective tax rate to 33 percent . Thus, the combination of tax policy changes and the decline in 

inflation has reduced the tax rate on the "typical" appreciating 

asset from a confiscatory level of over 100 percent in 1977 to a 

rate significantly lower than the tax rate on ordinary income. 

When the marginal investor had an "average'' marginal tax rate, 

the same changes in tax policy and inflation reduced the 

effective tax rate on growth assets from 44 percent to 21 

percent. Moreover, these tax rates overstate the average 

individual tax rates on the return to equity, especially for 

growth assets, because the computation of the average holding 

period does not account for the fact that many assets are not 

sold during the lifetime of the owner, and thus escape capital 

gains taxation entirely. 

The effective tax rate on the return to a representative 

yield asset, defined as an asset which appreciated at the rate of 

inflation and had a real annual cash flow of 4 percent, also 

dec l ined because of the tax policy changes and the reduction in 

inflation. The 1978 capital gains tax cut widened the disparity 

betwe en growth and yield assets, but the 1981 Act tax rate 

reductions narrowed this gap to less than it had been prior to 

the 19 78 Act. 

The second set of computations calculated effective tax 

rates for corporate shares and non-business real estate actually sold in 1977. These computations reveal that effective tax rate s 

on t he returns from assets actually sold were much lower than the 

estimated tax rates on assets with a 4 percent real rate of 

return. According to these computations, the 1978 Act reduced 

the effec tive tax rate on appreciation of corporate shares from 

29 percent to 20 percent, and reduced the effective tax rate on 

app r eciation of non-business real estate from 28 percent to 18 

percent. 

These results suggest that the changes in capital gains 

taxation in the 1978 Act offset what had become a very high real 

tax burden on the return to saving and investing in growth 

assets. At the same time, the 1978 capital gains tax reduction 

widened an existing large disparity between the taxation of 

growth assets and yield assets . The reduction in marginal tax 

rates in the 1981 Act, combined with the decline in the rate of 

inflation, has further reduced the tax burden and significantl y 

narrowed the disparity between growth and yield assets. These 
-91-

changes, on average, have left effective tax rates on yield 

assets slightly above marginal tax rates on ordinary income 

(because of the tax imposed on nominal gains when assets are 

sold), but reduced the tax rate on growth assets to less than the 

tax rate on ordinary income, even after accounting for the 

failure to adjust basis for inflation. 

This chapter also examined how the 1978 Act affected the 

''lock-in" effect, or the disincentive to sell assets with accrued 

gains. The tax price of realizations was defined as the value of 

an asset that one would need to sell, subject to the capital 

gains tax, in order to finance the purchase of one dollar of an 

alternative asset. Using data on sales of all capital assets, 

the tax price of realizations was shown to be on average only 

slightly greater than one (the price in the absence of any 

capital gains tax ) in 1973 and 1977. On average, this tax price 

was not greatly affected by the 1978 Act. For example, if 1979 

law had been in effect in 1977 the tax price of realizations on 

assets sold in 1977 would have been 1.03 instead of 1.05, a 

decline of only 2 percentage points. The tax price of 

realizations was, however, reduced substantially for taxpayers in 

the highest income groups. For taxpayers with incomes over 

$200,000, the tax price of realizations for corporate shares 

would have been 14 percentage points lower -- 1.18 instead of 

1.32 -- if 1979 law had been applied to 1977 realizations . Thus, 

while on average the capital gains tax does not significantly 

affect the incentive to sell assets, it does impose a significant 

tax price on sales by taxpayers with very high incomes. This 

impediment to asset sales was reduced significantly by the 

Revenue Act of 1978. 

This chapter has examined in detail the effect of the 1978 

changes in capital gains taxation on relative prices -- the r e al 

returns from investment in certain types of assets and the 

costs of altering one's portfolio. The next two chapters examine 

how these relative price changes are likely to have altered 

saving and investment, economic growth, the allocation of capital 

among industries, total realizations of capital gains, and 

Federal tax revenues. 
-92-

FOOTNOTES TO CHAPTER 2 

1/ The cost of these additional distortions can be quite large. 

For example, a recent study estimates that the marginal 

deadweight loss of an extra dollar of revenue raised through a 

uniform increase in all U.S . taxes is between 17 and 56 cents. 

See Charles L. Ballard, John B. Shoven, and John Whalley, 

"General Equilibrium Computations of the Marginal Welfare Costs 

of Taxes in the United States", American Economic Review, March, 

1985. 

2/ In this discussion, income is defined as the amount an 

Individual can consume while leaving net worth unchanged, or 

alternatively as the sum of consumption and the change in net 

worth. See U.S. Department of the Treasury, Blueprints for Basic 

Tax Reform, January, 1977 . 

3/ For example, the 1977 Treasury Department study of tax reform 

Tsee footnote 2) outlines two ideal tax bases -- a comprehensive 

income tax and a comprehensive ''cash flow" income tax that 

exempts saving from the tax base. Under the f ormer concept, 

increases in asset values would be taxed at the same rate as 

other forms of income on an accrual basis, with a basis 

adjustment for inflation and full deductibility of losses 

(although the Treasury study makes an exception and recommends 

taxation of capital gains upon realization). Under the cash flow 

concept, the purchase of all assets would be tax deductible, 

while the proceeds of asset sales (both return of capital and 

gains) would be fully taxable but only when consumed. An --- alternative version of the cash flow tax would allow no deduction 

for the purchase of assets, but would exclude all gains and 

losses from the tax base . 

i / In computing the arbitrage benefit to the investor/ borrower, 

one must, of course, take account of any tax on interest income 

received by the lender. The interest rate paid by the borrower 

will in general tend to be highe r than it would otherwise be 

because of the taxation of interest income. An arbitrage benefit 

can result, however, if the marginal tax rate of the borrower is 

greater than the marginal tax rate at which after-tax returns on 

taxable securities are equilibrated with returns on competing 

assets (such as tax-exempt bonds). In this case, the increase in 

the borrower's before-tax interest costs due to the taxation of 

lenders will be less than the tax benefit he receives from the 

deductibility of interest. In the past decade, the marginal tax 

rate at which after-tax returns on tax-exempt and taxable 

securities are equilibrated has ranged from 20 to 35 percent, so 

one can presume that the ability to deduct interest costs 

incurred to finance investment in tax-preferred assets provides 

potential arbitrage benefits to many high tax bracket investors. 
-93-

5/ For one analysis of how the tax system favors "natural 

aeferral" industries, see Joseph J. Cordes and Steven M. 

Sheffrin, "Taxation and the Sectoral Allocation of Capital in the 

United States," National Tax Journal, December, 1981. 

6/ Some recent theoretical work suggests that taxes on corporate 

aividends may not affect the shares of corporate profits that are 

retained and distributed. In these models, it is shown that the 

present value of after-tax corporate distributions made from past 

earnings is unaffected by the timing of the distributions as long 

as the rate of return on investments by corporations is the same 

as the discount rate of individual investors. As a result, 

shareholders are found to be indifferent between dividends and 

retentions and the dividend-payout ratio is indeterminate and 

unaffected by taxes on distributions. In addition, the tax on 

distributions is found to have no effect on the real investment 

decisions of corporations with past retained earnings. For an 

elaboration of this view, see Alan J. Auerbach, "Share Valuation 

and Corporate Equity Policy," Journal of Public Economics, June, 

1979; Alan J. Auerbach, "Tax Integration and the 'New view' of 

the Corporate Tax: A 1980s Perspective," Proceedings of the 

National Tax Association, Tax Institute of America, 1981; and 

David F. Bradford, 11 The Incidence and Allocation Effects of a Tax 

on Corporate Distributions," Journal of Public Economics, March, 

1981. In contrast, other models imply that taxes on 

distributions and capital gains may affect corporate distribution 

policy and the allocation of capital among alternative investment 

activities. For example, see Martin Feldstein and Jerry Green, 

"Why Do Companies Pay Dividends?" American Economic Review, 

March, 1983. 

7/ The question of whether taxation of the returns to investment 

ieduces risk taking is a controversial one. Theoretical 

arguments suggest that a proportional tax with full loss offset 

increases the proportion of wealth allocated to high risk 

investment by risk averse investors; this occurs because taxation 

reduces the variance of expected after-tax returns to investment. 

However, the applicability of this argument to the case of 

capital gains taxation is limited by the facts that the tax 

system is progressive, the deductibility of capital losses is 

limited, and nominal rather than real capital gains are subject 

to tax. For a general discussion of this issue, see Gerald E. 

Auten, "Capital Gains: An Evaluation of the 1978 and 1981 Tax 

Cuts," in Charls E. Walker and Mark A. Bloomfield, eds., New 

Directions in Federal Tax Policy for the 1980s (Cambridge_: __ Ballinger Publishing Co., 1QS3). 

8/ The calculation of a lower effective tax rate on yield assets 

than on growth assets when the after-tax return on both is 

negative does not.imply that there is a lower tax burden on yield 

assets. In fact, in the exampl e , the required before-tax return 

on yield assets (7 .2 percent ) is higher than the required return 
-94-

on growth assets (4 percent). A comparison of required 

before-tax returns provides the correct measure of the relative 

tax burden on the two assets. 

9/ For some taxpayers, the effective exclusion rate was less 

than 50 percent because of the minimum tax on capital gains and 

the poisoning of the maximum tax on earned income. For others, 

the effective exclusion rate was greater than 50 percent because 

they were subject to the alternative tax of 25 percent that 

applied to the first $50,000 of gains, and were in a marginal tax 

bracket greater than 50 percent. The data indicate that the 

sales-weighted exclusion rate was slightly below 50 percent. 

10/ Although "negative'' effective tax rates could be computed 

In such cases, no such computations are made in the tables below 

(see Table 2.7) in order to avoid the appearance of subsidies. 

11/ Under current law, taxpayers may deduct one-half of the 

excess of net long-term· capital loss over net short-term capital 

gain, up to a maximum of $3,000. Losses in excess of $3,000 may 

be carried forward indefinitely to future years. The 

computations of the marginal tax rate on capital gain income do 

not take account of the present value of the future tax 

deductions from capital loss carryovers. Thus, the reduction in 

tax liability per dollar of capital loss is somewhat understated 

in the computations, and the net effective tax rate on all 

returns (including returns with both net gains and net losses) is 

therefore slightly overstated. 

~/ A simple example may be used to illustrate this point. 

Suppose taxpayer A has real gains of $100, on which he pays a tax 

of $20 (a tax rate of 20 percent), while taxpayer B has real 

losses of $50, on which he receives a reduction in tax liability 

of $5 (a tax rate of 10 percent). The total real gain of the two 

taxpayers is $50 and the net change in taxes is $15, for a tax 

rate of 30 percent on net gains. The tax rate on net gains is 

greater than the tax rate on returns with gains only because of 

the lower rate on loss offsets. 

13/ For more discussion of this point, see Martin J. Bailey, ~rogressivity and Investment Yields Under U.S. Income Taxation," 

Journal of Political Econom , April-May 1974; and Harvey Galper 

an Er1c To er, Measur1ng the Incidence of Taxation of Income 

from Capital," National Tax Association- Tax Institute of 

America, Proceedings of the Seventy-Fifth Annual Conference on 

Taxation, October, 1982. 

14/ This discussion abstracts from any other transaction costs 

Incurred in buying and selling assets. Non-tax transaction costs 

do impede asset sales, but do not distort appropriate incentives 

if prices faced by transactors reflect real resource costs (for 

example, services provided by brokers) attributable to 

transactions. 
-95-

15/ The step-up in basis at death strengthens the probability 

tEat an individual will try to avoid selling an asset during his 

lifetime. 

16/ For a more formal discussion of the effects of the capital 

gains tax when an investment project is terminated, see Joseph E. 

Stiglitz, ''Some Aspects of the Taxation of Capital Gains," 

Journal of Public Economics, July, 1983. 
-97-

Chapter 3 

THE EFFECTS OF CAPITAL GAINS TAX REDUCTIONS ON SAVING, 

ECONOMIC GROWTH AND RESOURCE ALLOCATION 

The 1978 capital gains tax reduction lowered the tax burden 

on a portion of the return to some forms of household saving. As 

a result, it increased the overall incentive to save and also 

prov ided incentives to reallocate capital to those particular 

forms of investmen t mo st favored by the tax change. 

This chapter provides a general description of how changes in 

the taxation of capital gains affe c t saving, capital formation, 

economic growth, and the allocation of capital among industries. 

It then presents evidence showing how the capital gains tax 

changes enacted in 1978 are likely to alter saving, investment, 

economic growth, and the allocation of capital over time. The 

chapter then concludes with a discussion of the effects of the 

capital gains tax changes on investment in emerging, technologybased firms. 

The analysis in this chapter focuses on the effects of 

changing the tax structure holding the level of government 

expenditures fixed. Therefor e , the effects of reducing the 

capital gains tax are considered i n a revenue-neutral context in 

which other taxes would need to be raised if revenues were 

reduced. The case in which lower capital gains taxes do not 

reduce revenues is also examined. This case is relevant because 

the increased realizations induced by the tax change act to 

offset the negative effect on re venues of the reduction in the 

tax rate on realized gains. 

The first se c tion of this chapter provides an overall 

perspective on how much the 1978 capital gains tax reduction is 

likely to have increased saving. It provides estimates of the 

effect of the tax change on the expected real after-tax return 

available to savers, and then discusses in general terms the 

likely effect of a one- time increase in after-tax returns on 

saving, capital formation, and economic growth. Then, the next 

section discusses the effects of reducing capital gains taxes on 

the returns to different types of financial claims, and on the 

relative real costs of capital among industries after supplies of 

different types of financial assets have adjusted to the tax 

change. 

The following section presents estimates of the effects of 

the 1978 capital gains tax reduction on economic growth, capital 

formation, productivity and wages, the allocation of resources 

among industries, and the standard of living of households at 

different initial income levels. These estimates are derived by 

simulating a general equilibrium model of the u.s. economy 
-98-

originally developed for the Office of Tax Analysis of the u.s. 

Department of the Treasury by leading a cademic experts in the 

field of public finance.!/ The model is designed to capture the 

effects on the economy of changes in t he tax structure. 

The final section of the chapter focuses more specifically on 

the effects of the capital gains tax change on emerging and 

high-technology firms, with particular reference to effects on 

the level of investment by professional venture capital firms. 

The mechanisms through which a change in the capital gains tax 

might affect these types of investments are discussed and then 

developments in this sector since 1978 are reviewed. 

I. The Effects of Capital Gains Tax Reductions on Saving Incentives 

A. Introduction 

The 1978 reduction in capital gains taxation increased the 

incentive to save by increasing the after-tax return available to 

households. The previous chapter shows how the 1978 capital 

gains tax cut, the further reductions in marginal tax rates i n 

the 1981 Act, and the decline in the expected rate of inflati on 

since 1981 have increased the expected real after-tax return 

available to savers holding particular assets. In this section, 

some rough calculations are presented that provide a general 

perspective on the probable long-run quantitative impacts of the 

1978 capital gains tax reduction on aggregate saving and on 

capital formation in the u.s. economy. 

Households hold their wealth in many forms, only some of 

which give rise to expected taxable capital gains. For example, 

about 40 percent of household wealth consists of owner-occupied 

housing and consumer durables; the former largely escapes capital gains taxation because of rollover provisions, while the latter 

rarely produce any capital gains. In addition, another large 

share of household wealth is held either in the form of bank 

deposits, pension fund rights, or life insurance reserves -- which do not result in capital gains tax liability -- or in 

fixed-interest securities on which, in the long run, expected 

capital gains are zero. Even for those assets on which 

households may expect to receive capital gains - - principally 

corporate shares and assets used in non-corporate enterprises 

a large component of the return to capital is taxed as d iv idend 

income, rental income, or business income. Taxes on these other 

forms of capital income were not directly reduced by the capi tal 

gains provisions of the 1978 Act. 

This section provides rough esti mates of the aggregate effec t 

of the capital gains tax reduction on the overall return 

available to savers, taking account of all other sources of 

income from capital. This is done by first showing how the t a x 

reduction increased the long-run expected real rate of return on 
-99-

average for those assets with expected capital gains (either real 

or inflationary), and then combining those estimates with data on 

aggregate holdings of household wealth to compute a weighted 

average increase of the return to saving on all assets. 

The initial increase in after-tax returns on assets that are 

expected to yield taxable capital gains will be diluted and 

distributed over all assets as households bid up the prices of 

gains-producing assets relative to other assets. In addition, 

household saving in the model increases in response to the tax 

reduction , which permits additional capital investment. With a 

larger capital stock, pre-tax rates of return will be lower on 

all assets, offsetting in part the initial increase in the 

incentive to save. In equilibrium, total household saving and 

the aggregate capital stock will be somewhat higher as a result 

of the capital gains tax reduction, after-tax returns on all 

forms of saving will increase and, on average, before-tax returns 

(the cost of capital) will decline. 

B. Effects on Expected After-Tax Returns 

Table 3.1 shows the allocation of household wealth among 

types of assets, as reported in the flow of funds accounts 

published by the Federal Reserve Board . It can be seen in Table 

3 . 1 that only about 35 percent of household equity is invest ed i n 

assets on which the return is likely to be subject to a capital 

gains tax when the asset is sold -- corporate equities and equity 

in non-corporate businesses. Moreover, about 10 percent of the 

assets of non-corporate enterprises -- consisting mostly of 

financial assets and inventories -- are also either not taxed as 

capital gain or not likely to result in net capital gains. 

Table 3.2 summarizes the cal culation of after-tax returns on 

assets that on average give rise to taxable capital gains 

(hereafter referred to as capital gains assets). The estimates 

represent expected after-tax returns on representative capital 

gains assets held by the average saver who reports capital gain 

income. The table shows how these estimated after-tax returns 

might have changed initially as a result of the changes in the 

tax treatment of capital gains enacted in 1978. 

Capital gains assets are subdivided into four broad 

categories-- corporate shares, land (other than owner-occupied), 

residential struc tures (other than owner-occupied), and 

non-residential plant and equipment owned by non-corporate 

enterprises. The four capital gains assets so defined accounted 

for 32.3 percent of household net worth in 1979. The three forms 

of non-corporate equity differ in bo th the rate of economic 

depreciation assumed and the deprec i ation allowed for tax 

purposes. These differences affect the tax rate on real income 

from the asset and the net present value of tax liability when 

assets are sold. 
-100-

Table 3.1 

Household Yealth by Asset Type, 1979 

Type of 

asset 

Tangible assets 1/ 

Bank deposits, currency, and 

fixed interest securities 

Pension fund reserves 

Corporate equities 

Equity in non- corporate business 

Miscellaneous assets 

Total assets 

Total liabilities 

Net worth 

Amount 

($bil) 

3,330.4 

2,037.9 

598.6 

911. 3 

1 , 710 . 7 

66.7 

8,875.2 

1,380.5 

7,494.6 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Percentage 

of net worth 

44 . 4 

27 . 2 

8.0 

12.2 

22.8 

0.9 

118.4 

18.4 

100.0 

August, 1985 

1/ Tangible assets include owner- occupied housing (structures 

and land), consumer durables, r esidential structures, plant 

and equipment, and land held by non- profit institutions. 

Source: Balance Sheets for the U.S. Economy, 1945-1981, Board 

of Governors of the Federal Reserve System, 

Yashington, D. C., April, 1982. 
-101-

Table 3.2 

Initial Change in After-Tax Return on Capital Gains Assets 

Due to the 1978 Act by Asset Type !I 

Asset 

type 

Corporate equity 

Non-corporate 

equity 

Land 

Residential 

structures 2/ 

Non-residential 

plant and 

equipment 

All capital gains 

assets 

Total net worth 

Total 

capital Percent 

($bil) of net worth 

911.3 

815 .5 

312 .1 

383.6 

2,422.6 

7,494.6 

12 . 2 

10.9 

4 . 2 

5.1 

32.3 

100. 0 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

I After-tax 

Before- taxi return(%) 

return(%) 11977 I 1979 

4.00 1.46 1. 92 

4.35 1.46 1. 91 

4. 24 1.46 1.80 

4.75 1.46 2.03 

4. 27 1.46 1. 92 

August, 1985 

1/ The assumptions used in the calculations are as follows. The 

average marginal tax rate 0.40 in 1977, and 0.37 in 1979; the 

capital gains tax rate is 0.204 in 1977 and 0 . 16 in 1979. 

Inflation averages 8.0 percent per year. The real before- tax 

return on corporate shares is 4.0 percent. The average holding 

period is 6.5 years for stocks and 8. 0 years for other assets. 

The real dividend- payout ratio for stocks is 0.75 . 

2/ Excludes farm residences. 
-102-

The calculation of after-tax returns assumes an initial real 

rate of return on corporate equity, net of corporate taxes but 

gross of personal income taxes, of 4 percent; 3 percent of this 

return is dividend yield and 1 percent is expected real 

appreciation. There is assumed to be no expected real 

appreciation of non-corporate equity, but the nominar-value of 

non-corporate assets increases with inflation. The rate of 

inflation is assumed to be 8 percent, the rate prevailing on 

average between 1976 and 1980. The expected holding period is 

6.5 years for corporate shares and 8 years for non-corporate 

assets. The ••average" saver in this calculation has a marginal 

tax rate of 40 percent on ordinary income in 1979; 51 percent of 

realized capital gains are included in taxable income under 

pre-1978 law. (The 51 percent inclusion rate takes account of 

the fact that some taxpayers paid add-on minimum taxes or lost 

some benefits of the maximum tax on earned income because of 

capital gains preferences under 1977 law.) 

Under these assumptions, the tax rules prevailing in 1977 

reduced the real after-tax return on corporate shares to 1.46 

percent, a reduction of almost 65 percent of the before-tax reurn 

of 4.00 percent. This after-tax return is taken to be the same 

on all capital gains assets under the assumption that after-tax 

returns among assets were equilibrated in 1977 . The column 

labeled before-tax return in Table 3.2 then shows the real 

before-tax return on each capital gains asset required to produce 

an after-tax return of 1.46 percent, given the tax rates, tax 

depreciation rules and economic depreciation rates for 

representative assets in each class, the assumed holding periods, 

the capital gains inclusion rates and recapture rules, and the 

assumed 8 percent inflation rate. 

The last column in Table 3.2 shows the real after-tax returns 

on each asset, given 1977 before-tax returns and the tax rules 

prevailing after the 1978 capital gains tax reduction. The 1978 

capital gains tax changes reduced the capital gains inclusion 

rate to 40 percent in 1979. In addition, the computed average 

marginal tax rate of gains realizers declined to 37 percent 

because the reduction in taxable capital gains would have put 

some taxpayers in lower rate brackets at 1977 realizations 

levels. The expected real after-tax return is shown to increase 

substantially, in percentage terms, for all capital gains assets. 

On average , the rate of return increases to 1.92 percent, an 

increase of 31.5 percent. However, since this increase applies 

to only 32.3 percent of all household net worth, the average 

return to all household saving increases by slightly more than 10 

percent. 

The major reason for the dramatic increase in real after-tax 

returns on capital gains assets shown in Table 3.2 is the 

assumption of an 8 percent rate of inflation. At that inflation 

rate, the expected capital gains tax relative to real capital 

income is quite large, especially for assets with little or no 

expected real appreciation. The reduction in inflation since 
-103-

1981 has dramatically lowered real individual tax burdens on 

capital gains assets. For example, at an inflation rate of 4 

percent and a pre-tax real return of 4 percent, and at the 

average marginal tax rate on capital gains realizations expected 

under 1984 law (when the tax rate reductions in the 1981 Act are 

fully phased in), the estimated real after-tax return on 

corporate shares is 2.23 percent under the 1977 capital gains 

provisions and 2 . 39 percent under the 1979 capital gains 

provisions. Under these assumptions, the 1978 capital gains tax 

cut by itself increases the real after-tax return on this 

"representative'' corporate stock by only 7 percent, compared to 

an increase of roughly 31 percent at an 8 percent rate of 

inflation and with pre-1981 law marginal tax rates. Thus, the 

impact of the 1978 capital gains tax reduction on the incentive 

to save was much larger at the inflation rates ( and marginal tax 

rates) prevailing in the late 1970s than the impact would be 

under current conditions. 

The calculations in Table 3.2 overstate the burden of 

capital gains taxation, and thus the benefits of reducing capital 

gains taxation, by failing to account for the large amount of 

gains that are untaxed at death. Table 3.3 shows an alternative 

calculation of the increase in after-tax returns on capital gains 

assets under the assumption that 30 percent of accrued capital 

gains escape tax permanently because of the step-up in basis at 

death . 2/ Under this assumption, the 1978 capital gains tax 

reductions increased the after-tax return to capital gains assets 

from 1.86 percent to 2.22 percent, an increase of 19.4 percent. 

The estimated increase in the real after- tax return to all 

saving is then about 6.3 percent. 

In conclusion, the calculations presented here show that, in 

the aggregate, the 1978 capital gains tax changes probably 

resulted in a modest increase in the real after-tax returns 

available to savers. At an 8 percent expected inflati on rate, 

expected real returns increased on the order of 6 to 10 percent. 

However, at currently prevailing inflation rates and marginal tax 

rates, the difference made by the 1978 capital gains tax 

provisions is only on the order of about 2 to 3 percent . 

c. Effects on Saving and Capital Formation 

The initial i ncrease in the after-tax rate of re t urn on 

capital gains assets brought about by a reduction in capital 

gains taxation causes savers to shift savings from those forms of 

wealth not receiv ing a tax reduction. These movements of funds 

lower before- tax returns on capital gains assets and raise 

before-tax returns on other f o rms of wealth until r isk-adjusted 

after-tax returns are again equilibrated. As a result, the 

initial benefits of the capital gains tax reduction will be 

distributed over all assets. Wi th fixed asset supplies, the 

eventual increase in the overall rate of return to all wealth is 

equal to the initial increase in the after-tax rate of return on 

485- 125 o - as - s 
- 104-

Table 3.3 

Initial Change in After-Tax Return on Capital Gains Assets 

Due to the 1978 Act, by Asset Type with 

Estimated Gains at Death Excluded 1/ 

Total Percent of I After-tax 

Asset capital household Before-tax i return (%) 

t~Ee ($bil) net worth return (%)I !977 11979 

Corporate equity 911.3 12.2 4.00 1.86 2.00 

Non-corporate 

Equity 

Land 815.5 10.9 4.44 1.86 2.21 

Residential 

structures 21 312.1 4.2 4.59 1.86 2.16 

Non-residential 

plant and 

equipment 363.6 5.1 4.83 1.86 2.32 

All capital gains 

assets 2,422.6 32.3 4.36 1.86 2.22 

Total net worth 7,494.7 100.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ The assumptions are the same as in Table 3 . 2, except capital 

gains rates in both 1977 and 1979 are reduced by 30 percent 

to account for estimated untaxed gains at death. 

21 Excludes farm residences. 
-105-

capital gains assets multiplied by the share of all wealth held 

as capital gains assets. 

The ultimate effect of this increase in after-tax returns to 

saving on the saving rate, and the growth rates of the capital 

stock, national income, productivity, and real wages depends on 

1) the response of household saving to changes in the after-tax 

rate of return, 2) the responsiveness of capital investment to 

changes in the cost of capital, and 3) the extent to which the 

supply of domestic saving constrains the total amount of 

resources available for domestic capital investment. Evidence 

from the existing research on each of these three critical 

questions will be examined in turn. 

1. The Interest Elasticity of Savin~. The issue of how 

sensitive private saving is to a change 1n after-tax rates of 

return has long been controversial. An increase in the after-tax 

rate of return has offsetting effects on the incentive to save 

out of a given amount of income. With higher after-tax returns, 

the price of future consumption declines relative to current 

consumption, causing households to substitute future for current 

consumption by saving more. On the other hand, with higher 

available rates of return, households do not need to save as much 

to enjoy a given amount of future consumption. In the past, it 

was widely believed that this "income effect" -- the fact that an 

increased return makes it possible to consume more in the future 

with less current saving -- largely offset the relative price or 

"substitution effect'' of higher interest rates, causing private 

saving to be insensitive to the rate of return . Indeed, the 

apparent long-run constancy of the private saving rate was a 

subject of several major research papers.l/ 

More recently, both theoretical and econometric studi es have 

reexamined the question of how private saving responds to changes 

in after-tax interest rates. In one frequently cited econometric 

study, Boskin estimated that a one percent increase in the 

after-tax real inte rest rate will inc rease private saving by 

between 0.2 and 0.4 percent.4/ Soskin's findings, however, have 

been challenged by others who maintain tha t the evidence fails to 

show any relationship between private saving and the rate of 

return.S/ In addition, theoretical work by Summers that uses a 

life-cycle model to conclude that private saving is very 

sensitive to the rate of return has also been disputed.6/ Even 

if private saving is not posi tively related to interest- rates, it 

is still widely accepted, based on both theory and empirical 

research, that an increase in the real after-tax return to saving 

will cause households to allocate a higher share of their wealth 

to future consumption rather than current consumption . ?/ If 

household disposable income is left unchanged by substituting 

taxes on wages or consumption for taxes on capital income, then 

the tax change will cause private saving to increase because 

there will be a substitution effect leading to reduced current 

consumption, but no income effect allowing both current and 

future consumption to increase. 
-106-

If the higher of Baskin's estimates is used (an elasticity of 

saving with respect to the real after-tax return of 0.4), the 

estimated increase of between 6 and 10 percent in the after-tax 

return to saving caused by the 1978 capital gains tax changes 

would increase the private saving rate by roughly between 2 . 5 

percent and 4 percent . This represents an upper bound estimate 

of the effect of an increase in the after-tax return resulting 

from the 1978 capital gains tax changes on the private saving 

rate. 

2 . I nvestment and the Cost of Ca~ita . The increase in 

private saving described above will 1ncrease the capital stock. 

In equilibrium, the increase in the capital stock depends on both 

the response of private saving to the after-tax rate of return 

and on the response of the demand for capital services to changes 

in the before-tax return, as derived from the relationship 

between the marginal productivity of capital and the capital 

stock. 

Estimates of the long-run demand for capital as a function of 

the interest rate have been derived from econometric studies of 

production that show how levels of output depend on varying 

levels of capital, labor, and other productive inputs. These 

production studies , combined with models of profit-maximization 

by firms , generally i mply increases in the desired capital stock 

of between 0.5 percent and 1.0 percent for any 1 percent decline 

in the cost of capital.8/ Such increases in the capital stock, 

by driving down marginal returns on capital , will lower 

before-tax rates of return, thus somewhat offsetting the initial 

increase in after-tax returns to savers. In equilibrium, the 

after-tax return will rise by less than the 6 to 10 percent range 

that is consistent with constant before-tax returns, saving rates 

and the capital stock will increase by correspondingly smaller 

amounts, and the before-tax return on capital will decline . The 

increase in capital per worker will cause labor productivity and 

real before-tax wages to be higher. 

Of course , these increases in the capital stock could take a 

long time to materialize. Moreover , changes in the cost of 

capital from short-run factors, such as the influence of 

aggregate monetary and fiscal policies on interest rates, are 

likely to swamp changes resulting from the 1978 capital gains tax 

provisions. These factors make it impossibl e to detect immediate 

effects on i nvestment from the capital gains tax cut. 

Nonetheless, to the extent that the capital gains tax cut reduced 

the cost of capital in the long run, it should result over time 

in a larger capital stock than would otherwise be obtained . 

3 . Invest me nt and the Su Domestic Savin s . Finally, 

the effects escri e a ove epen on t e genera assumption that 

changes in domestic saving have an important effect on the total 

supply of saving available for domestic investment. At the 

extreme, if U. S. companies confront a constant cost of funds 
~----

-107-

determined on world capital markets, and if aggregate world 

saving is not substantially affected by changes in U.S. private 

saving behavior, then a tax cut that raises after-tax returns 

only to U.S. savers will not reduce the cost of capital in the 

United States. In this extreme case, domestic capital formation 

would not be significantly affected by a reduction in the 

taxation of individuals' capital income, unless those tax 

benefits are available only for returns on capital investments in 

the United States. 

It has been argued by some that domestic saving is still the 

primary source of domestic investment in the major developed 

nations, and that it is therefore reasonable to analyze the 

effects of changes in U.S. capital tax provisions as if the 

United States were a closed economy.9/ A closed economy model is 

in fact used in the subsequent analysis presented in this 

chapter. It is worth noting, however, that the availability of 

foreign supplies of saving, and the possibility of domestic 

saving being invested abroad, reduces the effect that an increase 

in the supply of domestic saving would otherwise have on the cost 

of capital for domestic investment and on capital formation. 

D. Conclusions 

This section has presented a brief overv1ew of the likely 

long run effect of the 1978 capital gains tax reduction on 

aggregate saving, investment, and economic growth. The likely 

overall effects on saving and capital formation are shown to be 

modest, largely because taxable capital gains represent only a 

fraction of capital income received by U.S. households. The 

capital gains tax does, however, impose a substantial real 

effective tax rate on a significant amount of private saving, 

largely because the tax is imposed on inflationary gains as well 

as on real income from capital. 

The next section of this chapter discusses in more detail how 

changes in the capital gains tax work through financial markets 

to alter relative costs of capital among industries and firms, 

thereby affecting the allocation of capital among industries. 

Following that discussion, simulations are presented using a 

model that simultaneously estimates the long-run effects of 

changes in the capital gains tax on the rate of aggregate capital 

formation and on the allocation of capital among alternative 

uses. 

II. The Effects of Capital Gains Tax Reductions on Financial 

Markets and Capital Allocation lO/ 

A. General Discussion 

One mechanism through which a change in the taxation of 

capital gains affects the allocation of capital among sectors of 

the economy is through its effects on financial markets. Firms 
-108-

finance their capital stock with a mixture of debt and equity 

claims that a r e differentially affected by changes in capital 

gains taxation . This mi xture of financial c laims differs among 

industr ies and among firms within an industry . Therefore, 

changes in the relative prices of these financ ial claims may hav e 

differential effects among firms and industries on the cost of 

capital. In turn, these changes in the relative cost of capital 

can affect the allocation of capital among indust ries and, 

ultimately, the types of final outputs produced. 

Firms finance their holdings of capital by issuing debt and 

equity . The tax treatment of returns to debt and equity differs 

at both the corporate and personal l ev els. At the corporate 

leve l, interest paid t o bondholders is deductible from corporate 

taxable income, but dividend payments are not deductible. At the 

personal level, the returns on debt instruments are generally 

taxable (except for certain tax-exempt "industrial development 

bonds" issued by state and local governments and then lent to 

corporations), while the returns from equity claims are taxed 

partly as ordinary income and partly as capital gain. Dividend 

payments on equity claims are taxed as ordinary income (in excess 

of a $100 per taxpayer exclusion), but taxes on any income 

arising from appreciation of equity claims are defe rred until 

realization and then taxed at favorable capital gains rates . Shares issued by firms with low div idend-payout ratios will 

therefore be taxed primarily as capital gain ; shares of firms 

with high dividend-payout ratios will be taxed primarily as 

ordinary income . 

An increase in the exclusion rate on capital gains increases 

the relative attracti veness of those assets whose income derives 

in the form of asset appreciation. Such a change, in general, 

benefits stocks more than bonds and stocks with low dividendpayout ratios more than stocks with high dividend-payout ratios. 

Prices of those relatively favored financial claims should rise 

initially to reflect the increase in their after-tax returns. 

Therefore, increasing the capital gains exclusion rate increases 

the price of equity claims compared to debt claims, and increases 

the price of "g r owth'' stocks compa red to "yield" stocks. 

These initial changes in the relative prices of securities 

suggest t hat certain firms and industries will be more favorably 

affected by an increase in the exclusion rate than will others . In particular, firms with low debt-equity ratios and low 

dividend-payout ratios would appear to benefit the most becau se 

the claims to the income derived from their earnings are most 

heavily in forms that r eceive the benefits of the capital ga i ns 

preference. Thus, increases in the capital gains exclusion rate 

would tend to benefit those fir ms a nd industries -- particularly 

growing firms and industries -- that rely heavily on equity 

finance and pay relatively l ow dividends. Since their cost of 

funds is reduced, this analysi s suggests that more capital will 

flow to those sectors. 
-109-

B. Qualifications 

This general description of the effect of a reduction in 

capital gains taxation on the allocation of capital among 

industries is based on three implicit assumptions . First, the 

analysis assumes that the increase in the capital gains exclusion 

rate does not affect debt-equity ratios and dividend-payout 

ratios. That is, firms do not respond to the more favorable 

taxation of capital gains at the household level by increasing 

equity relative to debt in their corporate financial structures. 

As a result, the initial change in relative security prices is 

not offset, either wholly or in part . Second, the sources of 

funds to finance new investments for a firm are assumed to be the 

same as those that financed the existing capital stock of the 

firm. Third, an increase in the capital gains exclusion rate is 

assumed to decrease the required before-tax return on shares 

issued by firms with low dividend-payout ratios. 

Each of these three assumptions is discussed below. To the 

extent any of these assumptions is not satisfied, the link 

between increasing the exclusion rate and favoring investment in 

firms with low debt-equity and low dividend-payout ratios is 

weakened. There are several reasons to believe that none of 

these three conditions is strictly satisfied in the United States 

economy. 

1. Adjustmen ts in the Sup~lies of Securities. A firm's 

leverage or debt-equity decis1on is based on balancing a number 

of considerations. Firms must compare the benefits from the fact 

that interest payments are deductible from taxable income against 

the costs of increased exposure to bankruptcy risk as the 

debt-equity ratio is increased. In addition, by reducing taxable 

income, increasing interest deductions beyond a certain point may 

limit a firm's ability to utilize other deductions and credits 

(such as accelerated depreciation allowances and the investment 

tax credit) fully . A firm must also take into account the 

relative price of debt versus equity claims as revealed in the 

market in order to determine i ts optimal financial structure. On 

the margin, a firm takes all these factors into consideration in 

calculating an optimal leverage or debt-equity position. 

Since an increase in the capital gains exclusion rate 

increases the price of equity relative to debt claims in the 

market, firms will find it profitable to substitute some of their 

debt claims for equity claims. This process may take some time 

because firms can only gradually retire debt, issue additional 

stock, or increase equity capitalization through retained 

earnings. Over time, however, as the supply of equity claims 

increases relative to the supply of debt, the relative price of 

equity to debt will fall. 

As an extreme case, it is possible that these supply 

adjustments could restore the relative prices of debt and equity 

claims that prevailed before the reduction in capital gains 
-110-

taxation.ll/ In that case, the economy as a whole would have 

less debt-and more equity; however, individual firms, after an 

adjustment period, would confront the same relative costs of 

raising capital by debt and equity issues as they did before the 

capital gains tax reduction. Since initial relative costs of 

capital among firms would be restored, the changes in financial 

markets brought about by the tax change would not alter the 

relative costs of capital among industries. In short, the 

capital gains tax cut would lead to an adjustment in relative 

supplies of financial claims rather than to a reallocation of 

physical capital among firms and industries. 

An adjustment of the type described above -- a complete 

adjustment of supplies of securities to offset the relative price 

change in favor of equity supplies -- is unlikely. Firms may be 

reluctant to change their capital structures enough to offset 

completely the added advantage conferred on equity finance by the 

increase in the exclusion rate. Other non-tax considerations may 

also be important in firms' capital structure decisions. 

However, as long as some firms do adjust the composition of their 

capital structures, a portion of the initial relative price 

change will be reversed. In other words, the permanent relative 

price adjustment in favor of equity claims will be less than the 

initial price adjustment. This dampening of the relative price 

change will also reduce incentives to reallocate physical capital 

among industries. 

2. Averafie vs. Marginal Financing Ratios. In evaluating the 

effects on t e allocation of capital of a reduction in the 

taxation of capital gains, it is important to distinguish between 

a firm's average debt-equity ratio on its entire capital stock 

and its marginal debt-equity ratio for financing new investment. 

Even if the relative price change in favor of equity claims 

induced by the tax changes persists, it will not reduce the 

relative cost of capital for firms that currently have low 

debt-equity ratios unless they are also the firms with the lowest 

debt-equity ratios for new investment . 

Firms with low average debt-equity ratios will find that the 

outstanding value of their securities will be favorably affected 

by any change in capital gains taxation that raises the relative 

price of equity claims. In terms of this value or wealth effect, 

firms with low average debt-equity ratios will be the ones that 

profit most from this change . However, unless these are also the 

firms with the lowest marginal debt-equity ratios, they will not 

be provided with an incentive to attract capital from other 

industries. 

This conclusion is based on the view that relative price 

effects rather than wealth effects are what determines the 

allocation of capital among sectors. The distribution of wealth 

among firms does not in itself affect the relative rates of 

return on different uses of capital. It should be noted, 

however, that some economists do attribute a role to wealth 
-111-

effects in investment decisions.12/ For example, if a firm's 

owners are more optimistic about-rts future prospects than the 

market, an increase in the wealth of its principal shareholders 

will cause more capital to flow to the firm for investment 

projects even if the relative costs of raising new capital and 

relative yields as perceived by the market as a whole remain 

unchanged. 

3. Marke t Valuation of Dividends and Retained Earnin s . Finally, t e v1ew t at cap1ta ga1ns taxat1on w1 ower the 

costs of capital for firms with low dividend-payout ratios rests 

on a presumption that relative market values of these firms will 

rise in response to a capital gains tax reduction. To date, 

empirical evidence sheds little light on this issue . Econometric 

studies have generally failed to detect any systematic market 

preference for securities of firms with low dividend-payout 

ratios , despite their tax advantages . When account is taken of 

risk differentials, it appears that the required price-earnings 

ratios on securities are independent of dividend-payout 

ratios.!l/ 

There are several possible explanations for this result. 

First , the studies themselves may have failed to detect a premium 

for low dividend-payout securities because of the difficulty in 

correctly adjusting the returns on securities to account for 

differential risks. Second, the public may simply have a strong 

preference for receiving income in the form of dividends -- either because of their information content or because of 

transactions costs of converting share appreciation to cash -- that overrides the tax advantage from receiving income in the 

form of asset appreciation. Finally, there may be different 

preferences among the buyers of equities, with institutions and 

low-bracket taxpayers preferring dividend-paying stocks and high 

bracket taxpayers preferring growth stocks. The corporate sector 

as a whole may adjust the relative supplies of stocks with 

different dividend-payout ratios so as on average to equalize the 

cost at the margin from issuing ••yield" and "growth" stocks . 

If the latter explanation is correct, an increase in the 

capital gains exclusion rate could disturb this equilibrium by 

increasing shareholders' demands for growth stocks . The question 

is whether or not changes in dividend-payout ratios in response 

to these demands will be large enough to restore the estimated 

equality between risk-adjusted rates of return on "growth" and 

"yield" stocks. 

To sum up, the ability of firms to respond to changes in the 

relative prices of debt and equity claims by changing debt-equity 

and dividend-payout ratios dampens the effects of a change in 

capital gains taxation on the allocation of capital among firms 

and industries. In addition, because marginal debt-equity ratios 

are not necessarily identical to average debt-equity ratios, the 

firms or industries with the lowest observed debt-equity ratios 

may not be the firms or industries which are provided with the 
-112-

greatest incentive to expand their capital stock as a result of a 

reduction in the capital gains tax. Finally, empirical studies 

showing that the market does not appear to pay a premium for 

shares with low dividend-payout ratios may be interpreted to 

suggest that the initial effec t s on market prices of a cut in the 

capital gains tax will be overturned by adjustments in 

dividend-payout ratios. 

C. Conclusions 

A reduction in the taxation of c apital gains, by changing the 

relative prices of different types of financial claims, tends to 

reallocate capital toward those firms and industries with low 

debt-equity ratios and low dividend-payout ratios. However, 

changes in the supplies of financial claims over time tend to 

offset the effects on the relative prices of securities, and thus 

on the relative costs of capital to different firms, of the 

initial increase in the demand f o r equity shares of firms with 

low dividend-payout rates. It is unlikely that changes in firms' 

financial policies can completely offset the changes in the 

relative prices of securities resulting from a change in the 

capital gains exclusion rate. However, any calculatio n of the 

changes in relative capital costs to industries which is based on 

an assumption of no adjustments in corporate financial policy is 

likely to be an upper-bound estimate that overstates the impact 

of changes in the capital gains tax on the allocati on of capital 

among sectors. 

III. Equilibrium Model Estimates of the Effects of 

A. Introduction 

This section provides estimates of the effects of the capital 

gains tax reduction on capital allocation, saving, economic 

growth, and the welfare of taxpayers in different income classes. 

These estimates were obtained from simulations using the Treasury 

General Equilibrium Model, which has been developed over the past 

six years by a team of academic economists in consultation with 

the Office of Tax Analysis of the Department of the Treasury. 

The model represents the state of the art in the analysis of the 

economic distortions generated by different types of taxes.!!/ 

The model incorporates taxes at the Federal, state, and 

local level and can be used to evaluate how a change in one or 

several taxes affects overall economic performance. In the 

model, taxes alter the relative prices confronted by firms and 

individuals; the relative p r i c e changes resulting from tax policy 

changes induce responses in fact o r supplies and in demands for 

factor services and consumer goods . By analyz ing these responses 

in a consistent economic framework, the model shows how changes 

in tax policy alter national output, consumption of different 
-113-

final goods, production by different industries, incomes of 

different groups, supplies of labor services and saving, and 

economic growth. 

A general equilibrium model differs from the type of 

macroeconomic models commonly used to forecast unemployment 

rates, inflation rates, and economic growth. Basically, most 

macroeconomic models focus on changes in aggregate demand and on 

how these changes will affect near term prospects for the 

economy. In contrast, general equilibrium models concentrate on 

equilibrium economic values and generally neglect factors causing 

short run fluctuations, such as changes in monetary policy, 

anticipated short-term changes in supplies and demands from the 

rest of the world, and current levels of inventories and plant 

capacity utilization . Instead, general equilibrium models focus 

explicitly on how policies that alter relative prices affect 

resource allocation among uses, including the choice between 

current consumption and capital accumulation. In that sense, the 

Treasury General Equilibrium model can be viewed as fully 

incorporating ••supply side" economic effects, because economic 

growth in the model is increased only by policies that either 

increase factor supplies -- supplies of labor and, especially, 

capital -- or that improve the efficiency of resource allocation 

among sectors. However, since the model assumes full employment, 

it cannot be used to evaluate policies that reduce involuntary 

unemployment by increasing aggregate demand. 

This type of model provides the appropriate framework to use 

in analyzing the long run effects of a reduction in capital gains 

taxes on economic growth . In the past few years, any effects the 

1978 capital gains tax reduction may have had on overall economic 

performance were swamped by large short run changes caused by 

swings in monetary policy, overall levels of taxation and 

spending, structural tax policy changes other than those in the 

treatment of capital gains, changes in world oil prices, and 

other factors. In the long run, the capital gains tax reduction 

will improve the performance of the economy to the extent that 

the long run improvement in certain economic incentives -- particularly the reduction in current tax distortions favoring 

current consumption over saving -- outweigh any possible adverse 

effects on the allocation of capital due to the targeting of the 

tax reduction only to some forms of investment and any adverse 

distributional consequences from focusing a tax cut on the 

highest income households. A general equilibrium model is the 

best analytical tool for analyzing this question because it 

provides insights on how particular types of changes in the tax 

structure affect the long run performance of the economic system. 

The next part of this section presents the results of 

simulating the 1978 capital gains tax reduction in the model. 

Several alternative assumptions regarding the offsetting tax 

increases required to hold revenues constant are analyzed, 

including the assumption that the capital gains tax reduction 

does not have to be "paid for•• because increased realizations 
-114-

offset the revenue effect of the reduction in the tax rate . Although the results of these simulations must be viewed as 

illustrative rather than definitive, they provide some 

interesting insights on the long run impact of the 1978 capital 

gains tax reduction . 

It is important to recognize that the results of policy 

simulations with any model are determined by key assumptions 

contained in the model about the nature of the economic system. 

A general description of the model, which specifies the major 

assumptions about the economic behavior of firms and households, 

the overall economic environment, the degree of responsiveness of 

factor supplies and consumer demands to relative prices, and how 

changes in capital gains tax rules alter equilibrium values, is 

provided in the Appendix. 

B. Simulation Results 

The effect of the 1978 capital gains tax reduction was 

simulated by lowering the inclusion rate on capital gain income 

by 20 percent , and then solving the model for the resulting new 

equilibrium values. One feature of the model is a government 

budget constraint that requires that any loss in revenue due to a 

tax cut be replaced by an alternative source of revenue or result 

in a decline in government expenditure . In the first set of 

simulations presented below, the rate of asset turnover remains 

constant and there is a net revenue loss from lowering the 

inclusion rate on capital gain income. In this case, it is 

assumed that this revenue loss is offset by increasing marginal 

personal income tax rates. In the second set of simulations, it 

is assumed that no tax increase is required because increased 

turnover of assets offsets the rate reduction and keeps revenue 

from capital gains taxes unchanged at the new capital gains 

inclusion rate. 

Since all capital income taxes in the model are modeled as 

accrual taxes (taking into account whatever benefits are 

conferred by deferral), a special assumption is needed to account 

for the possibility of revenue feedback from increases in 

realizations. The model does, however, automatically take 

account of any revenue "feedback" from increases in growth and 

improvements in the efficiency of resource use. 

1. Alternative Revenue Retlacement Assumptions. There are 

two alternative ways of speci ying an across the board increase 

in marginal tax rates which could replace any revenue lost from 

cutting taxes on capital gains -- an additive replacement tax and 

a multiplicative replacement tax. Under an additive replacement 

tax , it is assumed that the loss in capital gains tax revenue is 

offset by increasing all marginal income tax rates under the 

personal income tax by the same absolute amount. For example, if 

necessary, the marginal tax rate might be increased by one 

percentage point in all brackets. Under this assumption, upper 

income groups would experience a relatively smaller percentage 
-115-

increase in taxes than would lower income groups. The model 

solves for the amount of tax change (i.e., the increase in 

marginal tax rates) required. That solution takes into account 

the effects on national income and on the tax base of reducing 

the effective tax rate on returns to capital, but does not take 

into account increases in realizations. 

An alternative revenue replacement assumption would be a 

multiplicative replacement tax. Under a multiplicative 

replacement tax, the revenue would be replaced by increasing all 

marginal personal income tax rates by the same percentage rather 

than by the same number of percentage points. Under this 

assumption, the increases in marginal tax rates would leave the 

percentage distribution of taxes by income class unchanged. 

After-tax income is reduced by a relatively greater amount for 

upper income groups because these groups experience a greater 

increase in tax as a percentage of income. Compared to the 

additive replacement tax, the multiplicative replacement tax 

shows slightly smaller relative gains to upper income groups from 

reducing the capital gains tax. In effect, a larger proportion 

of the initial tax cut from lowering the capital gains tax is 

offset by higher personal income taxes imposed on upper income 

individuals to maintain government revenue. 

The results of simulating the model with a multiplicative 

replacement tax were qualitatively very similar to the results of 

simulations using an additive replacement tax. Therefore, the 

results using the multiplicative replacement tax are not shown 

separately. 

In the case where no tax increase is required, it is assumed 

that increased turnover of assets i.e., the increase in 

realizations out of a given stock of accrued gains -- in response 

to the capital gains tax cut will be sufficiently large that 

government revenue from capital gains taxes will be unchanged. 

As will be discussed in Chapter 4, there is considerable evidence 

that this assumption is realistic; the capital gains tax 

reductions of 1978 appear to have increased long run realizations 

enough to offset the revenue losses from lower capital gains tax 

rates. 

This case is modeled by assuming that government revenues are 

balanced by imposing higher lump sum taxes on each household in 

proportion to their initial shares of capital gains taxes paid. 

That is, the households who receive a direct reduction in taxes 

on capital gains income are assumed to increase realizations 

enough so that their total tax payments remain constant. These 

lump sum taxes reduce the disposable income of the households who 

pay them and increase the revenue of the government, but they do 

not reduce incentives to save or to work. In effect, as a result 

of increased realizations, the tax cut on capital gains leaves 

unchanged the tax payments of direct beneficiaries and thus 

government revenues and expenditures, increases the incentive to 
-116-

save, and lowers the cost of capital for those industries 

financed by assets subject to the capital gains tax. 

2. Simulation Results when the Additive Replacement Tax is 

Re~ired . Table 3.4 shows the simulated effects of the 1978 

cap1tal gains tax reduction after 5 , 20, and 50 years under the 

assumption that the tax cut is financed by increasing marginal 

personal income tax rates by the same absolute amount. The 

results of this simulation, and of the others shown in this 

section, are displayed as percentage deviations from the 

simulated growth path under pre-1978 tax law. 

It is important to emphasize that these results are not 

intended to be forecasts of how the capita l gains tax changes 

would alter national income after any specified period of time. 

As noted above, the model does not take account of short-run 

factors that could cause income to deviate from its long-run 

growth path . Rather, the time periods shown in the table 

represent approximations of how long it would take for the 

capital stock adjustments induced by the tax change in the model 

to occur, given that increases in the stock of capital in any 

year are limited by the estimated increase in the rate of saving. 

The capital gains tax cuts are shown to increase the annual 

rate of investment (and private saving) by about 1.1 percent. 

The investment increase gradually augments the capital stock, and 

as a result raises national income. The simulated change in the 

capital stock after 50 years, however, is only one-half of one 

percent, relative to the capital stock simulated to occur under 

the pre- 1978 capital gain rates. This increase in the capital 

stock is probably an overstatement because it is based on an 

upper-bound assumption of how private saving responds to changes 

in after-tax returns . 

Labor supply is reduced slightly because the increase in 

personal income tax rates required to offset the revenue loss 

from cutting capital gains taxes lowers after-tax wages. Labor 

productivity and gross wages increase because of the increase in 

capital per worker . Private consumption at first decreases 

because a greater share of income is saved , but ultimately 

increases slightly because the larger national income produced by 

the larger capital stock allows increases in both saving and 

consumption. 

The final row of Table 3.4 provides an estimate of how 

households perceive their change in living standards as a result 

of the tax cut . The measu r e of increased ''welfare" is best 

described as the aggregate dollar amount that households would be 

willing to pay to have the outcome of the new tax structure 

rather than the old. In the model, this evaluation of household 

welfare takes account of the amount of leisure and expected 

future consumption, as well as current consumption . It is 

consistent with the preference structure that determines 

household labor supply and saving decisions. 
Office 

-117-

Table 3.4 

General Equilibrium Effects on National Aggregates 

of the 1978 Capital Gains Tax Reduction 

with an Additive Replacement Tax (%) !I 

Years after tax reduction 

Aggregate 5 I 20 I 50 

Investment 1.11 1.11 1.09 

Capital stock 0 .10 0.31 0.53 

National income -0 . 01 0.06 0.13 

Consumption -0 .14 -0.02 0.11 

Labor supply -0 .11 -0 .11 -0.11 

Labor productivity 0.10 0.17 0.24 

!Jelfare 0.03 0 . 08 0.13 

of the Secretary of the Treasury August, 

Office of Tax Analysis 

1985 

1/ Changes in national aggregates are expressed as percentage 

deviations from the levels simulated to occur under pre-1978 

law. 
-118-

In the long run, the aggregate increase in welfare is about 

the same as the aggregate change in national income. In the 

short run, however, the change in welfare is slightly greater 

than the change in national income because households anticipate 

greater future consumption from current investment decisions. 

Aggregate welfare is shown to incr~a se in all time periods as a 

result of the capital gains tax cut. The main reason for this 

increase is that the tax cut, by reducing disincentives for 

saving, leads to an allocation of resources between current and 

future consumption more consistent with household preferences. 

Table 3.5 shows changes in output and in the use of capital 

and labor by each of the 19 producer goods industries in the 

model . The largest increases in output occur in capitalintensive industries and their suppliers -- motor vehicles, 

mining (including petroleum and natural gas), metals and 

machinery, petroleum refining, and construction. While the 

complexity of all the interactions in the model precludes a full 

explanation of these changes, reasons can be suggested for the 

observed pattern. The outputs of the construction, metals and 

machinery, and motor vehicle industries are heavily used as 

investment goods. Petroleum refining and crude petroleum and 

natural gas are capital-intensive industries that receive a 

significant direct cost reduction from the capital gains tax cut . Also, the outputs of these two industries and mining are heavily 

used as inputs (coal , iron ore, oil and gas) in production by 

many other industries. 

It is interesting to note the simulated effects of the 

capital gains tax reduction on certain specially taxed 

industries. The high degree of tax exemption under pre-1978 law 

of real estate (including owner-occupied housing) and 

agricultural income from land means that these industries do not 

receive a significant cost reduction from the capital gains tax 

cut. As a result, capital is bid away from these industries, 

their relative production costs rise, and output is lower than it 

would have been without the capital gains tax reduction. 

The second column of Table 3.5 highlights how changes in the 

capital stock are spread unevenly among industries. The largest 

percentage increase in the capital stock is in the fairly 

capital-intensive mining industry. (Mining also benefits because 

a portion of mining royalty income is taxed as capital gain.) 

Most industries show increased capital, but reduced employment of 

labor, as the tax changes encourage substitution of capital for 

labor. In some industries, expansion is so great that use of 

both capital and labor increases; these include metals and 

machinery, construction, and finance and insurance. In real 

estate and government enterprises, there is substitution of labor 

for capital because these sectors receive little or no 

significant direct benefit from lower capital gains taxes and as 

a result face higher relative costs of capital due to competition 

for capital resources from other industries. 
-119-

Table 3.5 

Changes in Output, Capital Use, and Labor Use 

After 20 Years from 1978 Capital Gains Tax 

Reduction with Additive Replacement Tax (%) !/ 

Industry 

Mining 

Motor vehicles 

Crude petroleum and gas 

Metals and machinery 

Petroleum refining 

Construction 

Lumber, furniture, stone, clay 

and glass 

Finance and insurance 

Chemicals and rubber 

Paper and printing 

Trade 

Government enterprises 

Services 

Textile, apparel and leather 

Food and tobacco 

Transportation, communication 

and utilities 

Agriculture, forestry and 

fisheries 

Real estate 

Output 

0.53 

0.48 

0.42 

0.39 

0.36 

0.33 

0.28 

0.26 

0.25 

0.15 

0.12 

0.05 

0.01 

0.00 

-0.10 

-0.13 

-0.25 

-0.29 

Capital 

2. 35 

1.62 

0.85 

1.50 

0 .83 

1.67 

1. 79 

1. 76 

1.46 

1.68 

1.72 

-0. 73 

1.08 

1.06 

0. 32 

0 . 49 

-0.26 

-0.34 

Labor 

-0 . 05 

-0.08 

-0 . 08 

0.16 

-1.11 

0.27 

-0 . 21 

0.49 

-0.21 

-0.24 

-0.11 

0.41 

-0 . 13 

-0 . 14 

-0.21 

-0.21 

-0.23 

0.17 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ Changes in output, capital and labor are expressed as 

percentage deviations from the levels simulated to occur 

under pre-1978 law. 
-120-

Table 3.6 shows changes in consumption after S, 20, and SO 

years and changes in welfare for each household group. The 

change in welfare is measured as the present value of future 

changes in consumption and leisure, with future values discounted 

at a real interest rate of 4 percent. 

Table 3.6 shows the capital gains tax cut lowers consumption 

for all income groups S years after the change, largely because 

of increased saving rates . Ov er time, the increased saving 

increases the capital stock and national income, allowing both 

consumption and saving to rise. After 20 years, consumption is 

still lower than it would have been without the capital gains tax 

cut, but has increased for households with income less than 

$10,000 per year and for households with annual income greater 

than $50,000. After SO years, consumption is greater for all 

income groups. 

The present value of welfare by household group is displayed 

in the last column of the table. The increase in welfare from 

the capital gains tax cut is largely concentrated in the highest 

income group. All other groups show changes in welfare of less 

than 0.02 percent relative to the base case, or S percent or less 

of the increase for the highest group. Welfare increases very 

slightly for income groups between $6,000 and $16,000, is 

unchanged for income groups between $16,000 and $24,000, and 

declines slightly for income groups between $24,000 and $40,000. 

Upper middle income groups show a slight decline in welfare 

because they have a relatively high proportion of labor income 

which is now taxed at a slightly higher marginal rate. For other 

groups, the increases in before-tax wages and transfer payments 

resulting from the increase in the capital stock and in output 

(government transfer payments are a fixed share of output in the 

model) outweigh the effects of higher marginal tax rates. The 

highest income class benefits most directly from lower tax rates 

on the return to saving. 

The changes in relative prices, economic growth, and the 

distribution of income attributable to the capital gains tax cut 

all have implications for how consumer dollars are allocated 

among final goods and saving. Table 3.7 displays these changes 

in consumption patterns 5 years, 20 years, and SO years after the 

tax change. After SO years, the only consumption good 

experiencing a decline relative to the base case is housing. 

Saving increases by 1.1 percent. Consumer goods with relatively 

large increases are gasoline and other fuels (O.S percent) and 

financial services (O.S percent). 

The decline in consumer housing purchases is not due to an 

increase in the number of hours one has to work to purchase 

housing; the price of housing in terms of wages actually 

declines. Rather, the decline in housing reflects relatively 

lower prices for other consumer products that induce consumers to 

shift their pattern of purchases. In effect, the relative 
-121-

Table 3.6 

Changes in Real Consumption and Welfare by Income Class 

from the 1978 Capital Gains Tax Reduction with an 

Additive Replacement Tax (%) !I 

!Change in real consumption: 

Household income I Years after tax chan e 

class 2/ 5 20 so 

0 - 6,000 - 0.08 0.01 0.09 o.oo 

6,000 - 8,000 - 0.09 0 .01 0.10 0.02 

8,000 - 10,000 - 0. 11 0.00 0.10 0.02 

10,000 - 12,000 -0.12 - 0.01 0.10 0.02 

12,000 - 14,000 -0. 13 - 0.01 0. 10 0.02 

14,000 - 16 ,000 -0.15 -0.03 0.09 0. 01 

16, 000 - 20,000 -0.18 - 0.05 0. 07 o.oo 

20,000 - 24,000 - 0.19 - 0.06 0.07 o.oo 

24,000 - 30,000 -0 .22 - 0.08 0.05 -0 .01 

30,000 - 40,000 -0.24 - 0.10 0.03 -0 . 02 

40,000 - 50,000 -0.22 -0 .08 0.05 0.01 

50,000 + - 0.10 0.24 0. 38 0.38 

Total -0.14 -0.02 0.11 0.07 

Office of the Secretary of the Treasury August, 1985 

Offi ce of Tax Analysis 

1/ Changes in consumption and welfare are expressed as - percentage deviations from the levels simulated to occur 

under pre-1978 law . 

21 Income figures are 1980 levels. -
-122-

Table 3.7 

Consumer Product Consumption Changes 

from the 1978 Capital Gains Tax Reduction 

with an Additive Replacement Tax 1/ 

Consumer product 

Years after tax change 

s I zo I so 

Food -0.2 

Alcoholic beverages -0.1 

Tobacco -0 . 2 

Utilities -0.1 

Housing -0.6 

Furnishings 0.0 

Appliances 0.0 

Clothing & jewelry - 0.1 

Transportation -0.1 

Motor vehicles, tires & auto repairs 0.0 

Services -0 . 1 

Financial services 0.2 

Reading, recreation, miscellaneous -0.1 

Nondurable, nonfood household items 0.0 

Gasoline and other fuels 0 . 2 

Saving 1. 1 

0.0 

0.0 

0.0 

o.o 

-0.4 

0.1 

0.1 

0 . 0 

0.0 

0 . 1 

0.0 

0.4 

o.o 

0.1 

0. 3 

1.1 

0.1 

0.1 

0 . 1 

0 . 1 

-0.2 

0 . 2 

0.1 

0 . 1 

0.1 

0.2 

0 . 1 

0.5 

0.1 

0 . 2 

0. 5 

1. 1 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ Changes in consumption are expressed as percentage deviations 

from the levels simulated to occur under pre- 1978 law. 
-123-

advantage of tax-favored owner-occupied housing is reduced 

because the capital gains tax reduction lowers costs more in 

other sectors of the economy. 

ired . e resu ts rom s~mu at~ng t e 

effects of a capital gains tax cut using the Treasury General 

Equilibrium Model under the assumption that increased turnover of 

assets exactly offsets the effects of the capital gains tax on 

Federal revenue. As will be shown in Chapter 4, the best 

available econometric estimates show that annual revenue from 

capital gains taxes either increased or was roughly unchanged in 

the long run by the 1978 capital gains tax reduction, as the 

revenue effect of the decline in tax rates was offset by an 

increase in realized gains. Thus , this simulation probably 

represents a more realistic simulation of the effects of changing 

the capital gains tax provisions than the analysis in the 

previous sub-secti on which assumed no change in realizations. 

In the simulation, Federal revenue is held constant by 

imposing tax increases in the form of lump sum taxes on each 

household class exactly equal to the reduction in capital gains 

taxes from the 1978 changes. As a result, there is initially - - i . e., prior to behavioral adjustments-- no change in the 

OTStribution of the tax burden. Although it would appear that 

this might lead to no economic changes, in fact the substitution 

of lump sum taxes for capital income taxes has two important 

consequences. First, because of the reduction in the capital 

gains tax, the incentive to save is increased and costs of 

capital are reduced by relatively greater amounts to those 

sectors that issue claims subject to capital gains taxation. In 

contrast, the offsetting lump sum tax does not alter the rewards 

households receive from either work effort or saving. In effect , the tax change improves economic incentives without reducing 

revenue to the Federal government. 

The second consequence of substituting a lump sum tax for a 

capital gains tax on households receiving capital gain income 

relates to how one interprets the resulting changes in after-tax 

income. In effect, people are realizing more gains -- that is, 

selling more assets on which past gains have been accrued -- because the tax price of such sales has been lowered. In 

comparison to the base case, the new lump sum taxes are being paid to the government voluntarily, as households decide to 

change their behavior . Since the increases in realizations that 

give rise to the lump sum taxes are voluntary, households who 

make them cannot be worse off than they were at the initial level 

of realizations . Thus, in evaluating welfare changes, taxes paid 

in response to a reduction in the '' tax price of realizations" 

that is, what has been modeled as lump sum taxes -- are not 

counted as a reduc tion in welfar e . 

As shown in Table 3.4a, the assumpt i on that no tax increase 

is required to keep revenue constant implies that the effects of 
-124-

Table 3. 4a 

General Equilibrium Effects on National Aggregates 

of the 1978 Capital Gains Tax Reduction 

Assuming No Revenue Cost (%) !I 

Years after tax reduction 

Ag:g:reB:ate s I 20 I so 

Investment 1.19 1.17 1.15 

Capi tal stock 0. 10 0.33 0.56 

National income 0.10 0.17 0.24 

Consumption 0.01 0.14 0.28 

Labor supply 0.04 0.03 0.03 

Labor productivity 0 . 06 0. 14 0.21 

Welfare 0.06 0.12 0.17 

Office of the Secretary of the Treasury August, 1985 

1/ 

Office of Tax Analysis 

Changes in national aggregates are expressed as percentage 

deviations from the levels simulated to occur under 

pre-1978 law. 
-125-

the capital gains tax reduction are more positive than those in 

the case in which the additive replacement tax is required (Table 

3.4) . After 50 years, the simulated increase in annual 

investment is 1.15 percent (compared to 1.09 percent under the 

additive replacement tax), in capital stock, 0.56 percent 

(compared to 0.53 percent), in national income, 0 . 24 percent 

(compared to 0.13 percent), in consumption, 0.28 percent 

{compared to 0.11 percent), and in welfare 0.17 percent {compared 

to 0.13 percent). Since there is no increase in marginal tax 

rates on labor income, and since the capital stock rises because 

of the improved incentive to save, real after-tax wages increase. 

As a result, labor supply increases by 0.03 percent (instead of 

declining by 0.11 percent) . However, labor productivity rises at 

a slightly smaller rate compared to the additive replacement tax 

because, with a greater labor supply, the increase in capital per 

worker is slightly smaller. 

Table 3.6a displays changes in consumption after 5, 20, and 

50 years and changes in households' perceived welfare for each 

household income class. When realizations increase enough to 

prevent a reduction in revenue from capital gains taxes, all 

household income classes experience a net increase in economic 

welfare. The percentage increase in welfare remains largest for 

the highest income class but, in contrast to the additive 

replacement tax case, the welfare change is now positive for all 

income classes. Most household income classes benefit, in 

percentage terms, about half as much as the highest income class. Significantly, upper middle income groups -- those households 

earning between $24,000 and $50,000 per year -- now experience 

net gains rather than losses or negligible gains. The reason for 

this change is that, when an increase in realizations offsets the 

revenue effects of lower capital gains tax rates, it is 

unnecessary to recover Federal revenue losses by raising marginal 

tax rates that fall heavily on middle and upper-middle income 

wage earners. 

Table 3.6a a l so shows that in this case the capital gains tax 

reduction increases consumption after 50 years for all household 

income classes, and increases consumption after 5 years and after 

20 years for all household income classes except the highest 

income group. For this group, consumption initially falls 

because a larger share of disposable income is saved, while 

actual capital gains taxes paid remain constant. Over time, the 

rise in GNP growth makes it possible for consumption to rise for 

all groups, even though saving rates are higher. 

4. Simulation Results when the Effective Tax Rate on All 

Capital Income is Reduced. An al t ernative simulation was 

performed to compare a reduction in the capital gains tax to a 

general reduction in taxes on the return to capital. In the 

comparative simulation, the shares of individual capital income 

subject to the personal income tax and to the corporate income 
-126-

Table 3.6a 

Changes in Real Consumption and Total Welfare by Income Class 

from the 1978 Capital Gains Tax Reduction 

Assuming No Revenue Cost (%) !I 

!Change in real consumption: I 

Household income I Years after tax change I Welfare 

class 2/ I 5 I 20 I SO I change 

0 - 6,000 0.04 

6,000 - 8,000 0.05 

8,000 - 10,000 0.07 

10,000 - 12,000 0.07 

12 ,000 - 14,000 0.06 

14,000 - 16,000 0.07 

16,000 - 20,000 0.07 

20, 000 - 24,000 0.05 

24,000 - 30,000 0.04 

30,000 - 40,000 0.02 

40,000 - 50,000 0.01 

50,000 + -0. 20 

Total 0.01 

0 .13 

0.16 

0.18 

0.19 

0.19 

0.200 

0.20 

0.19 

0.18 

0.16 

0.15 

-0.06 

0.14 

0.22 

0.26 

0.30 

0.31 

0.31 

0.33 

0.33 

0.33 

0.33 

0.31 

0.30 

0.09 

0.28 

0.10 

0.14 

0 .16 

0.17 

0.17 

0.18 

0.17 

0.18 

0.17 

0.17 

0.20 

0.40 

0.22 

Office of the Secretary of the Treasury 

Office of Tax Analysis August, 1985 

1/ 

2/ 

Changes in consumption and welfare are expressed as 

percentage deviations from the levels simulated to occur 

under pre-1978 law. 

Income figures are 1980 levels. 
-127-

tax rate are both reduced by 4.3 percent, with the revenue 

replaced by adding a constant amount to all individual marginal 

tax rates (an additive replacement tax) . These reductions in the 

inclusion rate for capital income and for income subject to the 

corporate tax were selected so as to require the same 

compensating increase in personal marginal tax rates as was 

required to offset a 20 percent reduction in the inclusion rate 

for capital gains. 

Tables 3.4b through 3.6b display the results of this 

simulation of an across the boa r d reduction in capital income 

taxes. A comparison of Tables 3.4b and 3.4 shows that this 

general reduction in capital income taxes results in slightly 

greater increases in investment, the capital stock, national 

income, consumption (after 50 years), productivity, and total 

welfare than does a reduction in inclusion rates on capital gain 

income alone (when both types of capital tax reduction are offset 

by the same change in marginal personal income tax rates). The 

more general reduction in capital income taxes achieves better 

results because it causes a more general rather than selective 

improvement in the allocation of resources among industries . 

Table 3 . 5b shows that an across the board reduction in 

capital income taxes increases output for all industries except 

real estate and services. Real estate output declines by 0 . 39 

percent because the relative tax advantage afforded to investment 

in owner-occupied housing is reduced when capital income taxes 

are lowered . The output of services remains constant because the 

service industry is a relatively labor-intensive sector, and thus 

loses more from the small increase in the cost of labor (the rise 

in the before-tax wage) than it gains from the reduction in the 

cost of capital. Capital use increases for all industries other 

than real estate and government enterprises, while labor use 

increases in some industries and declines in others. Capital 

intensive industries -- construction, motor vehicles, crude 

petroleum, and mining -- still experience some of t he largest 

gains in output and inc reases in capital use. 

Finally, Table 3.6b shows the change in economic welfare by 

household income group. Again, the general reduction in capital 

income taxation is shown to be slightly better than the reduction 

in capital gains taxes alone, particularly for lower income 

households. However, the differences between the two tax changes 

are small. 

The more fa vorable results for a more general reduction in 

capital income t a xes, compared to a reduction in taxes on capital 

gain income alone, disappear if one takes account of the revenue 

offsets from induced reali zation . Fo r example, a comparison of 

Tables 3.4a and 3.4b shows that, when no revenue replacement 

taxes are requir ed, the capita l gains tax cut leads to a larger 

increase in national income, consumption, and labor supply, and 

about the same change in investment and the capital stock, as 

does a general reduction in capital income taxation. In effect, 
-128-

Table 3.4b 

General Equilibrium Effects on National Aggregates 

of a Reduction in Capital Income Inclusion Rates 

of 4.3 Percent with an 

Additive Replacement Tax (%) !I 

Years after tax reducd.on 

Aggregate 5 I 20 I so 

Investment 1.20 1.18 1.16 

Capital stock 0 .10 0.33 0.56 

National income o.oo 0.07 0.17 

Consumption -0 .14 - 0.01 0.13 

Labor supply -0. 11 -0 .12 -0.12 

Labor productivity 0.11 0.19 0.27 

\I elf are 0 .04 0. 09 0.15 

Office of the Secretary of the Treasury August, 1985 

11 

Office of Tax Analysis 

Changes in national aggregates are expressed as percentage 

deviations from the levels simulated to occur under pre-1978 

law. 
-129-

Table 3. 5b 

Changes in Output, Capital Use, and Labor Use, by Industry 

After 20 Years from a Reduction in Capital Income Inclusion Rates 

of 4.3 Percent with an Additive Replacement Tax (%) ll 

Industry 

Mining 

Motor vehicles 

Crude petroleum and gas 

Metals and machinery 

Petroleum refining 

Construction 

Lumber, furniture, stone, 

clay and glass 

Finance and insurance 

Chemicals and rubber 

Paper and printing 

Trade 

Government enterprises 

Services 

Textile, apparel & leather 

Food and tobacco 

Transportation 

and communication 

Agriculture, forestry 

and fisheries 

Real estate 

Output 

0.20 

0.35 

o. 20 

0.29 

0.09 

0.31 

0.22 

0.07 

0.22 

0.11 

0.17 

0.06 

o.oo 

0.05 

0.12 

0.25 

0.10 

-0.39 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Capital 

0 . 70 

1.41 

0. 68 

1.42 

0 . 11 

2.45 

0 .86 

0 . 70 

1. 70 

1. 36 

1.65 

-0 . 05 

0.88 

2.13 

1.95 

1.58 

0.23 

-0.46 

Labor 

0.04 

-0.16 

-0.37 

0 . 06 

0 . 02 

0 . 22 

0.01 

-0 . 26 

-0.33 

-0.21 

-0.04 

0.12 

-0 . 12 

-0.22 

-0.37 

-0.23 

-0.13 

0.30 

August, 1985 

1/ Change in output, capital and labor are expressed as 

percentage deviations from the levels simulated to occur 

under pre-1978 law. 
-130-

Table 3. 6b 

Changes in Real Consumption and Welfare by Income Class 

from a Reduction in Capital Income Inclusion Rates 

of 4.3 Percent with an 

Additive Replacement Tax (%) !I 

Household income Years after tax change Welfare 

class21 5 I 20 I so change 

0 - 6,000 0.01 0.10 0.20 0.11 

6,000 - 8,000 -0 .04 0.07 0.17 0.08 

8,000 - 10,000 -0.08 0. 03 0.15 0.06 

10,000 - 12,000 -0. 10 0.02 0.14 0.06 

12,000 - 14,000 -0 .12 0. 01 0.13 0.05 

14,000 - 16,000 -0 .15 - 0.02 0.12 0.03 

16,000 - 20,000 -0.18 -0 .05 0.09 0.01 

20,000 - 24,000 -0.20 -0.06 0.08 0.01 

24,000 - 30,000 -0 .23 - 0.09 0.06 -0 .01 

30,000 - 40,000 -0.25 -0 .10 0.04 -0 . 01 

40,000 - 50,000 -0.23 -0.08 0.06 0.02 

50,000 + -0 .07 0. 22 0.37 0.36 

Total -0. 14 -0 .01 0.13 0.08 

Office of the Secretary of the Treasury August, 

Office of Tax Analysis 

1/ Changes in consumption and welfare are expressed as 

percentage deviations from the levels simulated to occur 

under pre- 1978 law. 

2/ Income figures are 1980 levels. 

1985 
-131-

the advantage of reducing capital gains taxes, as long as one is 

operating in the range where tax rate cuts do not reduce revenue 

from ca ital ains taxation, is that, relative to more general 

re uct1ons 1n cap1ta 1ncome taxation, they do not reduce work 

incentives and labor supply because they do not require 

offsetting increases in marginal tax rates. Moreover, as can be 

seen by comparing Tables 3.6a and 3.6b, a reduction in the 

capital gains tax, when no offsetting increases in marginal tax 

rates are required, provides much more benefit to households with 

income less than $50,000 than does a more general reduction in 

capital income tax rates. 

c. Conclusions 

In this section, a general equilibrium model of the u.s. 

economy was used to estimate the long run effects of the 1978 

capital gains tax reduction on economic growth, capital 

formation, and the standard of living of households in different 

income classes. The model was simulated under different 

assumptions about how the tax cut would need to be financed, 

including a scenario in which gains realizations increase enough 

to make the tax cut self-financing. The model was also used to 

compare the effects of reducing capital gains taxes with the 

effects of more general reductions of taxes on income from 

capital . 

The 1978 capital gains tax changes are shown to generate a 

noticeable, but modest increase in annual saving and investment 

of slightly over 1 percent. This rise in investment over time 

increases the capital stock, leading to a rise in national 

income, productivity, before-tax wages, and overall economic 

welfare, where welfare is defined to include the value of leisure 

and the expected present value of future consumption. All of 

these variables increase by much less than 1 percent. 

Consumption at first declines, reflecting a voluntary decision by 

households to save a larger proportion of their income, but 

eventually increases because the rise in national income 

ultimately makes it possible to have higher consumption and 

saving. Even after 50 years, however, the annual increase in 

consumption is estimated to be less than 0.3 percent. 

The capital gains tax reduction is shown to provide the 

largest net benefit to taxpayers in the highest income group. 

However, most other households also benefit slightly from the 

capital gains tax cut because the induced increase in the capital 

stock raises productivity and real before-tax wages . If it is 

assumed that induced realizations make the capital gains tax cut 

self-financing, then all household income groups benefit because 

there are no required offsetting increases in marginal tax 

rates; the welfare increases are distributed more uniformly 

across income classes in this case, although the highest income 

group still receives the largest benefit. 
-132-

The relatively modest benefits from the capital gains tax 

reduction of 1978 reflect the fact that the dollar amount of the 

tax cut was small, re lative to the total taxation of income from 

capital and relative to the size of the economy. As illustrated 

in the second section of this chapter, the capital gains tax cut 

of 1978 did not greatly increase after-tax returns from capital. 

Nonetheless, the important conclusion is that the tax reduction 

did produce net benefits -- even if one assumes that there were 

no induced realizations and that increases in marginal tax rates 

wer.e required to maintain government revenues . 

Finally, a comparison of the benefits of the 1978 capital 

gains tax reduction with the potential benefits of an alte~native, broad-based reduction in capital income taxes is 

sensitive to the amount of induced realizations from cutting 

capital gains taxes. If there are no induced realizations, the 

model results indicated that a more general reduction in capital 

income taxes would have been preferable; if there are enough 

induced realizations to offset fully the lower capital gains 

rates, then the capital gains tax reduction was shown to be 

preferable. 

Chapter 4 discusses in detail evidence on the effects of 

reducing the tax rate on capital gains on realizations of gains 

and on Federal revenue from capital gains taxes. 

IV. The Effects of Caeital Gains Tax Reductions on Emerging and 

High-Technology F~rms 

A. Introduction 

The previous three sections of this c hapter discussed the 

impact of the 1978 capital gains tax reduction on overall 

saving, capital formation, economic growth, and on the allocation 

of capital among broadly-defined industries. This section 

examines in more detail the effects of reducing capital gains 

taxes on emerging and high-technology firms, with particular 

emphasis on t he set of investments often referred to as venture 

capital. 

In the years following the 1978 Act, there has been 

spectacular g rowth in the amount of new capital committed to 

professional venture capital firms. These firms serve the 

important role of bringing together suppliers of risk capital and 

entrepreneurs whose companies are developing and marketing new 

products and services, many of them in "high tech'' industries. 

The set of professional venture capital firms for which published 

data are available are not the only source of high tech capital 

or of innovative activity. Nonetheless, the growth in venture 

capital firms following the reduction in capital gains taxes has 

been a sign i ficant development . 
-133-

Apart from a presumably small increase in overall saving, a 

reduction in capital gains taxes may be expected to encourage investment in emerging firms and industries for two reasons. 

First, ther e may be an increase in the supply of funds to these 

industries to the extent that lower capital gains taxes cause 

investors to reallocate funds from other investments. Second, 

there may be an increase in the number of people willing to leave 

stable jobs to undertake entrepreneurial activities, thereby 

creating an increased demand for funding of these activities. 

This section reviews the reasons to expect a direct 

relationship between lower capital gains taxes and increases in 

the funding of new and emerging enterprises, and then evaluates 

the evidence on t his subject based on available data on funding 

of new enterprises before and after 1978. The first part of this 

section discusses generally the relationship between capital 

gains taxes and the incentive to invest in new and/ or risky 

businesses. The next part reviews evidence on the financial 

structures of both new and high technology firms, compared to 

other firms and industries, and discusses the relationship 

between financial structure and the effect of lower capital gains 

taxes. The final part of this section provides a more detailed 

discussion of the role of venture capital firms and of what the 

available evidence reveals about the effects of reduced capital 

gains taxes on venture capital activity. 

B. Effects on Risk-Taking and Natural Deferral Activities 

An implicit assumption that underlies much of the economic 

analysis of capital gains taxation and risk taking is that the 

proportion of an investment's return that is paid in the form of 

price appreciation increases with the riskiness of the 

investment.15/ One situation consistent with this assumption 

occurs when-an investor, at the time of investment (time 0), 

expects no return to his investment between time 0 and some 

future point in time (t), but expects a stream of revenues 

beginning at time t. Although the owner-investor does not 

receive any net revenue between time 0 and time t, the investment 

activity nevertheless realizes a return during this period. The 

return can be characterized as a reward for waiting, as well as 

for assuming risk, and is determined by the difference between 

the initial value of the ownership share at time 0 and the 

capitalized value of the expected earnings stream when the 

investment's prospects become better known at time t. The return 

to the investment over this period (which could be either 

positive or negative) would be paid in the form of price 

appreciation (depreciation) in the ownership share. If t 

exceeded the minimum required holding period (currently 6 

months), this return would be taxed as a long-term capital gain. 

Equity investments in new firms engaged in the development 

and/ or application of new technologies are likely to encounter a 

gestation period with zero revenue as described above. Such 

investment activities would, therefore, be a type of "natural 
-134-

deferral" activity because the accrual of income in the form of 

price appreciation rather than cash flow returns results from the 

inherent nature of the investment. Favorable taxation of capital 

gains encourages real capital to flow toward such activities.~/ 

Thus, to the extent that reduced taxation of capital gains 

benefits natural deferral activities, a wide variety of risky 

investment activities may be encouraged. At the same time, not 

all natural deferral activities are necessarily risky. Moreover, 

many risky investments do not involve development and/ or 

application of new technologies; there are also risks, for 

example, in investment in commodities subject to large price 

fluctuations. Hence, favorable tax treatment of capital gains is 

not necessarily an efficient way of targeting tax incentives to 

emerging and high technology industries, although it does help 

entrepreneurial activity generally. 

C. Effects on Emerging High-Growth, High-Technology Firms 

Another reason that reduced taxation of capital gains might 

be of particular value to firms in high-growth, high-technology 

sectors relates to the way such firms are financed. It is 

widely believed that reduced taxation of capital gains generally 

favors equity relative to debt-financed investments. If this 

premise is correct, and if high-growth, high-technology firms 

rely on equity finance more than other firms, then this 

difference in firm financial structures provides another reason 

to expect lower capital gains taxes to help emerging, 

high-technology firms. 

An earlier section of this chapter examined the issue of how 

reduced capital gains taxation is relatively beneficial to firms 

with low debt-equity ratios. It was concluded that the changes 

in prices of financial assets resulting from a cut in capital 

gains taxes are indeed likely to reduce relative costs of capital 

for such firms, but that the initial effects on asset prices may 

be largely overturned by changes in market supplies of debt and 

equity. 

Tables 3.8, 3.9 and 3.10 present data on the financial 

structures of high-technology firms, small high-technology firms, 

and new firms as compared with other corporations. Table 3.8 

presents data showing the relative importance of equity as a 

source of external finance to firms in technology-based 

industries, compared to other industries. Table 3.9 presents 

estimates of the ratio of equity (including retained earnings) to 

total assets for ten industries traditionally viewed to be 

technology-based. Table 3.10 presents the ratio of new equity 

issues to new debt issues for firms incorporated for one year or 

less and for established firms. 

Table 3 . 8 shows that high-technology industries as a group 

are somewhat more likely to rely on equity as a source of finance 

than are manufacturing industries, but do not rely more on equity 

than do most other industry groups. Moreover, Table 3.9 shows 
-135-

Table 3.8 

Equity Offerings as a Share of 

Corporate Primary Cash Offerings 

by Industry Groups 

Utili-I I IAgrilYear tion turing !vices ties ITrade!Financelculture 

1971 . 30 .94 .19 .60 .38 .38 . 12 .06 

1972 .48 . 45 .36 .62 .40 . 63 .08 . 15 

1973 .27 .99 .33 .39 . 42 . 31 .25 .OS 

1974 .09 .49 .03 .10 .24 .02 .03 .11 

1975 .06 .33 .12 .11 . 38 .35 .04 . 06 

1976 .25 .53 .21 .15 .40 . 23 .07 .02 

1977 .14 .13 .09 .46 .30 .15 .06 .04 

1978 . 33 .36 .15 .13 .38 .18 . 07 .07 

1979 . 17 .22 .13 . 34 . 26 . 24 . 02 .02 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Securities and Exchange Commission, Registered Offering_ 

Statistics TaEes, 1972- 1976, 1976-1979. 

485-125 0 - 85 - 6 
-136-

that there is considerable variance among high-technology 

industries in their reliance on equity as a source of finance. 

Some rely more heavily on equity than "all manufacturing", while 

others have lower ratios of total equity to assets. The more 

(

consistent pattern shown in Table 3.9 is that small firms rely 

more heavily on external equity, and less on retained earnings, 

than do larger, more established firms. This may occur because 

relatively more small firms are new firms, rather than because of 

a difference in financing methods due to firm size per se. Table 

3.10 documents the importance of external equity for new firms. 

It shows that, in most years during the 1970s, the ratio of new 

equity issues to new debt issues was much greater for new firms 

than for established firms. 

Thus, although there is evidence that on average firms in 

high technology sectors would benefit relatively more than 

manufacturing firms in general from the changes in financial 

asset prices resulting from a reduction in capital gains taxes, 

this is not true for all high technology sectors. Further, the 

data in Table 3.9 suggest that the market value of small firms 

would not increase disproportionately from such changes because 

small firms do not in general have higher ratios of total equity 

assets than do established firms . However, the data show that 

small firms rely more heavily on external equity finance than do 

more established firms. 

These observations raise the question of whether firms are 

more likely to be affected by changes in capital gains taxation 

if their principal form of equity finance is the issue of new 

equity shares rather than reinvestment of retained earnings. 

When retained earnings, including the capital gains arising from 

retained earnings, are taxed less heavily than dividends, it is 

less costly to finance new investments through retained earnings 

than by paying dividends and issuing new equity shares.!l/ For 

this reason, most corporations -- other than regulated public utilities -- rarely issue new equity shares and pay dividends at 

the same time. Some economists have further argued that the cost 

of capital is lower for firms with retained earnings than for new 

firms because the taxes that shareholders of established firms 

must pay with respect to future dividends are already capitalized 

in share prices.~/ 

While these arguments suggest that new corporations are at a 

disadvantage compared to established corporations in raising 

equity capital, they also imply that this disadvantage results 

from the tax on corporate distributions, not the tax on capital 

gains. A reduction in capital gains taxes will reduce equally 

the tax on appreciation of old and newly-issued equity claims. 

Thus, while new firms may confront a higher cost of capital than 

existing firms because they must issue new equity rather than 

finance investment from retained earnings, reducing the capital 

gains tax may have little effect on this differential. The 
-137-

Table 3.9 

Relative Importance of Equity Finance for 

Selected Industries, by Size of Firms, 1976 1/ 

I External 

I equity 

IRS industry I to 

classification I assets assets 

Industrial chemicals .08 . 43 .51 .22 

plastics, & synthetics 

(2815) 

Drugs (2830) . 07 .53 .60 . 19 

Agricultural & other . 13 .42 .55 . 12 

chemical products 

(2898) 

Special industry .07 .39 .46 .12 

machinery(3550) 

Office & computing .11 .37 .48 .11 

machines (3570) 

Radio, TV, & .05 . 33 .38 . 10 

communication 

equipment(3665) 

Electronic components .OS .41 . 46 .11 

& accessories (3670) 

.38 

.38 

.28 

.35 

.26 

.22 

.26 

Aircraft, guided .07 .31 .37 . 14 . . 30 

missiles, and parts 

(3725) 

Scientific instruments .06 .46 .52 .11 . 44 

& measuring devices 

(3815) 

Optical, medical , & .08 . 53 .61 .18 .35 

opthalmic goods (3845) 

All manufacturing .07 .40 . 47 . 11 . 34 

Office of the Secretary of the Treasury August, 

Office of Tax Analysis 

. 60 

.57 

.40 

. 47 

.37 

. 32 

.37 

. 44 

.55 

.53 

.45 

1985 

1/ Small firms are those with assets less than or equal to $5 million. -

Source: Sourcebooks of t he Sta t istics of Income, 1976. 
-138-

Table 3.10 

Ratio of the Dollar Volume of New Equity to the 

Dollar Volume of New Debt by Age of Firm 1/ 

Year New firm Established firm 

1971 1. 78 .43 

1972 1.85 .52 

1973 5.40 .57 

1974 .19 .18 

1975 .60 .30 

1976 .64 .39 

1977 .32 .38 

1978 1.58 .37 

1979 3.70 .30 

Office of the Secretary of the Treasury August, 1985 

11 

Office of Tax Analysis 

New firms are defined as those incorporated for one year 

or less, and established firms are defined as those 

incorporated for more than one year. 

Source: Sourcebooks of the Statistics of Income, 1976. 
-139-

benefit to new and emerging firms from reducing the capital gains 

tax results more from the "natural deferral'' aspect of their 

activities than from the form of finance per se. 

D. Effects on the Suply of Venture Capital 

It is possible that the types of investors who supply funds 

to emerging, innovative enterprises are more sensitive than other 

investors to the tax treatment of capital gains. The investors 

most frequently mentioned in this context are the "venture 

capitalists" who specialize in providing financial capital to new 

firms. The discussion below examines the importance of venture 

capitalists as a source of long-term funds to emerging 

enterprises, and assesses the extent to which venture capitalists 

may be particularly sensitive to the tax treatment of capital 

gains . 

The amount of new capital committed to venture capital firms has frtcreased spectacularly in the past few years. According to 

data supplied by Venture Economics, the total capitalization of 

venture capital firms more than tripled in the five years 

following the 1978 capital gains tax cut, rising from $3.5 

billion in 1978 to $12.1 billion in 1983. New private capital 

committed to these firms was $570 million in 1978, $319 million 

in 1979, $900 million in 1980, $1.3 billion in 1981, $1.8 billion 

in 1982, and $4.5 billion in 1983. It should be noted that these 

firms, although they have grown spectacularly, still account for 

a very small fraction of the total u.s. capital stock. The 

estimated $12.1 billion invested in venture capital firms in 

mid-1982 is about 0 . 1 percent of total net worth at the end of 

1983 (which amounted to $11.2 trillion) and less than 1 percent 

of the market value of equity of all non-financial corporations 

(about $1 . 7 trillion). 

1. The Role of venture 

Tables , present some ev1 ence on t e ro e p aye y 

venture capitalists in the financing of new enterprises. Table 

3.11, based on data prepared for the National Venture Capital 

Association, shows the distribution of venture capital 

investments in 1981 by type of investment. This table suggests 

that venture capitalists do, in fact, have a propensity to invest 

in high-technology oriented investment activities. 

Tables 3.12 and 3.13 provide information on the relative 

importance of venture capital to emerging enterprises, both 

technological and non-technological. These data are based on 

financial information compiled by Charles River Associates (CRA) 

from a sample of 31 small technology-based firms and 26 small 

non-technological firms making their first public offerings 

between 1970 and 1974.~/ 

Table 3.12 shows that investors who were readily identifiable 

as venture capitalists provided approximately 12 percent of the 
-140-

Table 3.11 

Venture Capital Investments 

by Type of Investment 

Industrial activity 

Percent of total number 

of investments 

Communications 

Computer related 

Other electronics 

Genetic engineering 

Medical/health related 

Energy 

Consumer related 

Industrial automation 

Industrial products 

Other 

Total 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

11.2 

30 . 0 

14 .5 

6 . 2 

7.0 

4.9 

4.9 

6. 2 

4.4 

10 .5 

100.0 

Source: National Venture Capital Association . 

August, 1985 
-141-

Table 3.12 

Average Share of External Capitalization of Small 

Technology-Based Firms By Type of Security 

and Type of Investor (%) 

Tn~e of securi t~ 

Short term I Long term 

T~Ee of investor Eguit~ loans I loans 

Insiders 13.6 1.3 0 . 9 

Unaffiliated 11.3 0.5 3.5 

individuals 

Venture capitalists 9.8 0 . 6 1.9 

Companies other than 4.4 0 . 7 7.0 

venture capitalists 

Banks 16.8 2.7 

Government agencies 2.1 

Unknown 14.7 2. 0 6.2 

Total 53.8 21.9 24.3 

Total 

15.8 

15 . 3 

12.3 

12.1 

19 . 5 

2.1 

22.9 

100.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Charles River Associates, An Analysis of Venture CaEital 

Market ImEerfections, final report prepared for 

Experimental Technology Incentives Program, U.S. Department of Commerce, National Bureau of Standards, 1976. 
-142-

total external capitalization (excluding trade debt) of 

technology-based firms. If unaffiliated individuals and unknown 

investors were also assumed to be venture capitalists, the share 

of external capitalization attributable to venture capital would 

be as much as 50 percent. According to CRA, the capitalization 

of small, technology-based firms is 75 percent of their total 

external funds (including trade debt in the total). Thus, these 

estimates imply that venture capitalists supplied between 9 and 

38 percent of external funds to this sample of small technologybased firms. 

Table 3.13 shows that venture capitalists played a relatively 

less important role in the external finance of small, 

non-technological firms, providing between 7 and 36 percent of 

total external capitalization. Since capitalization was 

estimated by CRA to be 70 percent of total external funds for 

this group of firms, the percentage of external funds supplied by 

venture capitalists was between 5 percent and 25 percent. 

The data in Tables 3.11-3.13 permit several broad conclusions 

to be drawn about the role of venture capital. First, formally 

organized venture capitalists appear to have a clear preference 

for investments in technology- based enterprises. Second, 

formally organized venture capitalists do play an important role 

in the financing of new, small firms, particularly those which 

are technology-based. At least as important a role, however, is 

played by individuals not formally organized as venture 

capitalists, and by "insiders" -- those individuals directly 

\ involved in developing and managing incipient enterprises. 

2. The Role of Capital Gains Taxes. The impact of changes in 

the tax treatment of capital gains on the amount of capital 

supplied by venture capitalists depends on both the extent to 

which the return to venture capital is paid in a form that 

qualifies for capital gains treatment, and the extent to which 

venture capitalists are themselves subject to capital gains 

taxes. Tables 3.12 and 3.13 provide information on the percent 

of income received by venture capitalists that is likely to 

receive capital gains treatment. Of the 12.3 percent of total 

external capitalization of new technological firms supplied by 

formally organized venture capitalists, 80 percent (9.8/ 12.3) was 

in the form of equity. Among unaffiliated and unknown investors, 

the corresponding shares of equity participation were 74 percent 

and 64 percent. In the case of non-technological firms, of the 

6.9 percent of total external capitalization provided by formal 

venture capitalists, 74 percent {5.1/ 6.9), was in the form of 

equity. The corresponding shares of equity participation among 

unaffiliated individuals and unknown investors were 55 percent 

and 12 percent. 

The sensitivity of the supply of venture capital to the 

capital gains tax depends on the personal tax status of suppliers 

of venture capital. It is important to recognize that venture 

capital is supplied by a diverse group of investors. Some 
-143-

Table 3.13 

Average Share of External Capitalization of 

Small Non-Technology-Based Firms 

By Type of Security and Type of Investor (%) 

Tne of securi tl 

Short term I Long term 

Tn~e of i nvestor Eguitl loans I loans 

Insiders 16.4 3. 3 3.6 

Unaffiliated 4. 3 3.5 

individuals 

Venture capitalists 5.1 0.3 1.5 

Companies other than 1.3 6. 2 4.1 

venture capitalists 

Banks 13.4 14.6 

Government agencies 1.1 

Unknown 2. 6 6. 8 11.9 

Total 29.7 30 . 0 40.3 

Total 

23 . 3 

7.8 

6.9 

11.6 

28.0 

1.1 

21.3 

100.0 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Charles River Associates, An Analysis of Venture Capital 

Market Imperfections, final report prepared for 

Experimental Technology Incentives Program, U. S. Depart- ment of Commerce, National Bureau of Standards, 1976. 
-144-

venture capitalists are individual investors rather than formal 

venture capital firms. There are a wide variety of more 

organized sources of venture capital, including single-person 

venture capital firms , private venture capital partnerships , small business investment companies, investment bankers, 

commercial banks and bank trust departments, insurance companies, 

university endowment funds, pension and profit-sharing funds, 

mutual funds, closed-end investment companies, and major 

non-financial corporations. As shown in Table 3 . 14, in recent 

years between 16 and 32 percent of such formally organized 

venture capital has been provided by individuals and families who 

are subject to · the personal income tax (another 21 to 32 percent 

has been provided by insurance companies and corporations 

generally subject to the corporate tax on capital gains) . 

The evidence in Tables 3.12-3.14 may be used to place the 

role of organized "venture capital" suppliers into perspective 

and to assess the extent to which lowering the capital gains tax 

increases the supply of capital from this source. First, the 

data in Tables 3 . 12 and 3 . 13 suggest that between 9 and 38 

percent of the external funds flowing into small technological 

firms represented equity supplied by venture capitalists. In the 

case of non-technological firms, the corresponding percentages 

\

are between 5 and 25 percent. The data in Table 3.14 suggest 

further that at most 32 percent of the funds supplied by formally 

organized venture capitalists will be directly sensitive to 

changes in personal income taxation. Thus, using the 32 percent 

figure, between 3 and 12 percent of the external funds flowing to 

small, technological firms in recent years represented capital 

supplied by venture capitalists who are directly sensitive to the 

personal tax treatment of capital gains. In the case of 

non-technological firms, between 1 and 8 percent of funds are 

provided by this group. 

The data in Tables 3.12-3.14 further suggest that only a 

portion of the recently observed increase in venture capital 

flows can be attributed to the impact of the 1978 reductions in 

capital gains taxes on outside suppliers of venture capital to 

emerging firms. Roughly 47 percent of the increase in venture 

capital committed in 1981, compared to 1978, was from sources not 

directly affected by the 1978 reduction in capital gains taxes; 

this figu re increases to roughly 60 percent if one argues that 

insurance companies are sufficiently lightly taxed that they 

should be viewed as unresponsive to changes in capital gains 

taxation . In addition, the share of venture capital supplied by 

individuals and families -- the source most sensitive to changes 

in the individual capital gains tax -- declined from 32 percent 

in 1978 to 23 percent in 1981 and declined further to 21 percent 

in 1983 . 20/ 

However, 

capital from 

treatment of 

indirectly . 

it should be noted that the supply of venture 

sources not directly affected by changes in the 

capital gains may nevertheless be affected 

To the extent that taxable formally organized 

tax 
-145-

Table 3.14 

Sources of Committed Capital to 

Independent Private Venture Capital Funds 

Source 1978 1979 1980 1981 11982 1983 Total 

Dollar amounts ($mil) 

Pension funds 32 53 197 199 474 1,070 2,025 

Insurance companies 35 8 88 132 200 410 873 

Individuals and 

families 70 39 102 201 290 715 1,417 

Corporations 22 28 127 142 175 415 909 

Endowments and 

foundations 19 17 92 102 96 267 593 

Foreign 38 26 55 90 188 531 928 

Total 216 170 661 866 1,423 3,408 3,408 

Percent of total ca~ital committed 

Pension funds 15 31 30 23 33 31 30 

Insurance companies 16 4 13 15 14 12 13 

Individuals and 

families 32 23 16 23 21 21 21 

Corporations 10 17 19 17 12 12 13 

Endowments and 

foundations 9 10 14 12 7 8 9 

Foreign 18 15 8 10 13 16 14 

Total 100 100 100 100 100 100 100 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

Source: Venture Economics 
-146-

venture capitalists, as well as taxable insiders and founders 

(discussed in the next section), play the primary role in 

identifying potentially successful ventures -- only to be 

followed by supplies of venture capital from non-taxable or 

lightly-taxed investors -- the supply of venture capital from 

non-taxable sources is indirectly affected by the tax treatment 

of capital gains. 

3. The Role of Insider-Founders. The previous discussion 

pertains only to participation in ventures by outside investors. 

As shown in both Tables 3 . 12 and 3.13, insiders who are 

presumably the founders of emerging enterprises are also an 

important source of finan cing for such emerging enterprises. 

Furthermore, a larger share of insider financing is likely to be 

in the form of equity than in the case of financing from outside 

investors, and such investors are likely to be taxable and these 

directly sensitive to changes in the tax treatment of capital 

gains. 

More significantly, the willingness of "insider-founders'' to 

commit their own financial resources to new enterprises is 

presumably a pre-condition for the establishment of such 

enterprises. In this sense, the 1978 cut in capital gains taxes 

may have increased the demand for venture capital funds by making 

it more attractive for entrepreneurs to attempt to establish new 

enterprises. An increased demand for funds by entrepreneurs 

would widen the range of investment opportunities available to 

prospective suppliers of venture capital, thereby inducing more 

funding both from outside investors who benefit from reductions 

in personal capital gains taxes and outside investors (such as 

pension funds) who do not benefit directly. 

As discussed in the first part of this section, committing 

resources -- whether in the form of financial capital or foregone 

wage and salary earnings -- to new ventures is likely to involve 

both risk and deferral of returns. One attraction of taking such 

risks is the possibility of transforming otherwise fully taxable 

wage and salary income into capital gain. For example, in a 

survey of 122 corporate executives, Holland found a number of 

engineers and scientists who responded that favorable tax 

treatment of capital gains was a factor in inducing them to shift 

from salaried employment to management of their own firms.21/ ~imilarly, in a recent survey of executives in the semi-conauctor ·industry conducted by Charles River Associates, favorable capital 

gains treatment of stock options was cited as an important 

incentive in attracting skilled te chnical manpower to new 

start-up firms.~/ 

E. Conclusions 

This section has examined the effects of reducing capital 

gains taxes on emerging, high-technology firms. The principal 

conclusion is that there are good reasons to expect lower capital 

gains taxes to cause some reallocation of capital from other 
-147-

sectors of the economy to new enterprises. The experience of 

venture capital firms since 1978 is consistent with that 

expectation. However, examination of the data suggests that 

improved incentives to suppliers of outside funds due to lower 

capital gains taxes -- the principal reason often cited for the 

increased flow of funds to venture capital firms after 1978 

may be a less important factor (among others causing this 

increase) than is commonly believed. 

The most important reason to expect capital gains taxes to 

benefit new enterprises is that investments in such firms are 

likely to accrue earnings in a way that qualifies them for 

capital gains treatment. Such investments are likely to fall 

within a broader class of natural deferral activities, all of 

which benefit, relative to other types of investments, from 

favorable capital gains treatment. 

A considerably less compelling argument is that emerging, 

high-technology firms rely on equity finance. The evidence shows 

that such firms are not much more reliant on equity finance in 

general than most firms, but rather are more reliant on 

external as opposed to internal equity. Reduced taxation of 

capital gains favors both types of equity, and therefore should 

not be of special benefit to firms that rely relatively more on 

external equity. 

Finally, while reduced taxation of capital gains does 

affect some outside venture capitalists who supply funds to 

emerging firms, a substantial share of the increase in 

venture capital funds since 1978 has been supplied by investors 

not directly affected by changes in the personal tax treatment of 

capital gains. However, reduced taxation of capital gains may 

indirectly affect the supply of such funds and may also expand 

the investment opportunities available to venture capitalists not 

subject to the capital gains tax by encouraging entrepreneurs to 

establish new enterprises. 
-148-

FOOTNOTES TO CHAPTER 3 

! I The model was developed for the Treasury Department by 

Professor John Shoven of Stanford University and Professor John 

Whalley of the University of Western Ontario. For a full 

description of the model, see c. Ballard, D. Fullerton, J. B. 

Shoven, and J. Whalley, General Equilibrium Analysis of u.s. Tax 

Policies (North-Holland, 1983). 

2/ An estimate of untaxed gains at death was constructed using 

nistorical data on capital gains realizations, revaluations of 

capital assets, and data on wealth transfers reported on Federal 

estate tax returns. 

3/ See, for example, Edward F. Denison, "A Note on Private 

Saving," Review of Economics and Statistics, August 1958, and 

Paul A. David and John L. Scadding, 11 Private Savings : 

Ultrarationality, Aggregation and Denison's Law," Journal of 

Political Economy, March-April 1974. 

4/ See Michael J. Boskin, "Taxation, Saving and the Rate of 

Interest," Journal of Political Economy, April, 1978. 

5/ See, for example, E. Philip Howrey and Saul H. Hymans, "The 

Reasurement and Determination of Loanable- Funds Saving," and 

comments by Robert z. Lawrence, Michael J. Boskin, and John A. 

Brittain, in Joseph E. Pechman, ed., What Should be Taxed: 

Income or Expenditure (Washington, D.C., The Brookings 

Institution, 1980). 

6/ See Lawrence H. Summers, "Capital Taxation and Accumulation 

In a Life Cycle Growth Model," American Economic Review, 

September, 1981, and Owen J. Evans, 11 Tax Policy, the Interest 

Elasticity of Saving, and Capital Accumulation: Numerical 

Analysis of Theoretical Models," American Economic Review, June, 

1983. 

7/ For a discussion of the relationship between the 

Interest elasticity of saving and the substitutability of current 

for future consumption in a two-period model, see Martin S. 

Feldstein, "The Welfare Cost of Capital Income Taxation," Journal 

of Political Economy, April, 1978. For empirical estimates of 

the effects of interest rates on the allocation of consumption 

over time in a life-cycle framework, see Jonathan Skinner, 

"Variable Lifespan and the Intertemporal Sensitivity of 

Consumption," NBER Working Paper, February, 1983. 

8/ For a discussion of some of these studies, see Ernst R. ~erndt, "Reconciling Alternative Estimates of the Elasticity of 

Substitution," Review of Economics and Statistics, February, 

1976. 
-149-

9/ See Martin Feldstein and c. Horioka, "Domestic Saving and 

Ynternational Capital Flows," Economic Journal, June, 1980. 

10/ This section is based on material originally prepared for the 

Treasury Department by Joseph Cordes and Steven Sheffrin. 

11/ For an exposition of this extreme case, see Merton H. Miller, 

~ebt and Taxes," Journal of Finance, May, 1977. 

12/ For example, see Steven J. Nickell, The Investment Decision 

01 Firms (Cambridge Uni ve rsity Press, 1978 ) . 

13/ For examples of studies that compare the market va luation of 

Oividends and capital gains, see Roger Gordon and Burton Malkiel, 

"Taxation and Corporate Finance," in Henry Aaron and Joseph 

Pechman, eds., How Taxes Affect Economic Behavior (Wa shington, 

D.C., Brookings, 1981), and Robert H. Litzenberger and Krishna 

Ramoswarny, "The Effect of Persona l Taxes and Dividends on 

Capital Asset Prices: Theory and Empirical Evidence ," Journal of 

Financial Economics, 1980. 

14/ For a full discussion of the model, see Ballard, Fullerton, 

Slioven, and Whalley, op.cit . Briefer descriptions may be 

obtained from numerous journal articles. For example, see Don 

Fullerton, A. Thomas King, John B. Shoven, and J ohn Whalley, "Tax 

Integration in the United States: A General Equilibrium 

Approach," American Economic Review, September 1981. 

15/ For example, see Roger Gordon and Burton Malkiel, "Taxation 

and Corporate Finance," in Henry Aaron and Joseph Pechman, eds., 

How Taxes Affect Economic Behavior (Washington, D.C., Brookings 

Institution, 1981). 

16/ See Joseph J. Cordes and Steven M. Sheffrin, "Taxation and 

tfie Sectoral Allocation of Capital in the United States," 

National Tax Journal, De cember, 1981. 

17/ See, for example , Mervyn A. King, Public Policy and the 

COrporation, (London, Chapman and Hall Ltd., 1977), Chapter 4. 

18/ The point that the tax on distributions from retained 

earnings has already been capitalized in the va lue of shares, and 

therefore does not affect required pre-tax returns to corporate 

investment, has been made by Auerbach and Bradford. See Alan J . 

Auerbach, "Tax Integration and the 'New View' of the Corporate 

Tax: A 1980s Perspective," Proceedings of the National Tax 

Association-Tax Institute of America, 1981, and David F. 

Bradford, 11 The Incidence and Allocation Effects of a Tax on 

Corporate Distribut ions," Journal o f Public Ec onomi cs, March, 

1981. For a more extended discussion of this point, and its 

relationship to changes in the capital gains tax, see Cordes and 

Sheffrin, op.cit. 
-150-

19/ See Charles River Associates, An Analysis of Venture Calital 

Market Imperfections, final report prepared for Experimenta 

Technology Incentives Program, u.s. Department of Commerce, 

National Bureau of Standards, 1976. 

20/ The increase in capital supplied by pension funds is 

attributable in part to the liberalization of Securities and 

Exchange Commission regulations that limit the participation of 

pension funds in these ventures. 

21/ See Daniel Holland, "The Effect of Taxation on Effort: Some 

Results for Business Executives," National Tax Association--

Proceedings of the 62nd Annual Conference, September, 1969. 

22/ See Charles River Associates, Innovation, Competition, and 

GOvernment Policy in the Semi-Conductor Industry, final report 

prepared for Experimental Technology Incentives Program, u.s. 

Department of Commerce, National Bureau of Standards, 1980. 
-151-

Chapter 4 

THE EFFECTS OF CAPITAL GAINS TAX REDUCTIONS ON FEDERAL REVENUE 

I. Introduction 

A. Effects on Realizations and on the Income Tax Base 

As noted in earlier chapters, capital gains are subject to 

tax only when realized rather than as accrued . If capital gains 

tax rates are sufficiently high, there is a strong incentive to 

avoid or defer taxation of past gains by avoiding or delaying 

realizations. For taxpayers wh o wish to leave appreciated 

property to their heirs, this incentive to delay realization is 

strengthened by the fact that the basis of inherited assets is 

their market value when acquired by the beneficiary , rather than 

the cost basis of the decedent. Thus gains transferred at death 

escape Federal income taxation entirely. Taxpayers also may 

transfer capital gains by gift, in which case the gain is not 

realized at the time of the gift, but the recipient's basis is 

the cost basis of the donor. These opportunities to a void or 

defer realization imply that the existence of high capital gains 

tax rates deters taxpayers from some portfolio rearrangements 

that they would o therwise find advantageous. 

In any year, realizations of capital gains are only a small 

fraction of accrued gains. For example, net annual realized 

gains averaged only slightly over 3 percent of the stock of 

accrued gains between 1947 and 1980. In part , this reflects the 

existence of accrued gains on many assets, such as some 

noncorporate business assets and some closely-held corporations, 

that rarely would be sold or exc hanged even if capital gains 

taxes were zero. Nonetheless, the existence of such a large 

stock of accrued gains, relative to annual realizations, suggests 

a significant potential for unlocking accrued gains in response 

to lower capital gains tax rates. 

In the debates preceding enactment of the 1978 Act, some 

suggested that lowering capital gains tax rates would cause so 

much unlocking of ga i ns that Federal revenue would increase. A 

cut in capital gains tax rates should lead to an increase in 

realizations by reducing the costs to taxpayers of rearranging 

their portfolios and of liquida t ing assets to obtain funds for 

consumption. An increase in Fede ral rev enue from capital gains 

taxes would occur only if lowe r capital gains tax rates induced 

an increase in realizations suffi c iently large to offset the 

decline in the tax rates appli e d to capital gains realizations. 

Thus, the issue of whether re venue from capital gains taxes 

increases or decreases when capital gains tax rates decline 

cannot be determined on theoreti c al grounds. 
-152-

Regardless of the direction of the revenue effect, one would 

expect the short-run increase in realizations in response to a 

capital gains tax cut to be larger than the long-run increase. 

Since taxpayers are realizing gains from a stock of past 

accruals, which have in some cases accumulated over many years, 

additional gains unlocked by lower capital gains taxes in the 

first few years after a tax cut are not constrained by the volume 

of recently accrued gains. However, as past accumulated gains 

are realized, the stock of potential realizations from these past 

accruals will decline. Although lower capital gains taxes should 

increase the turnover of assets in the long run, one would expect 

a one-time "unlocking" in the first year or first several years 

after a tax cut that is larger than the long-run effect.!/ 

A reduction in capital gains taxes can also alter the tax 

base over time by changing the size and composition of the 

capital stock. However, as discussed in the previous chapter, 

any growth in the capital stock and in GNP due to increased 

saving in response to the capital gains tax reduction of 1978 is 

likely to have been relatively small and to have taken many years 

to materialize. Also, a capital gains tax reduction may induce 

changes in the methods of financing the capital stock which may 

either increase or decrease revenue. 

To the extent a capital gains tax reduction would induce 

capital to shift from owner-occupied housing and consumer 

durables, which yield returns in the form of untaxed service 

flows to households, to assets in corporations and uninco r porated 

businesses, the tax base would increase . However, to the extent 

that capital would shift from assets producing ordinary income in 

the form of rental income, taxable interest, dividends, and net 

income of unincorporated businesses, to assets producing returns 

in the form of capital gains, the overall income tax base would 

decline. In the long run, an increase in observed capital gain 

income might not be indicative of an increase in the income tax 

base if capital gains were being substituted for ordinary income. 

As a result of these changes in the size and composition of 

the capital stock and in the methods of financing capital, the 

total effect on the overall income tax base in response to a 

change in capital gains taxes is uncertain in sign as well as in 

magnitude. In contrast, both the economic theory discussed in 

Chapter 2 and the statistical evidence described below indicate 

that lowering the capital gains tax has a significant effect on 

realized gains by increasing taxable sales and exchanges of 

assets with accrued gains. Therefore, the analysis in this 

chapter focuses on the effect on Federal revenue of the 

"unlocking" of gains induced by a reduction in capital gains 

taxes. It is worth noting, howev er, that there are much more 

complex "feedback" effects of changing the capital gains tax 

which might either increase or decrease revenue -- that have not 

as yet been studied. 
-153- \ 

B. Historical Evidence on Realizations 

Before beginning a discussion of the statistical analysis in 

this report of the effects of capital gains tax reductions on 

realizations, it is useful to review the historical evidence on 

capital gains realizations. Table 4.1 shows capital gains in 

adjusted gross income, excluded gains, total gains, and taxes 

paid on capital gain income for returns with net long-term gains 

in excess of net short-term losses and/ or net short-term gains 

for the years 1954-1982. Taxes paid on capital gain income are 

computed from the Treasury's individual tax model as the 

difference between taxes actually paid and taxes that would have 

been paid if returns with positive net gains instead had gains 

equal to zero. Excluded gains are equal to one half of net 

long-term gains in excess of net short-term losses for the years 

1954-1978, and 60 percent of net long-term gains in excess of net 

short-term losses for years beginning in 1979. 

The ove rall trend for realizations throughout the 1950s and 

1960s is upward, although there are declines in years of 

recessions (1957, 1960) and in years of declines in the stock 

market (1957, 1960, 1962, 1966, 1969). During most of the 1970s, 

total realizations were volatile with little trend. There were 

sharp declines in realizations during the recession periods of 

1970 and 1974-1975, and large increases in realizations in 

periods of economic expansion such as 1971-1972 and 1976. The 

most dramatic year-to-year change occurred in 1979 when total 

realized capital gains increased by over 45 percent. This 

increase corresponded to the reduction in tax rates under the 

1978 Act, and occurred during a period with a rising stock 

market, increasing Gross National Product and high inflation 

rates. 

In 1980, 1981 and 1982, the year-to-year increases in total 

realized capital gains were 1.6 percent, 8.5 percent and 11.4 

percent. The small increase in realizations in 1980 suggests 

that at least some of the very large increase in realizations in 

1979 represented a one-time unlocking of accrued gains. However, 

this interpretation is clouded by the facts that the first half 

of 1980 was a recession period and that late in the year some 

realizations may have been delayed in anticipation of lower tax 

rates under tax changes being proposed for 1981. 

In order to focus on changes in realizations of capital gains 

over the period of reductions in capital gains tax rates, Table 

4.2 shows realized long-term capital gains by adjusted gross 

income class for the years 1978-1982. The data in this table 

show that the large increase in realizations between 1978 and 

1979 occurred in all income classes, but was most pronounced in 

the highest income classes that benefited most from the capital 

gains tax reductions. Thus long-term gains increased by 140 

percent in the $500,000 to $1 million income class, and by 317 

percent in the $1 million and over income class. 
-154-

Table 4.1 

Capital Gains and Taxes Paid on Capital Gain Income 

for Returns with Net Capital Gains, 1954-1982 

Gains in 

adjusted Taxes paid gross on capital Year income ain income 

1954 3,732 3,425 7,157 1,010 1955 5,126 4,755 9,881 1,465 

1956 4,991 4,692 9,683 1,402 1957 4,128 3,982 8,110 1,115 1958 4,879 4,561 9,440 1,309 1959 6,797 6,340 13,137 1,920 1960 6,004 5,743 11,747 1,687 

1961 8,291 7, 710 16,001 2,481 1962 6,821 6,630 13,451 1,954 1963 7,468 7,111 14,579 2,143 1964 8,909 8,522 17,431 2,482 1965 11,069 10,415 21,484 3,003 

1966 10,960 10,388 21,348 2,905 1967 14,594 12,941 27,535 4,112 1968 18,854 16,753 35,607 5,943 1969 16,078 15,361 31,439 5,275 1970 10,656 10,192 20,848 3,161 

1971 14,559 13,782 28,341 4,350 1972 18,397 17,472 35,869 5,708 1973 18,201 17,556 35,757 5,366 1974 15,378 14,839 30,217 4,253 1975 15,799 15,104 30,903 4,534 

1976 20,207 19,285 39,492 6,621 1977 23,363 21,974 45,337 8,104 1978 26,232 24,294 50,526 9,104 1979 31,331 42,112 73,443 11,669 1980 32,273 41,859 74,582 12,459 

1981 34,713 46,225 80,938 12,684 1982 38,514 51,639 90,153 12,900 

Office of the Secretary of the Treasury August, 1985 Office of Tax Analysis 

1/ For 1954-1978, 50 percent of net long- term gains in excess of net - short-term losses for returns with capital gains; for 1979-1982, 

60 percent such net long-term gains. 
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Table 4.2 

Capital Gains by AGI Class, 1978-1982 11 

Capital Capital Capital Capital Capital 

gains gains gains gains gains 

AGI 1978 1979 1980 1981 1982 

($thou) ($mil) ($mil) ($mil) ($mil) ($mil) 

10 or less 5,946 7,672 8,256 9,005 8,696 

10-20 6,832 7,189 6,977 5,428 4,870 

20-30 6,985 7,737 6,890 6,082 4,601 

30-50 8,865 11,121 9,790 9,611 9,234 

50- 100 8,409 11 '407 12,589 13,602 13,286 

100-200 5,489 8,920 9,109 10,922 10,859 

200-500 4,201 7,850 9,119 10,601 12,091 

500-1000 1, 720 4,126 5,304 5,504 7,584 

1000+ 2,198 9,156 8,156 9, 729 17,186 

Total 50,646 72,178 76,192 80,484 88,407 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Includes realized net long-term capital gains after loss 

carryover. 

Source : U.S. Internal Revenue Service, Statistics of Income - Individual Income Tax Returns, 1978-1982. 
-156-

In 1980, realized capital gains in the highest income class 

declined by 11 percent, even though total gains increased and the 

number of returns in this income class increased by nearly 23 

percent, from 3,601 to 4,414. In 1981, realized long-term gains 

increased in all of the income classes with AGI above $50,000. 

While the largest increase, 19%, occurred in the $1 million and 

over income class, the number of returns in this income class 

grew at a slightly faster rate of nearly 20 percent. Thus there 

did not seem to be a strong immediate response to the reduction 

of the maximum tax rate on long-term capital gains from 28 

percent to 20 percent on assets sold after June 9, 1981. 

However, it should be noted that the tax rate cut was in effect 

for only roughly half of the year, and that the beginning of the 

1981-1982 recession in July, 1981 tended to reduce the amount of 

capital gains realized in 1981. 

In 1982, with the lower capital gains tax rates in effect for 

the full year, realized long-term gains increased by 77 percent 

in the $1,000,000 and over class and by 38 percent in the 

$500,000-$1,000,000 income class, as compared to a total increase 

of slightly less than 10 percent. While real Gross National 

Product declined for almost all of 1982 and the trough of the 

business cycle was not reached until very late in the year, the 

stock market rose sharply beginning in August 1982. Thus key 

economic forces other than the change in capital gains tax rates 

had offsetting effects on the change in realizations in 1982. 

This brief discussion of changes in capital gains 

realizations over time illustrates some of the hazards of 

directly attributing year-to-year changes in realizations to 

changes in tax laws. First, it is difficult to separate the 

effects of macroeconomic factors such as inflation, recession, 

and economic growth from the effects of changes in tax rates. 

Realizations tend to increase with increases in real Gross 

National Product and tend to decline in recession periods. 

Second, realizations tend to vary directly with changes in the 

stock market. The stock market may in turn react to changes in 

tax rates on capital gains. Third, there can be one-time events 

that may affect year-to-year changes in realizations. For 

example, the Belridge oil merger in 1979 alone accounted for 

one-seventh of the increase in gains in that year. Fourth, it is 

not appropriate simply to compare gains in income classes across 

years. There is an upward trend in the distribution of returns 

in the income classes reported by the Internal Revenue Service as 

inflation and increases in real income move more taxpayers into 

higher income classes. Furthermore, the definition of Adjusted 

Gross Income, the income measure used to classify returns, 

changes from year to year. One of the most important changes in 

recent years was the reduction in the inclusion rate for 

long-term capital gains from 50 to 40 percent in the 1978 Act. 

Because of this change, AGI income classes are not strictly 

comparable before and after the capital gains tax reductions in 

the 1978 Act went into effect. 
-157-

C. Statistical Approaches 

The effect of l owering capital gains tax rates on 

realizations of capital gains can be examined usi ng two different 

statistical approaches. One approach is a "cross-section" 

analysis of how realizations of capital gains differ among 

taxpayers that face different marginal tax rates. Using a 

cross-section sample of individual taxpayers in one or several 

years, one can estimate how capital gains reali zations would 

increase if the capital gains tax were lowered . The estimated 

response of realizations to lower tax rates can then be used to 

simulate the effects on Federal rev enue of the changes in capital 

gains taxes enacted in 1978 and 1981. 

The alternative approach is a ''time-series" analysis of how 

aggregate capital gains realizations change over time when 

capital gains tax rates are changed. Since there have been few 

major changes in capital gains tax rates until recent years, it 

is difficult to construct statistical tests of the relationship 

between realizations and capital gains tax rates using 

time-series data . 2/ It is useful and instructive, however, to 

compare capital gains tax realizations and revenue following the 

1978 Act and the 1981 Act to the l evels of realizations and 

revenue that would have been proje c t ed to occur if there had been 

no change in capital gains taxes. 

The next section of this chapter reviews cross-section 

studies on individual taxpayer behavior that examined the 

relationship between realizations of gains and capital gains 

taxes. A representative equation which was estimated in one of 

these studies is then simulated to estimate the effects of the 

1978 Act and the 1981 Act on Federal revenue from capital gains 

taxes. The following section provides alternative estimates of 

the effects of the 1978 Act and the 1981 Act on revenue from 

capital gains taxes, based on a time- series analysis of 

realizations and revenue in 1979-1982 under different capital 

gains tax regimes . The final section summarizes the findings. 

II. Evidence From Cross-Section Studies 

A. Introduction 

One way of investigating the effect of changes in capital 

gains taxes on capital gains realizations, and thus on Federal 

revenue from capital gains taxes, is to examine the behavior of 

taxpayers confronted with different marginal tax rates. 

Essentially, one uses data from a sample of tax returns to obtain 

a statistical relationship between capital ga i ns realized by 

taxpayers and the characteristics of those taxpayers whic h are 

thought to influence realizati ons, including some measure of the 

marginal tax rate on gains. From these equations, one can derive 

estimates of how gains realizations would change in response to 

change s in the marginal tax rate on gains. The estimated 
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behavioral response of taxpayers to changes in the marginal tax 

rate on gains can then be used to simulate the effects on 

realizations and on revenue from capital gains taxes of any 

proposed changes in the capital gains tax. 

The development of large-scale data files with information 

from thousands of individual tax returns and the increased 

interest by both academics and policymakers in the behavioral 

effects of the taxation of capital income have combined to make 

econometric analysis of capital gains realizations both feasible 

and important. In particular, the debate over the capital gains 

provisions of the 1978 Act stimulated interest in estimates of 

the degree of "unlocking" of gains that would result if capital 

gains tax rates were reduced. As a consequence, there have been 

a number of detailed econometric studies of capital gains 

realizations in recent years. 

This section presents simulations of the effects of the 

capital gains tax reductions of 1978 and 1981 on realizations of 

long-term capital gains and Federal revenue from capital gains 

taxes. These simulations are based on econometric research, 

performed under contract to the Department of the Treasury, which 

uses a panel of individual tax return data for the years 

1971-1975.3/ This research, referred to below as the "panel 

study , " represents an extension of earlier work by Feldstein, 

Slemrod, and Yitzhaki, by Auten and Clotfelter, and by Minarik; 

it uses an improved data base and alternative equation 

specifications in an effort to resolve some of the unanswered 

questions from these earlier studies.4/ The consistent finding 

of all of this research is that differences in capital gains 

realizations among individuals are quite sensitive to differences 

in the marginal tax rate on capital gains. These studies all 

suggest that the 1978 capital gains tax reduction led to a 

significant unlocking of capital gains. While the exact 

quantitative magnitude of this unlocking remains in doubt, the 

equations estimated in the panel study provide the best evidence 

available at this time of how a change in capital gains taxation 

would affect gains realizations in the long run. 

The next part of this section discusses some of the problems 

of interpretation common to all studies that attempt to estimate 

capital gains realizations behavior from cross-section data. 

This is followed by a brief summary of the results of the panel 

study. Finally, estimates based on simulating an equation from 

the panel study are presented that show how realizations of 

long-term capital gains, and revenue from capital gains taxes, 

were affected by the 1978 Act and the 1981 Act. 

B. Issues in Cross-Section Studies of Gains Realizations 

All of the cross-section studies of gains realizations 

postulate a behavioral equation that relates realized capital 

gains, either from sales of all assets or from sales of some 

subset of capital assets such as corporate shares, to measures of 
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marginal tax rates on gains realizations, wealth, and income, and 

to other variables, such as the taxpayer's age, that might affect 

gains realizations. The coefficient on the marginal tax rate 

variable (or variables) is then interpreted as an estimate of how 

much higher capital gains realizations would have been per unit 

difference in the marginal tax rate. That is, the estimated 

coefficient on the marginal tax rate can be used to infer what 

capital gains realizations would be in the long run, with all 

other variables held constant , if capital gains tax rates had 

been permanently higher or lower. However, because the estimates 

are derived by observing the behavior of taxpayers in different 

circumstances at one point in time, they provide no insight on 

how quickly realizations will adjust in response to changes in 

marginal tax rates. 

All of the studies confront problems of design and 

interpretation. These problems are reviewed below.~/ 

1. Definition of Marginal Tax Rate Variable. One problem 

common to all the studies is that the marginal tax rate 

confronted by a taxpayer is not independent of the amount of 

gains realized. For taxpayers with less than $3,000 of 

short-term losses, the marginal tax rate on the first dollar of 

long-term gains is equal to the statutory marginal tax rate on 

ordinary income because the first dollar of gain reduces by one 

dollar the amount of short-term loss that can be deducted from 

ordinary income. For net long-term gains in excess of short-term 

losses, the marginal tax rate on gains is below the statutory 

marginal tax rate on ordinary income because of the capital gains 

exclusion. Except for top bracket taxpayers, the marginal tax 

rate generally rises with the amount of gains realized as 

additional taxable income from capital gains moves the taxpayer 

into a higher marginal tax bracket. 

All of the studies recognize that the marginal tax rate on 

gains depends on the amount of gain realized and attempt various 

corrections in order to derive an "exogenous" measure of marginal 

tax rates -- a measure that is independent of gains realizations. 

The techniques used to obtain an exogenous measure of the 

difference in marginal tax rates confronted by taxpayers include 

using the tax rate on the first dollar of capital gains,6/ using 

a predicted last dollar rate based on an equation relating the 

last dollar rate to the first dollar rate and to an average 

amount of capital gains for subpopulations classified by 

dividends and adjusted gross income net of gains,?/ and using a 

predicted tax rate based on average capital gains- by classes of 

taxpayers.8/ While all of these techniques remove the variation 

in marginai tax rates caused by differences in realizations, they 

also to some degree suppress the differences in tax circumstances 

among individuals . 

2. Measure of Potential Realizations. In theory, potential 

gains realizations for any taxpayer are limited by the amount of 

accrued gains in his portfolio. Ideally, a measure of accrued 
-160-

gains or potential realizations should be included in the 

equations for estimating the determinants of actual realizations. 

Unfortunately, data on accrued gains of individual taxpayers are 

not available. Moreover, even if one believes that ratios of 

accrued gains to wealth are similar among taxpayers, there are no 

tax return data on wealth . 

In the absence of data on accrued gains or wealth, the 

studies all use ''proxy" variables as rough measures of wealth 

differences among taxpayers. For example, dividend income is 

used as a proxy for ownership of corporate shares, and thus as a 

proxy for potential realizations of gains from selling stock. 

Combinations of dividend income and other forms of capital income 

(i.e. interest, rent, and partnership income) are also used as 

proxy measures for total wealth .2 / 

The studies also include measures of total income to reflect 

the fact that taxpayers at higher income levels may have 

accumulated more wealth over their lifetimes. The usual measure 

of total income used is adjusted gross income less included 

capital gains. The panel study uses a measure of positive income 

that includes all positive components of adjusted gross income, 

other than included capital gains, but does not deduct business 

losses. It is presumed that this variable better measures a 

taxpayer's economic circumstances because wealthy individuals 

often show a low adjusted gross income for tax purposes because 

of business or partnership losses which overstate real economic 

losses. 

The inclusion of income and wealth variables in the equations 

means that the studies are estimating the extent to which 

taxpayers with low marginal tax rates, for any given level of 

income and estimated wealth, have a propensity to realize capital 

gains. Taxpayers may have a low marginal tax rate, relative to 

their income, for a number of reasons, including large family 

size or high levels of deductible expenditures, such as medical 

expenditures or charitable contributions.lO/ It is impossible to 

determine statistically whether observed aifferences in capital 

gains realizations result from differences in marginal tax rates 

or from differences in other variables that are correlated with 

lower marginal tax rates. For example, if high medical 

expenditures are correlated with lower marginal tax rates, one 

cannot determine whether any resulting observed higher capital 

gains realizations are occurring because taxpayers are responding 

to the lower costs of realizations associated with lower marginal 

tax rates, or simply because taxpayers with high medical expenses 

are financing them by selling capital assets. In the absence of 

any persuasive reasons for believing otherwise, the analysis in 

this report assumes that deductible expenses do not have a 

significant effect on capital gains realizations, apart from 

their indirect effect through lowering marginal tax rates. 
-161-

3. Seearation of Transitory and Permanent Effects. A related 

issue in 1nterpreting the results of cross-section studies is the 

separation of the transitory and permanent effects of differences 

among taxpayers in observed marginal tax rates. If an 

individual's other sources of income and deductible expenditures 

vary greatly from year to year, leading to large annual 

variations in marginal tax rates, it is rational for that 

individual to time realizations of capital gains so as to offset 

other fluctuations in taxable income. That is, capital gains 

will tend to be realized in years when taxable income, and 

marginal tax rates, would otherwise be low. There is evidence 

that some taxpayers in fact do time realizations to offset 

variations in other forms of income.!!/ 

Thus, one reason past studies may have observed a strong 

relationship between capital gains realizations and marginal tax 

rates is that people are realizing gains in years marginal tax 

rates are temporarily low -- not that people are behaving 

differently because of permanent differences in tax 

circumstances. If the equations are only picking up a transitory 

effect, then they do not imply that realizations would increase 

in response to a permanent reduction in the tax rate on gains. 

In order to separate the transitory and permanent effects of 

differences in marginal tax rates, the panel study included in 

the equation for estimating gains realizations separate variables 

for the permanent marginal tax rate (an average of the current 

tax rate and the tax rate for the two previous years) and the 

transitory marginal tax rate (the difference between the current 

tax rate and the permanent rate). It was found that both the 

permanent and the transitory marginal tax rates were 

statistically significant in explaining differences in 

realizations among taxpayers. Moreover, including a transitory 

tax variable in the equation only slightly reduced the estimated 

effect on realizations of permanent differences in marginal tax 

rates. 

4. Appropriate Estimating Technique. The studies all fit 

some type of curve -- either a straight line or a relationship 

between squares, square roots, or logarithms of variables -- to 

the data. One problem with standard techniques is that they fail 

to account for the bunching of capital gains realizations at 

zero.12/ To adjust for this problem, the panel study used Tobit 

analySis -- an estimating technique that predicts both the 

probability of having any positive realizations, and the level of 

realizations for those who do realize, based on the values of 

variables that determine realizations behavior.13/ The use of 

Tobit analysis refines the measurement of the coefficients 

somewhat, but it does not alter the qualitative findings of 

earlier studies. 

5. Evaluation. This section has provided a brief overview of 

some of the problems in designing and interpreting studies that 

attempt to estimate from observations of individual taxpayers' 
-162-

behavior the extent to which realizations of capital gains will 

be altered by changing capital gains taxes. The purpose of the 

discussion was both to indicate how much serious and 

sophisticated effort has been devoted to these studies and to 

caution the reader that the results are still open to varying 

interpretations. The panel study resolves some of the questions 

raised by earlier studies, but other problems still remain. 

C. Summary of the Results of the Panel Study 

In the panel study, equations were estimated to explain 

differences in capital gains realizations among individuals for a 

variety of asset categories and for all assets. The equations 

were estimated using tax return information from a sample of 

approximately 17,000 taxpayers for the years 1971-1975. Since 

the construction of the permanent and transitory measures of 

marginal tax rates requires tax rates from the concurrent and two 

preceding years, the equations only explain realizations for the 

years 1973-1975. The estimated equations show that gains 

realizations are sensitive to differences in marginal tax rates 

on gains, when other relevant determinants of realizations are 

taken into account. 

Table 4.3 summarizes five different equations estimated in 

the panel study which explain differences in realized gains among 

taxpayers.14/ The equations differ both in the way the dependent 

variable is-defined and in the form of tax variables used. In 

some equations, the dependent variable is the ratio of gains to 

wealth, with wealth measured by the sum of dividends, interest, 

rent, and partnership income. In other equations, wealth is 

estimated by equations that use survey data on both wealth and 

capital income to estimate the relationship between wealth and 

the components of capital income.15/ (As noted above, some 

measure of wealth is used as a proxy variable for accrued gains, 

or potential realizations, in all of the econometric studies on 

gains realizations.) In Equation 4.4, the dependent variable is 

defined so as to constrain realizations to be no more than the 

amount of predicted wealth. 

In each estimating equation, the marginal tax rate is defined 

as the difference between the tax liability at the average amount 

of net long-term capital gains (in excess of net short-term 

losses) for the taxpayer's wealth and income group and the tax 

liability if net capital gains were zero divided by the average 

amount of net capital gains for the taxpayer's group. The tax 

variables include different combinations of the permanent and 

transitory marginal tax rates, and the square root of those tax 

rates. 

The last column of Table 4.3 displays the estimated 

elasticity for each equation, i . e., the percentage change in 

realizations per unit percentage change in the marginal tax rate. 

The elasticity is itself a function of the marginal tax rate; in 
-163-

Table 4.3 

Estimated Elasticities of Net Long-Term Capital Gains 

Realizations with Respect to Permanent Marginal 

Tax Rates on Long-Term Gains !I 

Estimated 

Equation Dependent Variable Tax Variables Elasticity 

4.1 

4.2 

4.3 

4.4 

4.5 

Ratio of Gains to 

Wealth 2/ 

Ratio of Gains to 

Wealth 2/ 

Logarithm of Gains 

Log of 100 Minus 

Percentage of Gains 

Ratio of Gains to 

Predi cted Wealth 3/ 

Permanent Tax Rate, -2.20 

Square Root of 

Permanent Tax Rate, 

Transitory Tax Rate 

Permanent Tax Rate, -1 . 34 

Transitory Tax Rate 

Permanent Tax Rate, -1 . 29 

Square Root of 

Permanent Tax Rate, 

Transitory Tax Rate 

Permanent Tax Rate, -1.73 

Transitory Tax Rate 

Permanent Tax Rate, -1 . 16 

Square Root of 

Permanent Tax Rate, 

Transitory Tax Rate 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

August, 1985 

1/ The method of estimation was Tobit Maximum Likelihood, and the 

elasticity estimates were based on simulations of the data file 

used in the panel study. Elasticities were calculated by 

reducing the permanent tax rate on capital gains for each 

taxpayer by 10 percent and then using the equation to calculate 

the predicted increase in realized net long-term capital gains. 

2/ The wealth variable is measured by the sum of dividends, 

interest, rent, and partnership income. 

3/ The predicted wealth variable is based on estimates using data 

from the 1963 Federal Reserve Board Survey of Financial 

Characteristics of Consumers. 
-164-

most of the equations estimated, the elasticity becomes smaller 

as the marginal tax rate declines. In each case shown in Table 

4.3, the elasticity is calculated by reducing permanent marginal 

tax rates for all taxpayers in the panel study sample by 10 

percent and then using the estimating equation to predict the 

resulting increases in gains. The estimated elasticities for a 

different sample would differ slightly because the total response 

depends on the distribution of gains realizations by marginal tax 

rate and by income class. 

The absolute values of the estimated elasticities in all of 

the equations in Table 4.3 are greater than one. This indicates 

that all of the estimated equations predict that a small 

reduction in marginal tax rates on capital gains below 1973-1975 

levels would increase revenue from capital gains taxes for the 

sample of taxpayers in the panel study file. 

The other independent variables used in the five equations 

for estimating capital gains realizations were permanent income, 

transitory income, wealth, and dummy variables for age groups and 

for the years 1974 and 1975. (A sample equation is described in 

detail in the following subsection.) Realized gains were larger, 

as expected, for larger values of permanent income, transitory 

income, and wealth. The age variables reflect two offsetting 

effects on realizations. Older taxpayers may be expected to have 

more accrued gains per dollar of wealth, and therefore would be 

expected to realize more gains. However, a bequest motive would 

lead taxpayers to be more reluctant to realize accrued gains as 

they become older, because gains can be transferred tax free by 

bequest. The estimated coefficients showed gains higher, all 

other variables constant, for taxpayers age 50-59 and 60-69, but 

lower for taxpayers age 70 and over.16/ Finally, the dummy 

variables for 1974 and 1975 adjust for differences in market 

conditions in those years relative to 1973; in each case, given 

values of other variables, realizations were smaller in both 1974 

and 1975 than in 1973. 

The panel study also estimated equations for realizations of 

gains on particular asset classes. Table 4.4 shows that the 

estimated permanent tax rate elasticities, using equations with 

the same specification as Equation 4.3 in Table 4.3, were -2.07 

for capital gains on corporate stock, -0.71 for real estate 

investments, and -0 .43 for all other assets. These results 

suggest that realizations of capital gains on corporate stock are 

more sensitive to tax considerations and thus are affected to a 

greater degree by the lock-in effect than are other assets. 

The general findings from the panel study of an absolute 

value of the elasticity of gains realizations slightly greater 

than 1.0 at early 1970s tax rates fall in the middle of the range 

of estimates from previous cross-section studies of gains 

realizations. A much larger response of realizations to marginal 
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Table 4.4 

Comparison of Estimated Tax Elasticity for All Gains and 

Estimated Tax Elasticities for Subsets of Assets 1/ 

Type of 

Asset 

Corporate shares 

Real estate 

All other assets 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Permanent 

Tax Rate 

Elasticity 

- 2.07 

- 0.71 

- 0.43 

August, 1985 

1/ The estimates are made using a logarithmic functional form 

where the dependent variable is the logarithm of gains and 

the independent variables are the permanent tax rate, 

square root of the permanent tax rate, transitory tax rate, 

permanent income, transitory income, wealth, and dummy 

variables for age 50 to 59, age 60 to 69, over age 70, 

1974, and 1975. The method of estimation is Tobit Maximum 

Likelihood. 

Source: Capital Gains Panel Study 
-166-

tax rates was estimated in the early, pathbreaking research by 

Feldstein, Slemrod, and Yitzhaki {FSY) , while studies by Minarik 

found a somewhat lower response.17/ The major reason for the 

high elasticity in the FSY results is that they assigned equal 

weight to all observations even though different observations in 

the Treasury data file they used represent different numbers of 

taxpayers. When the FSY equati ons were re-estimated with the 

panel study data with the observations weighted, the results were 

qualitatively similar to the other findings of the panel study. 

The Minarik studies that estimated a smaller response differed 

from FSY in the following three major respects: {a) the use of 

weighted regression; {b) the use of an alternative measure of the 

tax rate variable; and {c ) the inclusion of additional 

explanatory variables in a more flexible functional form. From 

the results presented in the studies, it appears that the use of 

weighted regression was the main reason for the dramatically 

different findings.~/ 

D. Simulated Revenue Effects of the 1978 and 1981 Tax Changes 

The effects of recent changes in the tax treatment of capital 

gains were simulated by comparing actual realizations in 1979 to 

what realizations might have been in 1979 under different rules 

for taxing realized capital gains. The estimated equation used 

to derive the effect of changes in marginal tax rates on 

realizations is Equation 4.3 in Table 4.3.19/ Specifically, the 

estimated equation is --

log G = 14.216 TXP - 29.522 TXP1/ 2 - 26.289 TXT 

{ 3. 18) (13.95) (8.54) 

+ 2.637 yp + 1.710 YT + 2.306 w 

{ 14.07) ( 4. 62) (25.35) 

+ 1.078 DA1 + 1. 624 DA2 - 0 .124 DA3 

- 4.331 D74- 2.773 D75- 40 . 273, 

where t-statistics are in parentheses, G is net long-term gains, 

TXP and TXT are the permanent and transitory tax rates, YP and YT 

are permanent and transitory income, W is wealth, DA1, DA2 and 

DA3 are dummy variables for ages 50-59, 60-69, and 70 and over, 

and D74 and D75 are dummy variables for the years 1974 and 1975. 

In performing the simulation, this equation was collapsed to 

the form 

1/ 2 log G = a + 14.216 TXP - 29.522 TXP , 

where a is a constant term unique to each taxpayer. In the 

simulation, the average amount of gains for the group is replaced 

by the taxpayer's actual gains in defining the marginal tax rate. 
-167-

The value of a is calibrated so that the amount of each 

taxpayer's actual realizations of net long-term gains in 1979 is 

on the regression line. That is, the constant term encompasses 

errors in the predicting equation unique to each taxpayer . 

Table 4 . 5 compares actual realizations of net capital gains 

in 1979 with simulated realizations under the tax provisions in 

effect prior to the 1978 Act . Restoring the pre-1978 capital 

gains tax rule~ raises the tax rate on net capital gains, at 1979 

levels of realizations, from 17 . 8 percent to 25 . 4 percent and 

reduces predicted realized net capital gains by about $24.1 

billion . Of this amount, about $3 . 0 billion is due to a 

reduction in the number of taxpayers realizing gains and about 

$21 . 0 billion is due to a reduction in gains by taxpayers 

continuing to realize gains . 

Tables 4.6 and 4.7 show the resulting simulated change in 

revenue from capital gains taxes. Table 4 . 6 shows the revenue 

from taxes on all net long-term capital gains (long-term gains, 

in excess of long-term and short-term losses) for returns showing 

positive net long-term gains. In 1979, revenue from capital 

gains taxes on long-term capital gains was about $10 . 8 billion . The revenue collected on these gains realizations would have been 

$15.2 billion if the gains · actually rea l ized in 1979 had been 

taxed at the rates prevailing prior to the 1978 Act . Because the 

higher rates would have lowered realized gains, however, the 

simulated revenue under pre-1978 law is only $8.7 billion . 

Table 4.7 shows that the increase in realized gains induced 

by the 1978 capital gains tax changes would have increased 

revenue by $6 . 5 billion at pre-1978 tax rates . The lower rates 

applied to 1979 gains, however, reduced revenue by $4.4 billion . The net effect on revenue from capital gains taxes derived by 

simulating the cross-section realizations equation is shown in 

the last column of Table 4.7. The changes in capital gains 

taxation in the 1978 Revenue Act are shown to have increased 

revenue from capital gains taxes by an estimated $2.1 billion. 

One striking feature of the simulation results reported in 

Tables 4.5-4.7 is the proportionately greater increase in induced 

realizations, and in capital gains taxes paid, by taxpayers in 

the highest income groups. Table 4.7 shows that $1.6 billion of 

the $2.1 billion increase in revenue from capital gains taxes 

attributable to the 1978 Act is accounted for by taxpayers with 

AGI greater than $200,000. These upper income taxpayers paid 44 

percent of taxes on long-term capital gains in 1979, but pay only 

37 percent in the 1978 law simulation. In contrast, the 

simulations show no net revenue change for the group of taxpayers 

with AGI less than $50 , 000. 

Tables 4 . 8-4. 10 show the effects of a similar simulation of 

the marginal tax rate changes enacted in the 1981 Act . When 

fully phased in (1984), these provisions reduce all marginal tax 

485-125 0 - 85 - 7 
-168-

Table 4.5 

Simulated Net Long-Term Capital Gains, 

Pre- 1978 Law and 1979 Levels 

Actual Simulated, I 

AGI class 1/ 1979 pre-1978 lawl Tax rate on 1979 g:ains (%) ($thou) ($mil) ($mil) I 1979 law I Pre-I9i8 law 

10 or less 4,425 3,263 5.1 7.3 

10-15 2,404 1,597 6.4 9.5 

15-20 3,331 2,399 7.3 10.7 

20-30 6,661 4,665 10.5 15.3 

30-50 9,435 6,584 13.6 19.8 

50-100 9,964 6,172 20.2 28.9 

100-200 8,237 5,357 22.9 31.3 

200+ 20,292 10,656 24.7 35.5 

Total 64,750 40,694 17.8 25.4 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ The definition of AGI used for the classifier in Tables - 4.5-4.10 is AGI under 1979 law. 
-169-

Table 4.6 

Simulated Revenue from Capital Gains Taxes, 

1979 Levels 11 

Revenues based 

Revenues based on estimated 

Revenues based on 1979 gains 1979 gains if 

on actual taxed at pre-1978 rates 

AGI class 1979 gains pre-1978 rates prevailed 

($thou) ($mil) ($mil) ($mil) 

10 or less 149 210 249 

10-15 156 227 149 

15-20 240 348 237 

20-30 687 984 656 

30-50 1,289 1,866 1,230 

50-100 1,831 2,562 1,604 

100-200 1,646 2,183 1,367 

200+ 4,765 6,784 3,209 

Total 10,764 15,164 8,701 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Includes only those returns with net capital gains . 
- 170-

Table 4.7 

Simulated Effect of 1978 Capital Gains Cuts on Revenue from 

Capital Gains Taxes , 1979 Levels 1/ 

Change in gains, I Change in rates, Total revenue AGI class pre-1978 rates I 1979 ra t es change ($thou) ($mil) I ($mil) ($mil) 

10 or less - 39 - 61 - 100 

10- 15 78 - 71 7 

15-20 111 -108 3 

20- 30 328 - 297 31 

30-50 636 - 577 59 

50-100 958 -731 227 

100-200 816 - 537 279 

200+ 3,575 - 2,019 1,556 

Total 6,463 - 4,400 2,063 

Office of the Secretary of the Treasury August, 1985 Office of Tax Analysis 

1/ Data in table are based on simulations in Tables 4.5 and 4.6 . 
-171-

rates by roughly 25 percent; the top rate is reduced from 70 to 

50 percent. The tax rates applied t o net capital gains decline 

proportionately with the de c line in tax rates applied to ordinary 

income; the maximum rate falls from 28 percent to 20 per c ent. 

Table 4.8 s hows that the tax rate changes enacted in 1981, 

when fully phased i n, reduce the tax rate on all net capital 

gains from 17.8 percent to 14.4 percent at 1979 realizations 

levels. If the lower tax rate had been in effect permanently, 

the estimated realizations in 1979 would have been about $23.6 

billion higher. 

Tables 4.9 and 4.10 show the simulated long-run revenue 

effects if 1984 marginal tax rates had been in effect in 1979 . The decline in tax rates, at the same level of realized gains, 

would have reduced revenue from $10 . 8 billion to $8.8 billion . However, the induced realiza t ions resulting from the lower tax 

rates would have increased revenue from $8 . 8 billion to $12.4 

billion. The last column of Table 4.10 shows that the reduction 

in marginal tax rates in 1981, including the cut in the top rate 

from 70 percent to 50 percent, resulted in an estimated net 

increase in revenue from capital gains taxes of $1.6 billion at 

1979 levels. 

The estimates presented in Tables 4.7 and 4.10 suggest that 

both the 1978 reduction in capital gains tax rates and the 

further lowering of marginal income tax rates in the 1981 Act 

increased revenue from capital gains taxes. The estimated 

revenue gain at 1979 levels of income was $2.1 billion from the 

1978 changes and $1.6 billion from the 1981 changes. Although as 

capital gains tax rates are lowered, revenue from capital gains 

taxes must eventually fall, the simulation results imply that tax 

rates on capital gains may still be above their revenuemaximizing level. 

The simulations shown are based on qne equation that is 

representative of the findings of a number of studies on how 

realizations of net capital gains are affected by changes in tax 

rates on capital gains . These studies find that realizations are 

sensitive to tax rates and most, but not all , have estimated 

absolute values of elasticities greater than one at tax rates 

prevailing in the mid-1970s. Thus, simulating the equations 

estimated by other investigators is likely, in most cases, to 

lead to a qualitatively similar result -- revenue from capital 

gains taxes is higher at current tax rates than at the tax rates 

on capital gains in effect prior to the 1978 Act. 

The next section presents alternative estimates of the 

revenue effect of the 1978 and 1981 reductions in capital gains 

tax rates, based on a time-series analysis of gains realizations 

and revenues in 1979-1982, compared to trends in earlier years. 

Then, the final section summarizes the available evidence on the 

revenue effects of the 1978 and 1981 capital gains tax change. 

485-125 0 - 85 - 8 
-172-

Table 4.8 

Simulated Net Long-Term Capital Gains under 1984 Law, 

1979 Levels 1/ 

-

Actual Simulated, AGI class 1979 1984 Law Tax rate on 1979 gains (%) ($thou) ($mil) ($mil) 1979 law I 1984 law 

10 or less 4,425 7,088 5.1 3.8 

10-15 2,404 3,154 6.4 5.2 

15-20 3,331 4,200 7.3 5.7 

20-30 6,661 8,602 10.5 8.4 

30-50 9,435 11,161 13.6 11.7 

50-100 9,964 12,810 20. 2 17.1 

100-200 8,237 10,821 22.9 19.1 

200+ 20,292 30,556 24.7 19.7 

Total 64,750 88,391 17.8 14.4 

Office of the Secretary of the Treasury August, 1985 Office of Tax Analysis 

1/ The equation simulated is the same equation used in Table 4.5. 
-173-

Table 4.9 

Simulated Revenue from Capital Gains Taxes 

Under 1984 Law, 1979 Levels 1/ 

I Revenues based 

!Revenues based on estimated 

Revenues based I on 1979 gains 1979 gains if 

on actual I taxed at 1984 1984 rates 

AGI class 1979 gains I rates prevailed 

($thou) ($mil) I ($mil) ($mil) 

10 or less 149 131 252 

10- 15 156 122 170 

15-20 240 176 252 

20-30 687 524 701 

30- 50 1,289 1,062 1,285 

50-100 1,831 1,589 2,024 

100- 200 1 ,646 1,377 1,868 

200+ 4,765 3, 778 5,817 

Total 10,764 8,759 12,370 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Includes only those returns with net capital gains. 
-174-

Table 4.10 

Simulated Effect of 1981 Tax Rate Cuts on Revenue from 

Capital Gains Taxes, 1979 Levels 1/ 

Change in gains Change in rates 

AGI class 1984 rates 1979 gains Total revenue 

($thou) ($mil) ($mil) change 

10 or less 121 -18 103 

10-15 48 -34 14 

15-20 76 -64 12 

20-30 177 -163 14 

30-50 223 -227 -4 

50-100 435 -242 193 

100-200 491 - 269 222 

200+ 2,039 - 987 1, 052 

Total 3,611 - 2,005 1,606 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Data in table are based on simulations in Tables 4.8 and 4.9. 
-175-

III. Evidence from Time-Series Analysis 

A. Introduction 

An alternative, and seemingly more straightforward, approach 

to investigating the effects of the 1978 and 1981 capital gains 

tax reductions on capital gains realizations and on Federal 

revenue from capital gains taxes is simply to observe what has 

happened to realizations and revenue since enactment of the 1978 

and 1981 Acts. If realizations and revenue increased following 

the enactment of a capital gains tax reduction, one might infer 

that the capital gains tax cut inc reased, rather than decreased, 

Federal revenue. 

The major difficulty with this approach is that one needs to 

know what would have happened to realizations of capital gains 

and Federal revenue from capital gains taxes if there had been no 

change in the tax law. Realizations and revenue both tend to 

grow over time even when there are no changes in tax policy. 

Moreover, this growth is uneven; capital gains realizations and 

tax revenue grow at varying rates , and sometimes decline, due to 

many factors unrelated to changes in the taxation of capital 

gains. 

This section develops projections of what might have happened 

to capital gains realizations and Federal revenue from capital 

gains taxes if the 1978 and 1981 capital gains tax changes had 

not been enacted , using a simple equation to forecast the growth 

in realizations over time in the absence of any tax policy 

changes. Projected realizations under pre-1978 tax law, and 

Federal revenue given those realizations, are used to derive 

alternative estimates of how revenue from capital gains taxes 

changed as a result of the tax law changes enacted in 1978; 

similarly, projected realizations and revenue under 1979 law are 

used to estimate the effects of the 1981 Act. 

B. Projectina Revenue from Capital Gains Taxes with a Time- Ser~es Mo el 

The effects of the 1978 and 1981 Acts on revenue from capital 

gains taxes cannot be assessed without baseline estimates of what 

realizations and revenue would have been without the changes in 

capital gains taxation. Table 4.11 presents baseline projections 

of capital gains realizations under pre-1978 law for the years 

1979-1982, and under 1979 law for the years 1981-1982 . The 

baseline estimates are calculated using a simple equation that 

relates changes in capital gains realizations over time to the 

changes in the capital gains tax rate in the current and previous 

years and to changes in three economic variables which are 

presumed to affect changes in realizations. Specifically, 

changes in realizations are calculated using the following 

equation (estimated over the years 1954-1982): 
-176-

CG 102.42 CRGNP + 11.774 CIGNP + 33.614 CSTK 

( 6. 21) (1.92) (4.23) 

- 1705.0 CTX1 + 814.28 CTX2 - 2445.7 

(6.44) ( 2. 06) ( 3. 09) 

(R2 = .884, D.W. = 1 . 987), 

where t-statistics are parentheses, CG is the change in realized 

net capital gains in millions of dollars (for returns with 

positive net gains), CRGNP and CIGNP are the changes in the real 

and inflationary components of Gross National Product in billions 

of dollars, CSTK is the change in the value of household holdings 

of corporate stock in billions of dollars, and CTX1 and CTX2 are 

the changes in the tax rate on capi t al gains in the current and 

previous years.20/ This equation explains nearly 90 percent of 

the variation in-year-to-year changes in capital gains 

realizations. 

Table 4.11 shows projected capital gains realizations under 

pre-1978 law of $59.5 billion in 19 79, $68.5 billion in 1980, 

$71 . 1 billion in 1981, and $73.7 billion in 1982.21/ The large 

growth in projected realizations in 1980, and the-small growth in 

1981 and 1982, reflect in part the large growth in stock values 

in 1980 and the relatively poor performance of the stock market 

in 1981 and early 1982. Under the assumption that the 1978 Act 

was passed but the 1981 Act was not, projected realizations were 

$77.8 billion in 1981 and $80.3 billion in 1982. In comparison, 

actual realizations were $73.4 billion in 1979, $74.6 billion in 

1980, $80.9 billion in 1981 , and $90.2 billion in 1982. 

Projected realizations under 1979 law exceeded projected 

realizations under pre-1978 law by 23.4 percent in 1979, 8.9 

percent in 1980, 9.3 percent in 1981, and 9.0 percent in 1982. 

This substantial increase in actual realizations in the years 

following 1978, relative to projected realizations, raises the 

possibility that revenue from capital gains taxes might have been 

higher than projected revenue at pre-1978 law capital gains tax 

rates. Similarly, actual realizations exceeded projected 

realizations under 1979 law by 4.1 percent in 1981 and by 12 . 3 

percent in 1982, raising the possibi l ity that the 1981 tax cut 

increased capital gains tax revenue.~/ 

Table 4.12 compares actual revenue from capital gains taxes 

to projected revenue at pre-1978 law tax rates for 1979-1982.23/ 

In 1979, actual revenue from capital gains taxes exceeded -- projected revenue by $0.9 billion. In contrast, actual revenue 

was only $11 million above projected revenue in 1980. These 

results imply a first-year increase in realizations in response 

to the capital gains tax reduc tions in the 1978 Act sufficiently 

large to result in a substantial revenue gain despite the 
- 177-

Table 4.11 

Comparison of Actual and Projected Capital Gains, 

1979- 1982 1/ 

Actual Projected gains, Projected gains, 

gains pre-1978 law 1979 law 

Year ($mil) ($mil) ($mil) 

1979 73 ,443 59,530 73,443 

1980 74,582 68,507 74,582 

1981 80,938 71,132 77 '767 

1982 90,153 73,651 80,296 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Figures are net long-term gains in excess of short- term losses 

plus short-term gains for all returns with positive net gains. 
Actual 

revenue 

Year ($mil) 

1979 11,669 

1980 12,459 

1981 12,684 

1982 12,900 

- 178-

Table 4. 12 

Comparison of Actual and Projected Revenue 

From Capital Gains Taxes, 1979-1982 !I 

Effects 

Projected revenue tax laws on 

I I 

Pre-1978 law I 1979 law 1978 Act I 

($mil) I ($mil) ($mil) I 

10,817 11,669 852 

12,448 12,459 11 

12,926 12,811 -115 

13,384 13,228 -156 

of new 

revenue 

1981 Act 

($mil) 

0 

0 

-127 

-328 

Office of the Secretary of the Treasury August, 1985 

11 

21 

Office of Tax Analysis 

Includes only returns with pos1t1ve ne t capital gains. 

revenues are based on projected gains i n Table 4.11. 

Projected 

The effect of the 1978 Act on revenue is computed as projected revenue 

under 1979 law minus projected revenue under pre-1978 law. The effect 

of the 1981 Act on revenue is computed as actual revenue minus 

projected revenue under 1979 law. 
-179-

reduction in capital gains tax rates. The induced realizations 

estimated for 1980, the second year after the tax reductions, are 

more modest, but are still large enough to offset the lower tax 

rates and produce a small net revenue gain. For 1981 and 1982, 

the increased realizations as a result of the 1978 tax reductions 

are not sufficient to offset fully the revenue effect of the 

lower rates, as actual revenues are estimated to be $0.1 and $0.2 

billion below the revenues projected to occur under pre-1978 law. 

It is important to recognize that these revenue estimates are 

based on a stochastic equation for projecting realizations . 

Although the equation fits the data well, its stochastic element 

implies that the estimates are subject to prediction error. One 

can compute a 95 percent confidence interval around the revenue 

estimate by comparing actual revenue with the revenue that would 

have been projected to occur if realizations had been at the 

upper and lower bounds of the confidence interval. For example, 

in 1979, a 95 percent confidence interval around the estimated 

revenue effect has a lower bound of a modest revenue gain of $66 

million and an upper bound of a large revenue gain of $1.6 

billion. For 1980 and later years, a 95 percent confidence 

interval around the estimated revenue effects of the 1978 Act 

includes revenue gains at the upper bound of projected 

realizations and revenue losses at the lower bound of projected 

realizations. 

Table 4 .1 2 also compares actual revenue for 1981 and 1982 to 

projected revenue if the 1978 Act had been passed but the 1981 

Act had not. The estimates imply that, relative to the 1978 Act, 

the r eductions in capital gains tax rates in the 1981 Act 

resulted in revenue reductions of $0 .1 and $0.3 billion in 1981 

and 1982. However , in evaluating the effects of the 1981 Act, it 

is important to remember that its passage resulted in a 

significant general reduction in income tax collections. It may 

therefore be more appropriate to evaluate its effects by looking 

at capital gains tax revenue as a share of total individual 

income tax collections. For example, in 1982, revenue from 

capital gains taxes represented 4.3 percent of total individual 

income tax receipts, as compared to a 4.0 percent share of 

revenue projected to occur under previous law.24/ 

C. An Alternative Comparison Taking into Account the Effect of 

Capital Gains Tax Changes on the Stock Market 

The projections of capital gains tax revenue under pre-1978 

law shown in Table 4.12, as well as the projected realizations 

shown in Table 4.11, do not account for any effect the change in 

capital gains taxes might have had on stock market values. In 

the equation used to derive projected capital gains, the value of 

corporate shares held by individuals in 1979-1982 is taken to be 

the actual observed value. Thus, no account is taken of the 

possibility that corporate share values might have grown at a 

slower rate if the 1978 capital gains tax reduction had not been 

enacted. If the value of corporate shares used in the simulation 
-180-

were lowered so as to rep r esent an estimate of corporate share 

values in the absence of the capital gains tax change, the 

estimate of baseline real i zations derived from the equation would 

also be smaller, and thus the estimated increase in capital gains 

realizations due to the t a x change would be larger than the 

estimates shown in Table 4 .11. 

As discussed in Chapte r 3 of this report, a reduction in 

taxes on capital gains, relativ e to o the r forms of capital 

income, is likely to raise the ma r ke t value of assets that 

generate taxable capital gain income . Corporate equity values 

are likely t o be higher than they wo uld have been if tax rates 

had been unchanged. Alte r natively, one can presume that if the 

1978 capital gains tax changes had not been enacted, corporate 

share values would have been s omewha t lower than they were in 

1979-1982 . 

In order to account for the e ffects of the capital gains tax 

reductions on the value of c orpo rate stock owned by households, a 

simple equation was estimated tha t r e lates stock values to Gross 

National Product and to the present value of the tax rate on real 

capital gains. Specifically, t he e stimated equation is 

log HSTK = .9004 log RGNP - .001098 RTX 

( 4. 33 ) (4 .23) 

+ .3998 log HSTK1 - 2 . 2613 

( 3.33 ) ( 2.87) 

(R2 = .928, D.W. = 2 .27 ) , 

where t-statistics are in parenthese s , HSTK and HSTK1 are the 

values of corporate shares owned by households in the current and 

previous years, RGNP is real Gross National Product in 1972 

dollars, and RTX is the present value of the tax rate on real 

capital gains when shares are assumed to be held 5 years and the 

discount rate is the BAA co rporat e bond rate (the calculation of 

this effective tax rate is s imilar t o that described in detail in 

Chapter 2). 

This equation shows that the value of corporat e shares held 

by households is positively related to changes in real Gross 

National Product and inversely related to the present value of 

the capital gains tax rate. The tax rate variable incorporates 

the following three key aspe c ts of t he effects of capital gains 

taxes on stock holdings: (a) the statutory tax rate on capital 

gains; (b) the effect of inf lati on in increasing the effective 

tax rate on real capital ga i ns; and (c ) the lower present value 

of anticipated capital gains taxes due to the ability to postpone 

the payment of t he tax until the stock is sold. During the 

1970s, the effecti ve tax r a te on real capital gains was high both 

because of high statutory t ax r a t es and high rates of inflation. 
-181-

Table 4 . 13 summarizes the calculation of the effects of the 

1978 and 1981 capital gains tax reductions on the value of stock 

holdings . Under pre-1978 law, the stock market is projected to 

be about 5 percent lower in 1979 and 1980, and about 4 percent 

lower in 1981 and 1982. The 1978 Act capital gains tax changes 

have a smaller effect in 1981 and 1982 because of the lower 

inflation rates in those years. The 1981 Act is projected to 

increase the value o f stock holdings by 1 percent or less in 1981 

and 1982. 

Table 4. 14 shows reali zed capital gains, taking into account 

the estimated effects of the capital gains tax rate reductions on 

stock values. In 1979, the stock market adjustment reduces 

projected realizations from $59.5 billion (see Table 4 . 11) to 

$58.0 billion, so t hat the effects of the tax cuts are $1 . 5 

billion or about 11 pe r cent greater than without the stock market 

adjustment . In 1980, 1981 and 1982, projected realizations under 

pre-1978 Act law are $66.7 billion, $69.6 billion and $72.2 

billion, as compared to $68.5 billion, $71.1 billion and $73.7 

billion without the stock market adjustment. Estimates of 

realizations (and thus of revenues) for 1981 and 1982 must be 

interpreted with considerable caution because realizations were 

affected by capital gains tax reductions under both the 1978 and 

1981 Acts. Moreover, the forecast error becomes larger the 

further away from 1978 the projections are made. 

Table 4.15 presents alternative comparisons of actual 

revenues from capital gains taxes and revenues projected at 

pre-1978 tax rates in 1979-1982 under the assumption that 

corporate share values held by individuals would have been lower 

if the 1978 capital gains tax reductions had not been enacted. 

The projected revenues in Table 4 . 15 are based on the equation 

for projecting reali zations, but with the values of corporate 

shares taken as the values projected in Table 4.13. Thus, these 

estimates reflect the effects of the capital gains tax reductions 

on both estimated share values held by individuals and on the 

projected amount of realizations, given corporate ·share values 

and Gross National Product. 

The inclusion of the effect of the tax reductions on share 

values increases the estimated changes in revenues from capital 

gain taxes which occur as a result of the 1978 capital gains tax 

reductions. Comparing Tables 4.15 and 4.12, the estimated 

revenue increase i n 1979 is $1 . 1 b i llion, compared to an 

estimated increase of $0.9 billion in the absence of the stock 

market adjustment. In 1980, the estimated revenue increase is 

over $300 million compared to an estimated revenue increase of 

only $11 million when share value s are taken as given. A similar 

computation for 1981 results in estimated revenue gain from the 

1978 tax reductions of about $1 42 million with the stock market 

adjustment, compared to a loss of $115 million when stock prices 

are taken to be independent of the tax . In 1982 , the estimated 

revenue gain is $38 million with the stock market adjustment, as 
-182-

Table 4.13 

Estimated Effects of Capital Gains Tax Rate Reductions on 

Value of Household Holdings of Corporate Stock, 1979-1982 

Projected values of holdin~s Actual Pre- 1978 I 197 value law I law Year ($bil) ($bil) I ($bil) 

1979 892 847 892 

1980 1,188 1,135 1,188 

1981 1,134 1,088 1,129 

1982 1,275 1,231 1,261 

Office of the Secretary of the Treasury August, 1985 Office of Tax Analysis 
-183-

Table 4.14 

Comparison of Actual and Projected Capital Gains, Taking into 

Account Estimated Effects of Capital Gains Tax Reductions 

on Stock Values, 1979-1982 !I 

Actual Projec ted gains, Projected gains, 

gains pre- 1978 law 1979 law 

Year ($mil) ($mil) ($mil) 

1979 73,443 58, 021 73,443 

1980 74,582 66,730 74,582 

1981 80,938 69,550 77 J 583 

1982 90,153 72,176 79,846 

Office of the Secretary of the Treasury August, 1985 

Office of Tax Analysis 

1/ Figures are net long- term gains in excess of short- term loss es 

plus net short- term gains for all returns with positive net 

gains. 
Year 

1979 

1980 

1981 

1982 

-184-

Table 4.15 

Comparison of Actual and Projec ted Revenue From Capital Gains Taxes, 

Taking into Account Estimated Effects of Capital Gains 

Actual 

revenue 

($mil) 

11,669 

12,459 

12,684 

12,900 

Tax Reductions on Stock Values, 1979-1982 1/ 

Pre-1978 law 1979 law 

($mil) ($mil) 

10,544 11,669 

12,126 12,459 

12,639 12,781 

13,116 13,154 

Effects of new 

tax laws on revenue 

1978 Act 1981 Act 

($mil) ($mil) 

1,125 0 

333 0 

142 - 97 

38 -254 

Office of the Secretary of the Treasury August, 1985 

1/ 

21 

Office of Tax Analysis 

Includes only returns with positive net capital gains . revenues are based on projec ted gains in Table 4. 11 . 

Projected 

The effect of the 1978 Act on revenue is computed as projec ted revenue 

under 1979 law minus projected revenue under pre- 1978 law. The effect 

of the 1981 Act on revenue is computed as actual revenue minus 

projected revenue under 1979 law. 
-185-

compared to a loss of $156 million without the adjustment. The 

revenue losses estimated to hav e occurred following the 1981 Act 

are also reduced when the stock market adjustment is taken into 

account. 

It must be emphasized that the effect of changes in the 

capital gains tax on stock market values is uncertain. Moreover, 

to the extent the increase in share values results from a shift 

in household portfolios from other income- producing assets to 

corporate shares, there are likely to be offsetting revenue 

losses not accounted for by these computations. These offsetting 

revenue losses will be relatively large to the extent that 

capital shifts from sources of income which are fully taxed, such 

as money market funds or taxable bonds, to sources of income 

which generate preferentially taxed capital gains. 

Bearing in mind these qualifications, the illustrative 

calculations presented above show that the estimated change in 

revenue from capital gains taxes attributable to the 1978 capital 

gains tax reduction is roughly $200-$300 million larger over the 

period 1979-1982 when one takes into account estimates of the 

effect of the change in capital gains taxes on the valuation of 

corporate shares. In 1979, this adjustment converts a large 

estimated revenue gain into an even larger gain. In 1980 it 

changes a small re venue gain into a more substantial gain, and in 

1980 and 1981 it converts relatively small revenue losses into 

relatively small revenue gains. 

D. Summary and Evaluation 

'one cannot determine the effe c t of reductions in capital 

gains tax rates on capital gains realizations and Federal revenue 

from capital gains taxes simply by observing the growth in 

realizations and revenue in the following years. Rather, in 

order to make such an estimate, it is necessary to specify what 

would have happened to realizations and revenue from capital 

gains taxes if the tax law had been unchanged. The estimated 

revenue effect is very sensitive to the assumptions made in 

deriving this baseline projection of what would have happened to 

realizations and r evenue in the absence of any tax policy 

changes. 

The difficulty in using observed data for a few years 

following the tax change to infer l ong-run revenue effects is 

further increased by the problem of separating transitory and 

permanent effects of the tax change. One would expect that a 

reduction in capital gains tax rates would induce a one- time 

unlocking of accrued gains. Whether a higher level of annual 

realizations would persist over time cannot be determined without 

observations over a long peri od o f time . These facts limit the 

inferences that can be drawn from the data. 

Notwithstanding these qualifications, the data shown in this 

section clearly support the conclusion that capital gains 
-186-

realizations increased as a result of the capital gains tax 

reductions in the 1978 Act. The data also support the tentative 

conclusion that the 1978 Act caused revenue from capital gains 

taxes to increase in the first year after the tax cut, and in the 

long run either increased or reduced only slightly capital gains 

tax revenue. Relative to the realizations projected to occur 

without the 1978 tax change, capital gains realizations increased 

by 23.4 percent in 1979, and by roughly 9 percent per year in 

1980, 1981 and 1982, as a result of the 1978 Act . Federal 

revenue from capital gains taxes clearly increased in 1979, as 

actual 1979 revenue was nearly $1 billion larger than revenue 

projected under pre-1978 law. In 1980, Federal revenue from 

capital gains taxes was sti ll about $10 million higher than 

projected revenue, while actual revenue was roughly $100-$150 

million lower than projected revenue in 1981 and 1982. 

Furthermore, if one takes into account the effect of the capital 

gains tax reductions on the value of corporate shares held by 

households, the estimated gains in Federal revenue from capital 

gains taxes increase by about $200-$300 million, and a revenue 

increase is indicated in each year, although the gains are modest 

in 1981 and 1982 . 

The 1981 Act, which lowered capital gains tax rates as part 

of a general rate reduction, is estimated to have resulted in a 

revenue reduction in 1981 and 1982, whether or not the stock 

market effect is taken into account. However, since the decline 

in capital gains tax revenue was proportionately smaller than the 

overall reduction in tax revenue, capital gains taxes actually 

increased slightly as a percentage of total income tax 

collections. 

I V. CONCLUSI ONS 

The available statistical evidence shows that the reduction 

in tax rates on capital gains in the 1978 Act caused a 

substantial increase in revenue from capital gains taxes in the 

first year after the tax cut, and in the long run either 

increased, or only slightly decreased, annual Federal revenue 

from capital gains taxes. The best point estimate from 

cross-section analysis of realizations behavior of individual 

t a xpayers suggests a long run annual revenue increase of about 

$2.1 billion. The time-series analysis indicates a smaller 

increase in revenue in the first year after the tax reduction of 

between $0.9-$1.1 billion. This increase is substantially larger 

than the estimated second year revenue gain of between $10-$300 

million. Revenue estimates in 1981 and 1982 indicate relatively 

sma ll revenue changes which range from a gain of slightly less 

than $150 million to a revenue loss of slightly over $150 

million. This pattern suggests that the extremely large increase 

in realizations in 1979 was in part temporary , but also suggests 

that the tax change led to a significant, though more modest, 

perma nent increase in realizations that is sufficient or nearly 

sufficient to offset the effects on revenue of the lowe r tax 

rates on capital gains. 
-187-

Cross-section econometric analysis of realizations behavior 

o f ind ividual taxpayers suggests that the further reduction in 

marginal tax rates in the 1981 Ac t also increased revenue from 

capital gains taxes. Simulation results imply that long run 

annual revenue from capital gains taxes would have been $1.6 

billion higher in 1979 if the tax rate reductions enacted in the 

1981 Act (fully phased in) had been in effect . The time-series 

analysis of realizations behavior following the 1981 Act, 

however, shows revenue in 1982 about $250-$330 million below 

projected levels following the 1981 Act . 

Taken as a whole, the results suggest that any effort to 

raise substantial revenue by increasing tax rates on capital 

gains, given the current parameters of the law (i . e . , a 

r ealizations-based tax with step-up in basis for gains 

transferred at death and carryover of basis for gains transferred 

by gift), is likely to be ineffecti ve . Although at some point a 

reduction i n capital gains tax rates will result in a long-run 

reduction in Federal revenue, the data suggest that revenue from 

capital gains taxes either increased or declined only slightly as 

a result of capital gains tax rate reductions in the 1978 and 

1981 Acts. 

Finally, it is important to recognize that changes in 

realized capital gains may occur for reasons other than increased 

turnover of assets o r hi gher stock prices. If investors are 

altering their portfolios so as to hold more assets on which 

returns are in the form of price appreciation, such a portfolio 

shift would cause accrued gains, realized gains and revenue from 

capital gains taxes to increase. Net Federal revenue from such 

portfolio shifts, however, may be positive or negative, depending 

on whether taxable investors are shifting their wealth from 

untaxed or lightly taxed assets, such as owner-occupied housing, 

or from assets on which returns are received i n t he form of fully 

taxable income. Reported data on realized capital gains do not 

supply any information on the d i rection or magnitude of the 

revenue eff ects from these portfolio shifts. 
-188-

FOOTNOTES TO CHAPTER 4 

l l In effect, in adjusting to a higher permanent level of 

capital gains reali zations, there is an "over-adjustment" in the 

first year. For a more thorough discussion of why the long-run 

revenue effect may have the reverse sign of the short-run effect, 

as well as an argument that increased short-run realizations may 

be associated with reduced private saving, see Joseph E. 

Stiglitz, "Some Aspects of the Taxation of Capital Gains," 

Journal of Public Economics, July, 1983. 

2/ For efforts using time-series data to estimate the effect of 

capital gains tax rates on reali zations, see Mai Nyugen Woo, "A 

Time-Series Analysis of the Lock-in Effect of Capital Gains 

Taxation in the United States," unpublished doctoral 

dissertation, Georgetown University, December 1980; and Gerald E. 

Auten, "Capital Gains: An Evaluation of the 1978 and 1981 Tax 

Cuts," in Charls E. Walker and Mark Bloomfield, eds., New 

Directions in Federal Tax Policy for the 1980s, (CambriOge, 

Mass., Ballinger Publishing Company, 1983.) For evidence that 

transactions volume inc reased significantly following the 1978 

Act, see Joel Slemrod, "Stock Transactions Volume and the 1978 

Capital Gains Tax Reduction," Public Finance Quarterly, January, 

1982. 

3/ See Gerald E. Auten, Es timation of the Effects of Capital 

Gains Taxes on the Realization of Capital Gains, Final Report 

prepared for the u.s. Depa r tment of the Treasury, Office of Tax 

Analysis, March 15, 1982. 

4/ See Martin S. Feldstein, Joel Slemrod, and Shlomo Yitzhaki, ~The Effects of Taxation on the Selling of Corporate Stock and 

the Reali zati on of Capital Gains ," Quarterly Journal of 

Economics, June, 1980; Ger a ld E. Auten and charles T. Clotfelter, 

11 Permanent Versus Transitory Tax Effec ts and the Realization of 

Capital Gains," Quarterly Journal of Economics, November, 1982; 

and Joseph J. Minari k, 11 Cap i tal Ga i n s , 11 in Henry Aaron and Joseph 

Pechman, eds., How Taxes Affect Economic Behavior (Washington, 

D.C., The Brookings Institution, 1981 ). 

5/ For another dis cussion o f some of the problems in 

Interpreting the findings o f cr oss-sec tion studies of capital 

gains realizations, see James w. We t z ler, "Comments," in Aaron 

and Pechman, ~ cit. 

6/ See Martin s. Feldstein a nd Shlomo Yit zhaki, "The Effe cts of 

the Capital Gains Tax on the Sel l i ng a nd Switching of Common 

Stoc k,'' Journal o f Publ ic Economi cs , February, 1978; and Auten 

and Clotfelter, ~cit. 
-189-

7/ See Feldstein , Slemrod , and Yitzhaki , ~cit. ; and Auten and 

Clotfelter, ~ cit. 

/ See Minarik,~ cit . ; and Auten, 1982, ~cit. 

9/ See Feldstein, Slemrod, and Yitzhaki, ~cit.; and Auten, 

I982 , ~ cit. 

10/ Studies such as these on capital gains and similar studies on 

the effects of charitable deductions make the impl icit assumption 

that all other tax decisions are made independently of the 

variable under examination . This assumption may not be 

completely valid. For example, a taxpayer who sells stock at a 

profit and also gives cash to a charity would be better off 

giving the stock directly to the charity, thereby avoiding the 

capital gains tax as well as obtaining the charitable deduction. 

On the other hand, this assumption is necessary in order to make 

the analytical problem tractable . A complete model of all 

interacting tax dec i sions would simply be too complex . 

11/ For evidence of the use of timing of capital gains as an 

Income averaging device, see Minarik,~ cit . ; Joseph J . Minarik , "Taxpayer Behavior Over SeverarYears: The Case of 

Realizations of Long-Term Capital Gains," Final Report prepared 

for the U.S. Department of the Treasury, Office of Tax Analysis, 

March 31, 1981; and Auten, 1982, ~ cit. 

12/ There is also a bunching of net gains at -$3,000, the maximum 

amount of short-term losses that can be deducted against other 

income in any year. 

13/ See James Tobin, "Estimation of Relationships for Limited 

Dependent variables," Econometrica, January, 1958 . 

14/ For details regarding these estimating equations, see Auten, 

1982 , ~ cit. 

/ The equations are estimated using data from t he 1963 Federal 

Reserve Board Survey of the Financial Characteristics of 

Consumers. 

/ One problem with interpreting this result is that many of the 

aged only have to file returns for years when gains are realized 

because of the filing threshold . As a result, it may appear that 

a larger fraction of the aged real ize gains than is actually the 

case . 

17/ See Feldstein, Slemrod, and Yitzhaki, ~ cit., 1980; and 

Minarik, "Capital Gains,"~· cit . ; and Joseph-:r:-Minarik, "The 

Effect of Taxation on the Sellrng-of Corporate Stock and the 

Realization of Capital Gains: Comment, "Quarterly Journal of 

Ec onomics, February, 1984. 
-190-

18/ For a discussion of the weighting issue, see Joseph J. 

Minarik, "The Effect of Taxation on the Selling of corporate 

Stock and the Realization of Capital Gains: Comment, "Quarterlf 

Journal of Economics, February, 1984 , and the reply by Feldste1n, 

slemrod, and Yitzhaki (FSY) in the same issue. Minarik argues 

that the use of unweighted regression procedures by FSY biased 

their estimates of the effects of tax rates because the sample 

they used was chosen by a method that made it more likely that a 

return with large capital gains would be included in the sample. 

FSY respond that the reduced tax rate effect found by Minarik is 

not due to sample selection bias, but to the fact that high 

income taxpayers are more sensitive to changes in tax rates. FSY 

argue that the use of weighted regression increases the influence 

of low-income households on the regression coefficients to a 

greater extent than is warranted by their share of stock 

ownership. The use of weighted Tobit regressions in the panel 

study allows for the greater sensitivity of high income taxpayers 

to tax rates since t he tax rate effect is calculated using a 

multiplying factor that depends on the values of all of the 

independent variables for each taxpayer. For a discussion of 

this procedure, see John F. McDonald and R.A. Moffitt, " The Uses 

of Tobit Analysis," Review of Economics and Statistics, May, 

1980. 

19/ This equation was chosen because the simulations include 

estimates of the effects of both higher and lower capital gains 

tax rates . With the dependent variables used in the other 

equations in Table 4 . 3, negative values for predicted capital 

gains realizations can result when the effects of higher capital 

gains tax rates are simulated . In Equation 4 . 3, the logarithm in 

the dependent variable forces the predicted gains to be positive, 

since the logarithm of zero (and negative numbers) is undefined . 

20/ The capital gains tax rate is calculated using a predicted 

amount of capital gain for taxpayers in income classes with 

$200,000 or more of Adjusted Gross Income in 1982 dollars 

(equivalent to about $56,000 in 1954 at the beginning of the 

sample period). This taxpayer group was most affected by the tax 

rate changes from the Tax Reform Act of 1969 through the 1981 

Act, and in 1982 accounted for more than 41 percent of long-term 

capital gains. The calculated tax rates take into account the 

effects of the minimum tax , the alternative tax, and income tax 

surcharges as well as changes in income tax rates. 

21/ The effects of the changes in capital gains tax rates were 

computed using the equation for realized capital gains to project 

realizations under pre-1978 law, 1979 law, and current law . In 

each case, the effects of the tax rate changes on realizations 

were assumed to be the difference between the predicted 

realizations before and after the specified tax change. In Table 

4 . 11 (and Table 4.14 below), this difference is subtracted from 

actual realized capital gains to obta in the "projected gains" 

shown; this procedure was utilized to facilitate comparison with 

published figures on actual realizations of capital gains. 
-191-

22/ Note that the 1981 tax cuts were not fully phased in until 

1984 . Since 1982 data were the latest available at the time of 

this report, the analysis of the effects of the 1981 Act are 

necessarily preliminary. 

23/ Actual revenue from capital gains is computed using the 

Treasury Department Individual Tax Model by comparing actual tax 

liability for each sample return with positive net capital gains 

to tax liability if reali zed capital gains had been zero. 

Projected revenue is computed for each year by multiplying the 

average tax rate on capital gains by AGI class times the amount 

of projected gains. It is assumed that in the absence of the tax 

cuts under the 1978 and 1981 Acts, the distribution of capital 

gains would have remained the same as in the final year under the 

old tax law. 

24/ These calculations are based on individual income tax 

receipts of $297.7 billion in 1982 and estimated receipts of 

$331.5 billion without the reduction in tax rates. The 

calculations do not take into account changes in tax provisions 

other than the overall reduction in tax rates. 
-193-

Appendix 

A BRIEF DESCRIPTION OF THE TREASURY GENERAL EQUILIBRIUM MODEL 

I. Structure and Assumptions of the Model 

The structure and assumptions of the Treasury General 

Equililbrium Model are summarized as follows. The population is 

represented by 12 household groups, which are classified 

according to income. The households differ in their initial 

endowments of labor skills and wealth. Households can accumulate 

wealth over time by saving a portion of their income. In any 

time period, households supply labor services and capital to 

business firms. The supply of labor services depends on the 

after-tax wage; the supply of saving (which determines the net 

additional capital services available to business firms) depends 

on real after-tax returns to suppliers of capital. 

The income of a household is derived from the employment of 

its labor and capital services in the marketplace . Capital 

income comes either from the corporate sector in the form of 

dividends, interest, capital gains, and rent, or from the 

non-corporate sector as business income, interest and rent . Each 

source of income is assigned an inclusion rate in the personal 

income tax base. Personal income taxes are represented by a 

simplified tax rate schedule which consists of a negative lump 

sum tax and a fixed marginal tax rate applied to the personal 

income tax base. Higher income households face higher marginal 

tax rates. 

There are 19 producer goods industries. Producers use fixed 

proportions of ''intermediate goods" -- outputs of other 

industries -- in production but vary the amount of capital and 

labor services used in response to changes in relative prices. 

The production relationships differ among industries; at any 

given set of relative factor prices, some industries are 

relatively more labor intensive, while others are relatively more 

capital intensive. 

The cost of the output of e ach industry depends on the costs 

of labor and capital. In turn, the costs of labor and capital 

depend on wages and interest rates gross of personal taxes and 

taxes applied to the use of factors of production by industry. 

In the model, the corporation income tax, state corporate taxes, 

and local property taxes are modeled as ad valorem taxes on each 

industry's use of capital. The social secur1ty tax (both the 

employee and employer portion ) and workmen's compensation taxes 

are modeled as ad valorem taxes on each industry's use of 

labor.!/ 
-194-

Households allocate their income among 15 consumer goods and 

one investment good (saving). Saving in any period increases 

both the future supply of capital available to businesses and the 

future income of households who save. Consumers within each 

household income group receive different amounts of ''utility" o r 

satisfaction from the 15 consumer goods, future consumption 

(determined by saving) and leisure. Consumer preferences result 

in demands for each of the consumer goods that depend on total 

income and relative prices of consumer goods, which include sales 

and excise taxes. These consume r demands are converted through 

an input-output system into demands for the various producer goods. 

The government collects taxes and uses the proceeds either to 

buy labor, capital, and producer goods to produce public services 

or to make transfer payments to households. The government 

maintains a constant share of total expenditures and transfers as 

a proportion of national income. 

Over time, labor supply and technical change that increases 

labor productivity each grow at a constant rate of 1.4 percent. 

Policies that increase saving cause growth to accelerate because 

increases in saving rates at first cause the capital stock to 

grow faster than labor. Eventually, the faster growth of the 

capital stock depresses real before-tax returns to capital, thus 

lowering the saving rate and restoring the initial rates of 

growth of capital and output. However, this long run equilibrium 

growth path may not be reached for over 50 years. At this long 

run equilibrium, the saving rate and the capital-labor ratio are 

permanently higher, and national income and output are higher 

than they would have been along the initial growth path. 

The relationships in the model result in a system of 

simultaneous equations which is solved for general equilibrium 

levels of outputs and prices. Households are both the ultimate 

suppliers (through their supplies of factor services) and 

demanders of goods and services. Household income depends on 

factor prices {wages and returns to capital) which determine 

prices of goods and services, which in turn determine household 

demands for goods ahd services. Similarly, household demands for 

goods and services determine demands for production goods, which 

in turn determine demands for labor and capital and thus wages 

and returns to capital. The entire system is in equilibrium at 

the set of prices that simultaneously equalize demands and 

supplies for all consumer goods, producer goods, and factors of 

production . 

Taxes enter the model as wedges between the prices paid by 

buyers and the prices received by sellers. By altering relative 

prices, taxes affect the supplies of factors of production, the 

relative costs of different producer goods, and relative prices 

of final goods. As a result of the existing tax structure, labor 

and capital supplies are smaller, and the composition of output 

is different, than they would be were government expenditures 
-195-

financed by a set of lump sum taxes that did not distort costs to 

buyers and returns to sellers. 

In the model, the initial values of the outputs of each 

industry, the consumption levels of each consumer good, the rates 

of each type of tax on each industry and good, the tax rates and 

total taxes paid by each household group, and other values in the 

model are derived from published data sources. Where data 

collected from different sources are inconsistent because of 

different data collection procedures, they are adjusted to assure 

consistency. Behavioral parameters of the model, such as labor 

supply responses to changes in after-tax wages and the response 

of savers to changes in after-tax interest, and technological 

relationships, such as the production relationships for each 

industry, are selected on the basis of the best available 

econometric estimates. Othe r parameters of the model are then 

calibrated so as to replicate the ••base case " equilibrium. 

II. The Effects of Changing the Capital Gains Tax in the Model 

As noted above, the various forms of capital income included 

in the personal income tax base are assigned an inclusion rate; 

eight separate categories of capital income are identified in the 

model. The only source of expected real capital gains in the 

model is corporate retained earnings . The capital gains tax is 

in part a tax on r eal corporate retained earnings, with a low 

inclusion rate be cause of deferral of tax until realization and 

the capital gains exclusion (50 percent prior to 1978, 60 percent 

after 1978), and in part a tax on inflationary gains from 

corporate shares and from real property held directly by 

households. Thus, the capital gains tax affects the inclusion 

rate on both corporate retained earnings and on capital income 

from certain types of real property . A decline in the percentage 

of capital gains included in the personal income tax base is 

modeled by computing the corresponding reduction in the inclusion 

rate on income from corporate shares and from real property. The 

model simulation assumes an inflation rate of 7 percent, which 

corresponds roughly to the inflation rate prevailing at the time 

of the 1978 capital gains tax reductions; thus the inflationary 

component of capital gains taxation is quite significant. Real 

capital gains attributed to income from corporations in different 

industries vary according to the share of corporate capital 

income accounted for by retained earnings. 

Changes in the tax treatment of capital gains are assumed not 

to affect the inclusion rate on capital income from owneroccupied housing because rollover effectively excludes most 

capital gains on owner-occupied housing from tax. Capital gains 

tax changes are also assumed to have only a minor effect on the 

taxation of nominal appreciation of agricultural land because 

such land is seldom exchanged in a taxable manner . 
-196-

The simulation of the effects of the 1978 capital gains tax 

reductions also accounted for the special provisions of the tax 

law that allow capital gains treatment for sales of timber and 

certain agricultural products and for royalties from coal and 

iron ore p r operty . The revenue loss to the Treasury from all of 

these special provisions was estimated to be $135 million in 

1978. To account for these special provisions, 20 percent of 

this amount was used as an estimate of the initial reduction in 

the capital costs of production in the mining and paper 

industries resulting from the reduction in the capital gains 

inclusion rate from 50 to 40 percent in 1978. 

In the model , households hold a balanced portfolio of all 

financial assets. Therefore, a reduction in the inclusion rate on 

capital gains increases the after-tax return to saving. In the 

model, a 1 percent increase in the after-tax return is assumed to 

increase annual saving by 0.4 percent, the highest of the saving 

elasticity estimates reported by Baskin. As noted in the text, 

use of this parameter gives an upper-bound estimate of the 

effects of the capital gains tax reduction on saving and capital formation. 

The reduction in the tax wedge between the prices paid by 

firms that use capital subject to personal capital gains taxes 

and the returns to households also reduces the cost of capital to 

those firms. Industries in which corporations have low 

debt-equity and dividend-payout ratios receive the largest 

initial benefit. Industries with many non-corporate enterprises 

where households pay tax on inflationary gains also receive 

benefits. 

The reduction in the tax on the income from capital generally 

raises after-tax returns to savers, and also lowers before-tax 

returns which represent the cost of capital to capital-using 

industries. However, those industries where equity does not 

receive a significant benefit from a reduction in the capital 

gains tax may experience an increase in the cost of capital. For 

example , for sectors where capital income is initially taxed very 

lightly, such as real estate, the gap between before-tax and 

after-tax returns is narrowed only slightly. Since savers must 

earn the same after-tax returns in equilibrium in all industries, 

the rise in after-tax returns means that before-tax returns and 

costs of capital increase in lightly-taxed sectors. Thus the 

shifts in capital use toward the beneficiaries of capital gains 

tax cuts reallocates capital from some sectors of the economy, 

especially the housing sector. 

The changes in the cost of capital induce changes in the 

capital-labor ratios used in the different production sectors. 

They also cause changes in the relative prices of final consumer 

goods; those goods that use inputs of industries where factor 

costs have been lowered become relatively less expensive. 

Consumer demands respond to these changes in relative prices, 
-197-

causing consumer sectors with lower costs to expand, which in 

turn causes the industries that supply these sectors to expand . The changes in relative after- tax income among households also 

cause the pattern of demands for consumer goods to change. 

Initially, the capital gains tax reduction increases the 

after- tax income of households with large amounts of capital 

primarily the highest income group. Over time, as these 

households save more in response to higher after-tax returns, the 

capital stock grows more rapidly. The increase in the capital 

stock raises labor productivity and before-tax wages . However, 

after-tax wages may decline depending on which tax instruments 

are used to recoup any lost government revenue. In the case 

where increased turnover of capital assets prevents revenue from 

capital gains taxes from declining, higher taxes on wage income 

are not necessary. Since the government share of national income re~ains constant, more rapid economic growth increases the growth 

of transfer payments, and thereby benefits the recipients of 

transfers, especially the lowest income groups. 

In summary, the capital gains tax reduction is modeled as a 

reduction in the inclusion rate in the personal income tax base 

of income from certain types of capital holdings - - primarily 

corporate shares and real property holding, other than 

owner-occupied housing and agricultural land. The capital gains 

tax reduction directly reduces the cost of capital for those 

industries that bene fit from special , industry-specific capital 

gains tax provisions. These tax changes alter after-tax returns 

and the costs of capital in differ e nt industries, and thereby 

result in a complicated set of changes in factor usage , prices of 

consumer goods, consumer demands, rates of saving and capital 

formation, and the growth of na tional income and its distribution 

among households at different income levels. 

Two shortcomings of the model f o r analyzing the effects of 

capital gains taxation - - and the c onsequences of these 

shortcomings -- should be mentioned . First, the financial policy 

of all industries - - i . e . , the debt-equity ratio and the 

dividend-payout ratio - - is assumed to be fixed eve n thou gh, as 

noted in the text, there are likely to be some changes i n the 

supplies of securities in response to a change in the capital 

gains tax. The major consequence of this simplification in the 

model is that the changes in the relative costs of capital among 

industries resulting from the cut in capital gains taxes are 

somewhat overstated . As a result, the shifts in resour c e 

allocation among industries predicted by the model may be too 

large . However, as the results described in the text indicate , these shifts in resource allocati on are not large despite this 

overstatement. 

Second , by assuming that all households hold a representative 

portfolio of financial assets, the model fails to account for 

differences among households in financial asset holdings. In 
-198-

particular, the relatively greater propensity of high income 

households to hold tax-p r eferred assets is not taken into 

consideration.3/ As a result, the model fails to detect fully 

the extent to which reducti ons in capital gains taxes 

particularly benefit savers in the highest tax brackets, relative 

to increases in other saving incentives. Therefore, the model 

may underestimate the extent to which the benefits of reductions 

in capital gains taxes are distributed to the highest income 

class. 
-199-

FOOTNOTES TO THE APPENDIX 

1/ This treatment assumes that workers do not perceive future 

retirement benefits as being directly related to tax payments; it 

thus may overstate tax disincentives to work effort. 

/ See Michael J. Baskin, op. cit. 

ll For examples of more recent modeling efforts that attempt to 

capture the effects of taxation on portfolio choice, see Joel 

Slemrod, "A General Equilibrium Model of Taxation with 

Endogeneous Financial Behavior," in Martins. Feldstein, ed., 

Simulation Methods in Tax Folic Anal sis (University of Chicago 

Press, ); an Harvey Gaper an Er1c Toder, "Transfer 

Elements in the Taxation of Capital Income," in Marilyn Moon, 

ed., Economic Transfers in the United States (University of 

Chicago Press, 1984).