PAPER #10

ADVOCATING CAPITAL GAINS TAX REFORM IN AUSTRALIA: THE ECONOMICS AND POLITICS OF OPPOSITION

By

ALAN REYNOLDS Senior Fellow, Director of Economic Research, Hudson Institute, Washington, D.C. Presented to:

2000 SYMPOSIUM ON CAPITAL GAINS TAXATION

September 15, 2000 Vancouver, B.C. Canada Organized by: Herbert Grubel, David Somerville Chair in Fiscal Studies The Fraser Institute, 4th Floor, 1770 Burrard Street Vancouver, B.C. Canada V6J3G7 Tel: 604-688-0221. Fax: 604-688-8530 Eml: events@fraserinstitute.ca

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Advocating Capital Gains Tax Reform in Australia: The Economics and Politics of the Opposition Alan Reynolds Hudson Institute In the Spring of 1999, I was asked to prepare a study of the capital gains tax (CGT) for the

Australian Stock Exchange (ASX), largely based on US experience and research. The paper

appeared on the ASX website shortly before the report of the Ralph tax reform commission, and

quickly generated considerable controversy. The debate was ostensibly about whether or not a

lower marginal tax rate on realized gains would significantly reduce tax receipts. But the passion

generated by this particular tax goes far beyond bookkeeping. The unique fascination of

English-speaking economists with attempting to tax unpredictable capital gains as routine

income has little to do with revenue or economic performance, and much to do with aesthetic

and moral opinions about how owners of appreciated assets “should” be taxed, regardless

whether such a crusade proves quixotic or harmful to prosperity.

Since 1985, Australia has taxed residents‟ nonresidential capital gains at income tax rates that

recently reached 48.5 percent for individuals earnings more than Aus$50,000, albeit with

indexing and averaging. In this respect, the ambition of Australian tax collectors was

unmatched by any country, except Iran (54 percent) and the Congo (50 percent). As Hans

Werner-Sinn remarked, “the rare occurrence of capital gains taxes is a fact and it shows that the

tax discrimination against equity capital is more of an Anglo-Saxon specialty” [i.e., a unique

feature of the Haig-Simons linguistic group]. Most of the stronger European and Asian

economies and financial centers do not tax individual capital gains at all (Germany, the

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Netherlands, China, Singapore, etc.), or at least do not tax gains on listed shares (Taiwan, South

Korea). Other relatively vigorous entrepreneurial economies have flat or maximum tax rates on

gains that typically remain below 30 percent — e.g., 20 percent in Ireland and the US, 26

percent in France, 28 percent in Finland. In contrast with the simplicity of reasonable marginal

rates, Canada exempts one-fourth of the gain and has allowed a lifetime exemption of up to

Can$500,000 for farms and small businesses. The UK has also used an almost equally

inefficient combination of generous annual exemptions and an uncompetitive 40% tax rate, but

recently added a new defect — a “tapered” rate that drops to a 5-10 percent rate after four years

to penalize capital agility and lock people into investments they might not otherwise prefer.

In short, Australia was (and Canada still is) out of step when it came to the capital gains of

individual investors. Did Australia know something the others did not? Australians were eager

to explain how their CGT worked in theory. But how did it work in practice?

Capital gains tax receipts amounted to 2.3 percent of Australia‟s corporate and individual income

tax collection in 1996-97. But very little of that revenue was collected at the highest individual

tax rates. The Australian Taxation Office (ATO) claimed “80 percent [actually, 74 percent] of

all tax paid on capital gains was paid by those with a taxable income of more than $50,000.”

Since Aus$50,000 was the threshold at which the highest 48.5 percent rate tax applied, the ATO

statement invited the erroneous conclusion that 80 percent of capital gains had been taxed at 48.5

percent. If taxable income is measured without capital gains included, however, only $387

million or 18 percent of all reported net gains were received by “individuals” with “other taxable

income” above $50,000. If we exclude partnerships and proprietorships, individual non-

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business (INB) incomes above Aus$50,000 accounted for only $250 million or 12 percent of the

$2.1 billion in CGT revenue in 1996-97.

During the 1999 debate over CGT, Australian editorial writers repeatedly echoed the hoax that

high-income households paid 80 percent of the CGT, although the true figure is 12 or 18 percent,

depending on whether or not we include businesses taxed as individuals. How did this statistical

artwork come to be believed? For one thing, more than half of all capital gains taxes were not

paid “by individuals” at all, but by superannuation (retirement) trusts taxed at 15 percent, and by

corporations taxed at 36 percent. For another, nearly two-thirds of the CGT reported paid by

“individuals” was actually from partnerships, or from the sale of a small farm or shop.

Total CGT revenue amounted to only 20.6 percent of recorded gains, which clearly indicates that

most was collected where tax rates were lowest. High tax rates were effective only in

discouraging households from holding or selling assets subject to this tax. Moreover, many

unrecorded gains on Australian assets have been entirely tax-exempt — notably, housing and

corporate stock held by foreign portfolio investors or by tax-exempt entities.

Total CGT from individuals and unincorporated enterprises has amounted to about 1 percent of

individual tax collections in both Australia and Canada, where the tax on gains is unusually high,

compared with more than 10 percent in the US, where the tax rate is tolerably low. Cross-

country comparisons surely put the burden of proof on those who still assume that higher tax

rates yield more revenue. So does US time series evidence (e.g., an appended graph) showing

that real CGT receipts grew far more briskly for years after the tax rate was reduced in 1978,

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1982-84 and 1997.

When the Australian government first asked the Ralph Commission to report on reforming

“business taxation,” the emphasis was on adding a 10 percent Goods and Services Tax (GST),

similar to Canada‟s, reducing individual income taxes at low and middle-income levels, and

gradually shrinking the corporate tax rate from 36 to 30 percent. The initial list of alternative

means of “reforming” the capital gains tax presumed an end to two desirable features, indexing

and averaging, but offered little or no rate reduction in exchange. The options initially

considered included a UK-style “tapered” rate to make it even more lucrative to leave assets

untraded for years or generations (Australia has no death tax); a miniature UK-Canada

exemption of Aus$1,000 a year to minimize revenue without risking the slightest efficiency gain;

and “targeted” tax cuts for investments favored by incorruptible politicians and would-be central

planners. A relatively sensible plan of capping the rate at 30 percent was mentioned, but

considered a remote long shot. In the end, however, the Ralph commission surprised everyone

by opting for excluding half of all gains, thus cutting the top CGT to little more than 24 percent.

Exempting half the gain had been my second-best recommendation (I prefer a flat rate because a

graduated CGT causes intertemporal and interfamilial distortions, and has no coherent rationale).

Because the Australian government also adopted my figures for revenue elasticity, this American

meddler was widely blamed for the government‟s unseemly benevolence toward Australian

investors.

Before the debate was won, however, Australian Democrats had issued a lively assault on one of

my seven chapters. I had simply surveyed and averaged 11 of 13 major US studies on the

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relationship between tax rates, realizations and revenues (including the omitted two studies

would have raised the long-run elasticity from -0.9 to 1.1). The thrust of the Democrats‟

backgrounder can be gleaned from the following excerpts:

The Reynolds-ASX paper represents a radical and selective view of capital gains

tax reform consequences. The „official family,‟ in terms of US Treasury, the

Congressional Offices and the Federal Reserve have adopted a more cautious

approach in their estimates. . . .

[The Reynolds-ASX paper is] at odds with the more recent research of many

other credible research organizations in the United States, including the

Congressional Budget Office, US Treasury, the Congressional Research Service,

the Brookings Institution, the Federal Reserve, the Levy Economics Institute and

the Economic Policy Institute.

That was an impressively long list of fabrications. The “Federal Reserve” does not mean Alan

Greenspan (who favors abolishing CGT), but some theoretical musings of staff economist

Randall Maringer, who wrongly assumed that all gains must be realized within a lifetime.1 The

Democrats‟ two references to the Treasury and Brookings Institution mean a single book by Len

Burman (1999), written while he was outside the “official family” and published with

trepidation.

1 “Between 1960 and 1984. . . only 3.1 percent of the stock of accrued gains was realized

in any given year. . . . It is clear that the vast majority of capital gains are never realized.” Jane

Gravelle & Larry Lindsey, “Capital Gains” in Tax Notes, 25 January 1988.

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The cited Congressional Budget Office (CBO) paper on “Potential Macroeconomic Effects of the

Economic Growth Act of 1998,” contained no new research (past CBO forecasts of CGT

revenues had been infamously inaccurate), but wisely relied on the JCT estimates. The CBO

thus predicted that slashing the 10-20 percent CGT rate to 7.5-15 percent would raise revenue

for two years, followed by an insignificant 3 percent annual revenue loss after that (cutting a rate

as low as 10 percent would lose revenue). The Levy Institute‟s five-page memo from Steve

Fazzari, and the Economic Policy Institute‟s three-pager by Dean Baker, involved Keynesian

comments on the economic impact, not on revenues.

When the Australian Democrats referred to the Congressional Research Service, that meant their

consultant Jane Gravelle. In 1991, working with a 1988 theme from Auerbach, Gravelle offered

what Burman now describes as “theoretical evidence.” She used a historical ratio of realizations

to accruals to argue that the highest elasticity estimates (above -4.0) implied that realizations

might be so large that they would soon outgrow accrued gains. Rapid realizations could not

persist forever, she argued, because people would eventually run out of gains to realize. The

supposedly small inventory of unrealized gains, she still argues, must eventually put an upper

limit on elasticity of about 0.6. In a footnote, even Burman concedes that the US bull market has

trampled this “theoretical evidence.” The market value of US stocks alone rose by $2.3 trillion

in 1998, but individual realizations were only $424 billion in that year. And the realizations

included gains on the sale of businesses and real estate, not just stock. Contrary to Gravelle,

annual realizations could obviously become many times larger, even in the post-1997 US,

without remotely beginning to use up trillions of dollars of accumulated, unrealized gains.

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Ironically, Gravelle neatly summarized the actual “official family” estimates in her 1994 book:

The JCT [Joint Committee on Taxation] used a 0.7 elasticity at a 20 percent tax

rate and a 0.975 elasticity at a 25 percent tax rate. OTA [Treasury Office of Tax

Analysis] use a 0.9 percent elasticity at a 20 percent rate and 1.125 elasticity at a

25 percent rate.

In her 1999 memo for Australian Democrats, Gravelle again presented the official estimates of

the effect of reducing a low 22 percent capital gains tax:

At a 22 percent tax rate, they [the JCT staff] use an elasticity of -1.28 in the first

two years and -0.76 thereafter.

Clearly, the Ralph Commission‟s use of -0.9 elasticity in the long run was not at all “radical and

selective” when compared with the “official family” estimates. On the contrary, the

Commission‟s estimate was far too stingy for Australia, where marginal tax rates are nearly

twice as high as those contemplated by the JCT and OTA. Indeed, at highest of Australia‟s tax

rates, official US studies predict an elasticity of at least -2.0. At the midpoint between

Australia‟s old and new tax rates of 48.5 and 24.25 percent, the elasticity would be about -1.5.

And that implies (as the Ralph commission did not) that revenues should be substantially larger

after tax rates fall, even disregarding any beneficial effects on economic growth or asset values,

reduced corporate leverage, reduced avoidance, repatriation of growth stock held abroad, etc.

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Gravelle and the Democrats searched for another way out of their uncomfortable corner. They

argued that indexing, averaging and “negative gearing” made Australia‟s (average, not marginal)

tax rate lower than it appears, so the elasticity estimates should be lower too. In her 1999

memo, Gravelle claimed that because inflation had accounted for half of taxable gains in the US

in the distant past, it somehow followed that indexing in Australia must be comparable to cutting

the rate in half. At low post-1982 rates of inflation the claim that indexing is equivalent to

cutting the rate in half is arithmetically impossible, unless assets were typically frozen in

portfolios for many, many years (confirming that high rates had locked-in gains). Besides,

studies showing that marginal tax rates discourage asset trading do not show that effect varying

with changes in inflation, which would be quite apparent if true. People appear equally reluctant

to part with 48.5 percent of any gain, regardless of how large or small that gain may be in real

terms (which, unlike the timing of realizations, is not within the seller‟s control).

Averaging keeps some people whose usual income is below top-bracket thresholds from being

pushed into top brackets as result of realizing an unusual gain. But this has nothing to do with

the estimates, which deal only with elasticity of realizations among those actually subject to high

marginal rates.

Australia‟s “negative gearing” (leverage) also has no effect on US elasticity estimates, because

the U.S. also allowed investment interest to be deducted at income tax rates until 1993.

Available elasticity estimates do not cover the period after 1993, when investment interest could

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only be deducted against dividend or interest income.2 Incidentally, the JCT and OTA also

reduce estimated elasticity to compensate for the (unproven) possibility that firms might cut

dividends and buy back shares to reward shareholders in ways that minimize individual taxes.

Newer Meant Older

A constantly repeated theme among critics of my ASX paper was that some “newer research”

debunked all previous research. This was intended to suggest that the estimates in my paper

(and, by inference, those of the JCT and OTA) are obsolete. As noted above, nearly all of the

cited “newer research” was literally nonexistent. But there was one exception.

The “newer research” repeatedly mentioned by Gravelle and the Democrats turns out to be a

single, flawed 1994 study of the unusual 1980-83 period by Burman and Randolph. Studies

published earlier actually covered a greater number of years, and also more recent years, but

Gravelle used the Burman-Randolph paper‟s later publication date as a symbol of its fashionable

modernity. A half dozen studies included in my supposedly “selective” list were simply

excluded from hers -- notably any paper published after 1990, particularly by any economist not

currently working for the government (e.g., Larry Lindsey or Joel Slemrod). Her only addition

to my list was an infamously erroneous 1986 estimate by the CBO, which was disowned by a

subsequent 1988 CBO study cited in my paper (that version is also now ignored by the CBO).

2 The post-1993 US scheme creates new distortions, forcing leveraged investors to shift

into junk bonds and cash in order to deduct interest expense. Since Australia is taxing only half

of the gains, I suggest allowing only half of related interest expense to be deducted, not zero.

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In 1992, former Treasury economists Gillingham and Greenlees revised their estimate to -1.1

from about -0.7 in an earlier study. Ms. Gravelle‟s sample did not include that 1992 study, of

course, nor a 1990 paper by Slemrod and Shobe that estimated elasticity at -0.9 to -1.8, nor a

1993 paper by Bogart and Gentry which used Burman-Randolph techniques to arrive at estimates

of -0.8 to -2.0 at high incomes. Gravelle even failed to disclose the 1989 study by Auten,

Burman and Randolph, which estimated the elasticity at -1.6. These studies are well known,

easily identified in survey articles (Zodrow). For Gravelle and the Democrats, however, the

only papers considered worth mentioning were a few from 1986 to 1990. That made their

favorite study by Burman and Randolph, which was belatedly published in 1994, appear “newer”

by comparison, even though it dealt with an older time period (1980-83) than many others.

Gravelle argued that time series studies were superior to those using cross section data, because

only the time series could separate a “transitory effect from a permanent effect.” All studies in

my average involved time series, and six offered higher estimates for short-term effects, and a

lower figure for permanent effects. I used only the lower figures in arriving at an average of -

0.9. Yet Gravelle disingenuously described all elasticity estimates, even those explicitly

identified as permanent, as “a short run response.”

One of two studies discussed at length in my paper, but deliberately left out of the average, was

the only published study that Gravelle and the Democrats want counted at all — namely, Burman

and Randolph. Gravelle also alludes to an unpublished replication of Burman-Randolph by two

Treasury staffers, which reportedly came up with “statistically insignificant” results. But

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statistically insignificant does not mean “small,” as Gravelle suggested. It means lacking

significance.

Burman‟s 1999 book says, “the response of individuals to permanent differences in tax rates was

small or zero.” But that is not what the 1994 Burman-Randolph study said. That study said,

“long-run elasticities of 0.0 and -1.0 are both included in a 95 percent confidence interval.”

In reality, Burman and Randolph studied only one seemingly permanent, not temporary, change

in tax rates enacted in late 1981. And they came up with a dazzling range of elasticities, from -

6.4 in the short run to 0.2-1.0 in the long run (at a low 18 percent CGT rate). In contrast to

Burman‟s words, his numbers imply that cutting even a low CGT will produce a huge revenue

windfall in the short run, and a 95 percent chance of zero revenue loss in the long run. The

extremely high short run elasticity, and the extreme ambiguity of a zero-to-unity range in the

long run, are just two reasons I excluded Burman-Randolph from my average.

Burman and Randolph attempted to distinguish between temporary and permanent effects by

using the largely unchanged differences between state tax rates on gains to gauge the permanent

effect. Unfortunately, the low level of state income taxes on gains (which are further reduced by

their deductibility from federal tax) is far below the level at which anyone would expect any

measurable realizations response. And differences between most state CGT rates are trivial.

Auerbach, whose rather dated 1988 essay made the Democrats‟ list of “newer” research,

remarked in telecast testimony to the Australian Senate that his efforts to replicate Burman-

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Randolph came up with a similar (supposedly small) effect of CGT rates on realizations. But the

invisible paper that he was referring to, Auerbach-Siegel, has since been published, and it says

something quite different from what Auerbach told the Australians. Unlike Burman and

Randolph, Auerbach and Siegel account for expectations by allowing realizations in one year to

be influenced by the tax rate expected in the following year. Adjusting for expectations makes

the permanent elasticity jump from -0.34 (in the Burman-Randolph clone) to a huge -1.73. Once

expectations are included, the permanent effect is nearly twice as large as the average in my

ASX paper. Auerbach-Siegel estimates of the transitory effect are larger still, ranging from -4.35

to -4.9, thus predicting a huge short-term revenue boom from lower rates.

For the unusual bust-boom 1980-83 period that Burman and Randolph investigated, expected

future tax rates were extremely important yet entirely ignored. The authors never mentioned that

the reduction of marginal income tax rates enacted in late 1981 was phased-in. For at least 99%

of taxpayers (all those unaffected by the rarely-applied 70 percent tax on “unearned” income),

the reduction of the capital gains tax rate that Burman and Randolph have taking effect in 1981

did not actually take effect until 1983-84. Nearly all taxpayers had an incentive to delay

realizations, and that incentive grew larger between 1982 and 1984. Consistent with that

incentive, the volume of realized gains rose from 2.7 percent of GDP in 1981 to 2.9 percent in

1982, 3.6 percent in 1983, 3.7 percent in 1984 and 4.2 percent in 1985. After the CGT was

increased in 1987, by contrast, realizations dropped back to less than 2.3 percent of GDP from

1987 to 1995.

Gravelle claims that “evidence from Burman and Randolph . . . suggests the response to a

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temporary tax change is quite high.” But the 1981-84 reduction in tax rates was supposed to be

permanent, not temporary. Besides, there is nothing in the Burman-Randolph model to account

for an expected change in the future tax rate (such as the spike in realizations in 1986 before the

CGT went up, or the 1982-84 phase-in of lower rates). Since Burman and Randolph claimed to

be focusing on incentives to vary the timing of realizations, failure to incorporate the 1982-84

phasing-in of tax rate reduction was not a technical glitch but a fatal flaw.

Revenue Growth Depends on Economic Growth

The main reason to keep the tax rate on capital gains as low as possible is to improve potential

economic performance, not to maximize government receipts. Elasticity of realizations is

important only because it suggests deadweight losses in excess of revenue, and also suggests the

CGT can be cut in Pareto-optimal fashion without being replaced with some other tax.

In reality, elasticity of realizations is only one of many parts of the revenue puzzle. It is logically

impossible to estimate the effect of a lower CGT on revenues, for example, without considering

the impact on economic growth. If any reduction in tax distortions and disincentives enhances

the prospects for economic growth, that must enlarge the future tax base for all national and

local taxes on income, property and sales.

Even aside from revenue gains from stronger growth and reduced avoidance (briefly discussed

below), there are numerous other ways in which a lower tax rate on gains is likely to enlarge

future tax receipts from the CGT itself and from other taxes. A “tax clientele” effect is likely to

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be important for Canada and Australia. That is, a lower CGT can lure back into the hands of

resident taxpayers many assets previously drawn into the hands of exempt entities, notably

foreign portfolio investors. Younger and smaller companies will also find it easier to finance

investments with equity rather than debt; such reduced leverage improves corporate tax

collections by reducing deductions for interest expense (Pozdena). A higher expected after-tax

return from growth stocks is also capitalized in higher stock market valuations, generating larger

gains to tax (Lang-Shackelford).

As for economic growth, reducing the capital gains tax wedge can be expected to reduce the cost

of capital, enhance national savings, improve the efficiency and mobility of capital markets, and

improve incentives for entrepreneurial activity and the “venture capital” (including angels and

IPOs) needed to finance it. These complex issues are dealt with in some detail in my ASX paper

and in the vast literature on the impact of tax policy on investment (e.g., Cummins, et. al.). My

ASX paper reveals that academic skepticism about the importance of the CGT (and related

optimism about relief from integrating dividends) usually arises from old theory rather than new

facts — namely, from the “old view” about the incidence of corporate and individual taxes on

capital. In the new view, the CGT‟s multiple taxation of retained earnings does considerable

damage to investment, while failure to integrate dividends (as in the US) is of little importance.

As a test case of the importance of CGT to economic progress, Australia‟s new tax law is far

from ideal. Australia is not just halving the CGT, but simultaneously adding a big GST. Unless

a new GST or VAT is accompanied by deep reductions in the highest income tax rates (as in the

UK and New Zealand), I would expect it to be followed by disappointing long-term GDP growth

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(as in Japan and Canada). Australia‟s latest reform raises income tax thresholds, but leaves top

individual tax rates too high. Reducing the corporate tax to 30% from 36% just shrinks the

dividend credit to resident shareholders for corporate tax paid, though it will benefit foreign

investors and reinvested earnings. In short, halving the CGT is a terrific sweetener, but may not

be enough to prevent the total tax package from leaving a bitter aftertaste.

In the “new growth” literature, many factors thought to have a major influence on economic

growth are qualitative and rather difficult to measure, such as incentives for technological

innovation and entrepreneurship. The evidence that exists, however, is encouraging. In 1999,

two Harvard researchers, Paul Gompers and Josh Lerner, published an extensive study, “What

Drives Venture Capital Fundraising?” The results were provocative:

We find that . . . capital gains tax rates have an important effect at both the

industry, state and firm-specific levels. Decreases in the capital gains ta rates are

associated with greater venture capital commitments. . . . Increases in capital

gains tax rates have a consistently negative effect on contributions to the venture

industry.

These findings seem to contradict Burman‟s book, which describes Jim Poterba‟s earlier research

as suggesting that, “changes in the individual capital gains tax rate may have only minimal

effects on the supply of capital for new ventures.” Actually, Poterba wrote that “rapid growth of

venture financing after the 1978 and 1981 reductions in capital gains tax rates.” In 1997, when

the CGT was cut agains, money flowing into US venture funds again doubled in the first year

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and doubled again by 1999. Contrary to Burman, Poterba did not deny this obvious link. What

he argued, as do Gompers and Lerner, was that the conspicuous surge of venture capital after

every cut in CGT is most likely because a lower capital gains tax increases the supply of

interesting entrepreneurial projects to fund, not necessarily because it motivates venture capital

groups (largely financed by tax-exempt institutions) to supply more funds. Regardless of the

direction of causality, however, Poterba and Gompers-Lerner both predict that a lower CGT will

lead to more entrepreneurial ventures and more venture capital.

Haig-Simons v. Ramsey-Mirrlees

The Haig-Simons vision of a “comprehensive” income tax base, which defined income as the

annual increase in nonhuman capital, became a secular crusade for early tax reformers. True

believers claim to see no difference between a regular monthly paycheck and the unpredictable

timing and amount of any gain or loss on capital put at risk (so they should presumably be

indifferent to being paid entirely in stock options or lottery tickets, rather than in salary).

Optimal tax theory, by contrast, is primarily concerned with raising revenue in ways that

minimize distortions and disincentives (Cooper). Optimal tax theory explicitly rejects the tax

moralists‟ creed, that everything that appears superficially similar “should” be taxed at the same

rate. In the case of commodities, for example, it would be unwise and ineffective to put high tax

rates on some goods, if the sale of those particular goods is highly responsive to the tax rate. The

fact that demand for vices is inelastic, rather than morality, explains why liquor, tobacco and

gambling are always heavily taxed.

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Similarly, optimal tax theory would regard it as imprudent and inefficient to put high tax rates on

activities that are highly responsive to the tax rate, such as the frequency with which capital

gains may be realized by the sale of assets. Optimal tax theorists do not assume that a tax which

“should” be paid is a tax which will in fact be paid. They take behavior into account.

When Australia added a CGT in 1985, politicians and scholars assumed the moral rectitude of

taxing realized capital gains at (various) income tax rates. This attitude was still evident in

journalistic reactions to my ASX paper, and to the Ralph Commission‟s recommendations.

But Australia‟s tax regime never really came close to taxing capital gains as Haig-Simons

“income.” To do that, Australia would have had to tax gains as they accrued, to have included

gains on housing, and to have allowed full deduction of capital losses against any sort of income.

No government ever tried collecting taxes on ephemeral paper gains not realized as cash in hand,

least of all gains on housing. Treating capital losses as negative income could easily be gamed in

ways that would greatly reduce income tax receipts. Neither Australia nor any other country

ever taxed capital gains as they tax income. Australia did put high tax rates on certain realized

gains, but that was little more than a voluntary transactions tax. And Australia was running short

of volunteers.

Efficient tax policy is not helped by the old habit of labeling every deviation from the conceptual

tidiness of Haig-Simons accounting conventions as a “tax preference.” Haig-Simons was never

much more than a dubious excuse for favoring indebted big spenders over savers, and it has

proven to be an unworkable and therefore irrelevant illusion in practice. Efficient tax policy is

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the art of plucking entrepreneurial geese that lay golden eggs, without turning them into dead

ducks.

It is no more “unfair” to tax realized gains at a lower rate than bank interest than it is to tax beef

at a lower rate than beer. What matters is the effect on taxpayer behavior, and therefore on the

growth of the real economy and real tax base.

In the 1999 Australian tax debate, political and press critics of a lower CGT simply ignored any

beneficial effect on economic growth. The idea that a lower CGT might improve the economy

in any way was not criticized, but simply left unmentioned. By leaving nothing at all on the

positive side of the cost-benefit scale, attention could more easily focus on hypothetical, even

fanciful, anxieties.

The most common complaints about reducing the CGT were about (1) the supposed ease with

which people would use “tax arbitrage” to convert income into capital gains, and (2) the

supposed merit of a high CGT in preventing people from becoming too wealthy (mowing down

the “tall poppies,” in Australian parlance). Both objections depend on the untenable assumption

that high tax rates on realized gains are effective, and impossible to avoid.

Taxpayers Avoid Higher, Not Lower, Tax Rates

Defenders of Australia‟s steep CGT claimed to be particularly anxious that a lower tax rate

would promote rampant tax avoidance. This is a novel idea. If we were talking about any other

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tax, we would surely predict that higher tax rates would provide a greater incentive to cheat,

while lower rates would have opposite effect. Indeed, this is precisely what research on CGT

avoidance in the US has discovered.

Poterba (1987) found that the extent of under-reporting of capital gains was so sensitive to the

tax rate that a lower rate might well be self-financing due to reduce evasion alone. Making a

widely neglected point, Poterba also found that “compliance is much lower for sales of real

assets . . . than on corporate stocks and bonds.”

A decade later, Auerbach, Burman and Siegel (1997) revisited the issue of capital gains tax

avoidance, although they did not deal directly with Poterba‟s observation about outright evasion

(e.g., on small sales of collectibles and real estate):

Like Poterba, we also find that a minority of taxpayers — mostly those with high

incomes and wealth — manage to shelter all or most of their gains with losses.

We find evidence that tax avoidance increased after 1986, and that it increased

most for high-income, high-wealth taxpayers. As many as one-third of the

wealthiest taxpayers were able to realize their gains without immediate tax. . . .

We could make only indirect inferences about the gains that are never realized,

but which represent the most successful avoidance strategy.

The Auerbach team adopted a pedantic definition of avoidance, arguing that “the perfect tax

planner . . . would have net capital losses of at least $3,000 every year” [because the US allows

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only $3,000 of net losses to be deducted against other income]. That may be perfect tax

planning, but it would be terrible investment planning. The higher tax rate foolishly applied to

US short-term gains (except in 1987-90) does inspire impatience to realize losses quickly while

holding on to gains (taxed at 20% after one year, 18% after five).3 That is the predictable price

of a politically correct but economically unwise policy that equates short-term trades with evil

“speculation.” But to define everyone who shorts stocks or deals in options as a “sophisticated”

tax avoider, as this study did, is itself financially naïve. Most of us sophisticated investors hope

to have gains from shorts and options, not losses, and will gladly realize those gains if the tax is

not too punitive.

Australian critics of a lower CGT had quite different avoidance anxieties than Poterba or

Auerbach. They were not at all concerned about obvious signs of wholesale avoidance of the

steep CGT itself, but only about such matters as people being paid in stock or options rather

than salary, or about companies substituting gains for dividends taxed at a higher rate.

Concern about executives being compensated with shares or options was not well thought out.

Paying executives with stocks options is no different than paying them in ounces of gold, and

neither of those modes of payment allow anyone to escape taxation. In countries with no CGT,

like Belgium, stock options (or shares) are valued at the current market price and taxed as

3 A leading argument for a tapered rate, that it promotes “patient capital,” is backwards

as well as irrelevant. Auerbach, a logically consistent Haig-Simons proponent, favors “a

realization-based tax that offsets the deferral advantage by imposing a higher tax rate on gains

held for longer periods of time.” — “Retrospective Capital Gains Taxation,” NBER Working

Paper No. 2792, Dec. 1988.

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income. In countries with a low CGT, like the US, the value of options becomes the basis for

future capital gains, if any, and those gains are taxed at ordinary income tax rates. There is no

evidence of a higher or lower CGT influencing the share of executive compensation paid in stock

options (Hall & Lieberman). But the Clinton Administration‟s limit of $1 million on deductible

salary expense presumably boosted the option share of compensation, to the great benefit of the

best paid CEOs.

What about companies reinvesting profits, which generate capital gains to individual

shareholders, rather than paying them out as dividends? Australia allows a credit for corporate

tax paid out as dividends, so paying smaller dividends means paying more corporate tax (albeit at

a lower rate than the highest two individual rates). Besides, the evidence for capital gains

taxation having any effect on the portion of profits paid as dividends is considerably weaker than

economists‟ opinions about this factual question.

In theory, the much higher CGT receipts in the US, compared with Australia and Canada, might

have come at the expense of lower receipts from individual taxes on dividends. But economic

theory has trouble explaining dividends, so we need some evidence. Cross-country evidence and

US experience reveal no visible link between CGT rates and dividend payouts. Mature

corporations seem to pay globally competitive dividends even in countries with zero CGT on

equities, like New Zealand.

My ASX paper demonstrates the US dividend payout did not rise when the CGT was increased

in 1987, as many theorized, nor did payouts fall when the CGT was reduced. It also shows that

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US tax receipts from ordinary income did not decline, even among the top 1 percent, when

capital gains tax rates were reduced and CGT receipts increased. In fact, US tax receipts from

the individual income tax have remained at 9-11 percent of personal income since 1951,

regardless of whether the highest income tax rate was 28 percent or 91 percent, and regardless of

whether the highest CGT rate was 18 percent or 46 percent. Overall tax receipts were larger and

grew faster (with the economy) when the CGT was low than when it was high.

I also reviewed the literature on “tax arbitrage” and was unable to find even one plausible

example, not even a hypothetical example, that involves the capital gains tax. Tax arbitrage has

to do with interest deductions exceeding taxable interest income. Tax shelters result from

inadequate recapture of depreciation allowances on assets (such as real estate) that have actually

appreciated.

Many economists talk loosely about “converting income into capital gains,” but this is much

easier to say than to do. Anyone who could explain how to do it would have an instant best

seller.

The Dubious “Fairness” of Unpaid Taxes

In Australia, the alleged “fairness” of a high CGT was a constant theme, largely because nobody

questioned the official hoax that 80 percent (rather than 12 percent) of CGT is paid by top-

bracket individuals. In fact, high-income individuals in Australia and elsewhere are sufficiently

intelligent and well-off that they are rarely compelled to sell assets if doing so will result in

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splitting the gains with tax collectors. Taxes that “the rich” avoid paying do not “redistribute”

income, much less wealth. In fact, the US discovered that a lower CGT (and lower marginal

rates in general) resulted in a much larger share of the tax burden being paid by the most affluent

taxpayers.

The concept and measurement of “fairness” in taxation are complicated by looking at tax

burdens in a single year rather than over a lifetime. Young people begin work with valuable

human capital which depreciates with age and must be replaced with financial capital. The

immediate burden of a CGT falls heavily on older people. A CBO study showed that the US

capital gains tax accounted for a larger share of the tax burden on elderly taxpayers earnings less

than $20,000 than it did for younger taxpayers earning more than $100,000.

To the extent that a high CGT retards capital formation, the increased scarcity of capital raises

pretax returns for those who already own capital. But the lower ratio of capital to labor reduces

productivity and real wages (Stiglitz). To the extent that the general equilibrium incidence of a

CGT is shifted to labor, avoidance is concentrated at the highest incomes, and the lifetime

burden is concentrated at old age, conventional views about the “fairness” of this tax deserve

more careful examination that it usually gets.

Conclusion

Being intimately involved in the debate over capital gains taxation in Australia was a fascinating

experience. I was surprised to encounter zealous Haig-Simons missionaries, imported from the

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US, being so eager to bend logic and fabricate evidence to an extent that I could not imagine

them attempting among US peers. I doubt that a proposed change in any other tax would

generate so much agitation and confusion.

Anyone contemplating involvement in a similar effort to reduce a steep tax on realized gains

must retain a wary attitude toward vague claims that the latest research proves this or that. The

word “should” is a warning sign that the speaker is evoking theoretical or normative criteria.

Economists may say that overtaxing dividends “should” be matched by overtaxing capital gains,

or that indexing of capital gains “should” only be done if the country also indexes interest

income and expense. Such decidedly debatable statements are typically made as though the

point “should” be self-evident. Yet statements about the elegant symmetry or ethical propriety

of any particular tax structure are invariably derived from some unrevealed theory. The precise

nature of such theories need to be brought out into the open, and their empirical relevance not

taken for granted.

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New Evidence from Panel Data,” Urban Institute.

Bradford David F., ed. (1995). Distributional Analysis of Tax Policy, AEI Press.

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Lang, Mark H. & Shackelford, Douglas A. (2000). “Capitalizations of Capital Gains Taxes:

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Poterba, James M. (1987). “Tax Evasion and Capital Gains Taxation,” American Economic

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