The Elusive Search for "the Capital" in Capital Gains

Terry O'Keefe

This article is from the March/April 2001 issue of Dollars & Sense: The Magazine of Economic Justice available at

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This article is from the March/April 2001 issue of Dollars & Sense magazine.

If the Republicans have their way, Congress will soon enact another hefty cut in the capital gains tax. That proposal is based on the claim that, if we tax investments less, investors will rush to invest more, thereby expanding the economy and enriching our jobs base. But a closer look shows that most investments have little to do with building the economy and even less to do with creating new jobs.

Investing in Luxury

Art collections provide a great example. Recently, according to the New York Times, Pablo Picasso's Woman With Crossed Arms was sold at auction for $55 million. Since the painting has been owned by Chicago collectors since 1936, the profit from the sale would be taxed as a capital gain—at one half the tax rate that applies to "ordinary" income. It's hard to see how this transaction contributes to the economy or creates jobs. So why are we rewarding it—or the sale of any collectibles—with our most preferential tax rates? Incidentally, if Picasso were a U.S. citizen and still alive to sell the painting himself, the sale would be recorded as ordinary income and the great master would have to pay full income taxes.

The Residential Real Estate Waterfall

Another dubious area of "investment" is residential real estate. In September 1999, the San Francisco Chronicle reported that an anonymous dot-commer paid $20 million to purchase a house in tony Marin County from builder Mitchell Weiner.

That may be great good fortune for Weiner, but it's hard to see how the economy is stimulated in any direct way by his windfall. In fact, it's worse than that. When too much money flows into a tight real estate market, it produces a waterfall effect—overbidding on houses at one level leads unsuccessful buyers to overbid at the next lower level, and so on down the chain until housing prices at every level have risen. Thus, outlandish offers for palatial estates in Marin inevitably beget outlandish offers for dingy stuccos in Oakland.

Luxury house buying is already heavily subsidized by the U.S. Treasury in the form of tax deductions for mortgage interest and property taxes. Given its adverse effects on everybody's cost of living, why are we thinking about lowering taxes on these capital gains when we should probably be thinking about raising them?

Commercial Real Estate—A Drag on the Economy

New construction of office buildings and factories of course benefits the economy. It stimulates construction-related industries, creates well-paid jobs, and helps to keep a lid on rents in places where commercial space is in short supply.

But what about existing commercial real estate? Here, purchase activity adds nothing to the supply of space and creates no new economic activity or jobs. Moreover, building owners who pay high purchase prices tend to push up rents, which means higher overhead for business tenants. Since there is no corresponding increase in productivity, rent increases are pure inflation. So not only does the sale of existing commercial real estate not contribute directly to the economy, it generally raises business costs and therefore the country's inflation rate. Is there any reason why we should reward this activity with even bigger tax breaks?

One could make the counter-argument that raising the general rent level encourages new construction. But if that is our aim, why reward every real estate transaction merely to encourage the few that actually create new space?

A Look at Business Investments

In 1989, George W. Bush organized a partnership to buy the Texas Rangers major league baseball club. Riding a seller's market for professional sports teams, Bush and his partners sold the Rangers in 1998 for a huge profit. The President's share was $14.9 million on an investment of $606,000. Bush's windfall pushed his total income that year to more than $18 million. Thanks to generous capital gains tax breaks, Bush paid only 20% in federal taxes, when the federal tax bite on ordinary income would be almost double that.

Unlike, say, drilling for oil or investing in an early-stage dot-com, running a baseball team wouldn't seem to have much of a positive impact in the way of new jobs, new industries, new infrastructure, or new natural resources.

Stadium attendance did grow during the '90s, so stadium jobs probably went up. But most of those new jobs were likely of the part-time ticket taker and hot dog vendor variety. No doubt concession sales went up too, but selling ever larger quantities of overpriced beer, soda and junk food might strike some as a questionable contribution to the economy.

No matter. Capital gains tax breaks aren't qualitative, they are quantitative. If an investment increases in value over several years, as the Rangers did, it gets preferential tax treatment.

And Then There's Wall Street

The stock market has only a tenuous connection to "investing in the economy." Of the trillions of dollars of stock traded each year, only a miniscule amount actually winds up in the hands of the companies whose stock is traded.

In 1999, for example, trading on the NASDAQ Exchange—the home of most new stock issues—was about a trillion dollars. Of that amount, only about $50 billion, or 5%, went to companies making their first public offerings. While there may have been some secondary offerings (or resales) whose proceeds also would have gone into company coffers, almost all of that trillion dollars in volume was stock traded from investor to investor.

If spurring new investment is the goal, why are we subsidizing every long-term stock transaction (i.e., transactions involving stock held for more than one year) with capital gains tax breaks, whether it benefits the economy or not?

Of course, some will argue that lower capital gains taxes will spur new stock market investment. But as the shrinking stock market shows, hyper-investment is driven by the expectation of hyper-returns. When those opportunities dry up, so does investment. Certainly a lower tax rate will make investment more attractive, but it is really the lure of giant gains that makes investors gush money.

Those Who Already Have Get to Have Even More

Capital gains tax preferences may have a dubious effect on the U.S. economy, but they have a definite effect on wealth. By definition, they bring the most benefits to those who are already rich.

The tax-cut lobby has gotten very adroit with language and symbols. The estate tax morphs into the evil-sounding "death tax," while capital gains tax reductions masquerade as "investing in the economy." In that same spirit, we ought to call the proposal to cut capital gains taxes a "wealth transfer plan"—one that unfortunately runs in the wrong direction.

So let's separate the rhetoric from the reality. Most so-called "capital" gains have little or nothing to do with building a better economy. For the most part, lowering the capital gains tax is just another device for ensuring that those who already have get to have even more.

Terry O'Keefe is a freelance business writer and columnist from Oakland, California. His bi-weekly journal of commentary on business, politics, and change is available on the Internet. He can be reached by email.

Terry O'Keefe 2001