The Beginnings of the U.S. Capital Gains Tax Preference

With the recent release of the Trump administration’s tax plan, discussions of tax “reform,” or at least tax cuts, are once again at the center of American law and politics. Although the president’s tax plan is short on details, it has plenty of potential benefits for high-income earners, including a reduction in top marginal income tax rates and a modest decrease in the tax rate on capital gains. More specifically, the White House tax plan seeks to repeal the 3.8 percent Obamacare tax on net investment income, thereby increasing the tax preference for realized gains from capital investments.

Unsurprisingly, the benefits of the capital gains tax preference disproportionately go to the top income earners. In 2016, according to estimates by the non-partisan Tax Policy Center, nearly 76 percent of all capital gains went to households earning more than $1,000,000 a year. Because the capital gains tax preference is a well-established “tax expenditure,” the federal government regularly forgoes revenues by extending this tax benefit. Indeed, in 2016 alone, the capital gains tax preference cost over $130 billion in foregone federal tax revenue, according to the Joint Committee on Taxation.

Despite the significance of the capital gains tax preference, there is little empirical scholarship on the historical origins and early development of this tax benefit. In fact, there is a general sense that the tax preference has always been a natural and necessary part of the U.S. tax code. History, however, suggests otherwise.

In a recent article, we explored the origins of the tax code’s enduring preference for capital gains. We found that this tax benefit has not been a fixed or an inevitable part of the U.S. internal revenue code.

Rather, since its beginnings in the 1920s, the capital gains tax preference has been a politically contested and historically-contingent provision of American tax law.

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The modern American income tax began in 1913, with the ratification of the Sixteenth Amendment, and the subsequent enactment of the first set of progressive income tax laws. Initially, it was unclear whether capital gains were even part of the income tax base. Because the early income tax rates were relatively low (with top marginal rates of 7 percent), the uncertainty of taxing capital gains was less significant – for taxpayers and the U.S. Treasury.

All that began to change when tax rates skyrocketed as part of U.S. entry into World War I. With top marginal rates reaching up to 77 percent, the taxation of capital gains became a pressing yet still ambiguous issue. After the war, most experts and policymakers were divided over both whether capital gains ought to be part of the tax base and whether there should be a preference for capital gains. Many believed that labor income ought to be taxed at a lower rate.

The U.S. Supreme Court eventually settled part of the ambiguity in 1921 when it held that gains derived from the one-time sale of property constituted taxable income (Merchants’ Loan & Trust Co. v. Smietanka). In that same year, Congress addressed the secondary question of the tax rate that applied to capital gains. The 1921 Revenue Act thus included a provision that taxed capital gains at 12.5 percent, well below the top marginal rate of 65 percent for ordinary income at the time.

There were several justifications for the first capital gains tax preference – all of which continue to support the benefit today. First, proponents of the preference contended that a lower rate would “unlock” the free flow of capital. With the high wartime rates still in effect, corporate lawyers argued that numerous commercial transactions were not occurring because of the high tax rates, which “locked-in” capital.

Second, supporters of the preference maintained that a lower rate would compensate investors for the unfair “bunching” of income that had occurred over the many years. Similarly, others argued that because inflation had eroded nominal capital gains, a lower rate was a fairer way to tax capital gains.

Finally, because the U.S. economy was in the midst of a modest postwar economic recession, supporters of the capital gains preference argued that a lower rate would encourage more transactions and hence stimulate economic recovery and prosperity, and even increase total tax revenues.

Opponents of the new tax preference argued that it was an unnecessary give-away to the rich, as did some economic experts who believed a lower tax rate for labor income might be more productive. Indeed, political economists such as the University of Michigan’s Henry Carter Adams had long argued that a truly progressive tax system required distinctions between different sources of income. In his pioneering 1898 public finance treatise, Adams explained that, because income from services (e.g. wages and salaries) was “both terminal and uncertain” while income from property (e.g. interest, dividends, and capital gains) was “by comparison considered as perpetual and certain,” the difference warranted “a distinction in the law of taxation by which income from property is rated higher than income from effort” (Adams 1898, 357-8).

High-ranking policymakers also questioned the capital gains tax preference. U.S. Treasury Secretary Andrew Mellon, one of the richest men in the world, began to popularize the idea of a lower tax rate for wages and salary income. “The fairness of taxing more lightly incomes from wages, salaries, and professional services than the income from business or from investments is beyond question,” wrote Mellon in his influential 1921 book, Taxation: The People’s Business (Mellon 1921, 56-7).

Mellon’s calls for an “earned” income tax preference soon became enacted as part of the 1924 revenue law, which provided a lower tax rate for the first $10,000 of taxable income from labor. Economic experts hailed the provision, though they noted that because of relatively high exemption levels, the preference would have almost no impact on ordinary American wage-earners.

Ultimately, the tax preference for labor income was short-lived. But its existence alongside the early capital gains tax preference demonstrated that neither lawmakers nor economic experts were quite clear about which source of income – capital or labor – would be more responsive to changing tax rates.

Despite these uncertainties, supporters of the capital gains tax preference not only continued their campaign for lower rates, many went even further, rallying for the complete elimination of all taxation of capital gains. The onset of the Great Depression provided the economic conditions to accelerate the claim that any tax on capital gains was interfering with the free flow of capital and thus the possibilities for economic recovery.

Beginning in the mid-1930s, leaders of the New York Stock Exchange (NYSE) focused on the taxation of capital gains as an impediment to economic recovery. Like earlier advocates of the tax preference, these business leaders argued that reducing taxes on capital gains would spur more trades and transactions, setting in motion the “circulation” of “frozen” or “stagnant” capital.

Yet, unlike earlier advocates, these supporters were not satisfied with simply reducing the current tax rate on capital gains. They sought to eliminate all taxes on capital gains, while they claimed that capital gains flowed to all Americans. NYSE president Charles Gay counseled that businesses needed new and enlarged “productive facilities,” in anticipation of increased consumer demand. That would require businesses to raise “new capital …through the issuance of stock and bonds.” And that, in turn, required the NYSE to maintain a “continuously liquid security market,” which it could not do until the “deadening hand” of capital gains taxation released its grip (Gay 1937).

In the end, lawmakers did not abolish the capital gains tax. But, with the Revenue Act of 1938, they did lower the rate further, increasing the spread between the taxation of ordinary income and capital gains.

The past political contests over the capital gains tax preference illustrate the unstable and conditional nature of this tax provision. Indeed, during the landmark Tax Reform Act of 1986, Congress even went so far as to eliminate the preference for capital gains, thus taxing ordinary income and capital gains at the same rate. Although this regime did not last long, it too shows that there is nothing preordained or inevitable about the capital gains tax preference.

Today, economic experts, many of whom have documented the limited empirical justifications for the preference, have continued to question the necessity of the capital gains tax preference. Eric Toder and Alan Viard have recently revived their earlier call to eliminate the preference as part of a comprehensive corporate income tax reform (Toder & Viard 2016). Similarly, Steven Rattner recently penned a New York Times op-ed critiquing the recent Trump tax plan and citing the need for corporate tax reform, including increasing the taxation of capital gains to match the top rate on ordinary income (Rattner 2017).

Our historical story about the curious origins of the capital gains preference is thus meant to be more than merely of antiquarian interest. Reflecting back on the contested, contingent, and changeable nature of the provision can remind us that there is nothing natural, neutral, or necessary about the capital gains tax preference. At a time when economic inequality has once again become a serious concern, rethinking the historical experience, and not just the economic logic, of the capital gains preference might be just what is needed for today’s tax reform debates.

REFERENCES

Adams, Henry Carter. (1899). The Science of Finance: An Investigation of Public Expenditures and Pubic Revenues. New York: Henry Holt & Co.

Gay, Charles. (1937). Capital Markets and Business Recovery, Address at the Illinois Manufacturers’ Association (on file with the New York Stock Exchange Archives).

Mellon, Andrew W. (1921). Taxation: The People’s Business. New York: The Macmillan Co.

Rattner, Steven. (2017). Trump’s Tax Cuts May Be More Damaging than Reagan’s. New York Times, May 1, 2017.

Toder, Eric and Alan D. Viard. (2016). A Proposal to Reform the Taxation of Corporate Income. Tax Policy Center

This post comes to us from Ajay K. Mehrotra, the executive director and a research professor at the American Bar Foundation and a professor of law at Northwestern Pritzker School of Law, and from Julia C. Ott, an assistant professor of the history of capitalism and co-director of the Robert L. Heilbroner Center for Capitalism Studies at The New School for Social Research. It is based on their recent article, “The Curious Beginnings of the Capital Gains Tax Preference,” available here.

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