Ah well, tax reform was nice while it lasted. The U.S. House Ways and Means Committee is one vote away from restoring the lower tax rate on capital gains that tax reform eliminated just three years ago. That's not the end of the matter, of course - in Washington, it's never over even after it's over. But at the moment it doesn't look good.
Nothing better illustrates the futility of traditional left-right politics than the capital gains issue. For conservatives, that capital gains should be taxed at a lower rate than ordinary income is revealed economic truth. It is what pollsters call a ''hot-button issue,'' like the pledge of allegiance.
Liberals, for their part, can't get past the idea that special treatment for capital gains is a giveaway for the rich. This is true, but unhelpful. The important principle is that the fiscal system as a whole should be progressive, not that it must be so in each constituent part. In any event, conservatives are likely to take the argument that a tax break benefits the well-to-do as a point in its favor.
If liberals really want to get anywhere on this, rather than just work themselves into a self-righteous lather, they should hit conservatives where it hurts: on the growth issue. The best case against special treatment for capital gains is one of efficiency, not equity.
FOOL'S MARKET ECONOMICS
The capital gains preference is mined from the vein of similar right-wing prejudices that might be called ''fool's market'' economics. Because of its tribal symbolism, a lot of people who consider themselves supporters of free markets have been suckered into upholding an idea that is wholly anti-market.
The argument holds that a tax break on capital gains is needed to ''encourage risk-taking and capital formation.'' There's no evidence that the lack of such an advantage since 1987 has deterred U.S. capitalists much, and anyway, this is what the rest of us might think the capital gain itself does.
Like any tax shelter, the capital gains preference increases the after-tax return to a given investment. That's what matters to investors, but the returns that matter for economic growth are the pre-tax returns: the real gain or loss an enterprise generates. A well-designed tax system leaves different investments in the same order of attractiveness after tax as before.
What determines the attractiveness of an investment is not only the return, but the risk. Assessing that tradeoff is clearly a subjective judgment. So there is no necessary virtue in puffing up the after-tax return on risky investments, even if it produces higher economic growth. For that matter, why should investors risking their financial capital get a break, while wage-earners risking their human capital get none? Risk-taking is one of the few justifications for capitalists' existence. Why should they have to be subsidized by workers to do it?
That's assuming the capital gains preference actually does increase risk-taking. While the lower tax rate might encourage some shift of funds into You Only Live Once Ltd. from the Widows & Orphans Credit Union, the extra wealth in their hands may also make investors feel more contented with their lot, and hence less disposed to gamble.
Finally, a lot of what a capital gains exemption promotes has less to do with investing than accounting. Not only are tax specialists occupied tarting up ordinary income into capital gains, but the way is opened for tax-motivated trading between investors for whom the chance to make tax-free capital gains means a great deal, and those willing to trade it for something they value more.
It certainly makes sense to tax only real gains, sparing any gains arising from inflation, and sometimes the preferential rate is defended as a sort of rough equivalent. But why use this crude fix-it, when as Britain and Australia have shown, it is possible to index gains to inflation? Taxing capital gains as they accrue, rather than when realized, would dispose of another objection to full taxation: the alleged ''lock-in'' effect. New Zealand has shown the way here.
The best solution of all is to recognize that there is really no such thing as an income tax: all taxes eventually fall on consumption. If we were to drop the pretense of taxing income, and tax expenditures instead, then the problems of measuring inflation and accrued value melt away. The simplest way of equalizing the tax treatment of different types of income is not to tax income at all.
Like any tax shelter, the capital gains preference increases the after-tax return to a given investment. That's what matters to investors, but the returns that matter for economic growth are the pre-tax returns: the real gain or loss an enterprise generates. A well-designed tax system leaves different investments in the same order of attractiveness after tax as before.