Wife-Swapping, Taxes and Spreads Are All Related

Aug. 1 (Bloomberg) — Senate Finance Committee leaders are signaling that Congress will take up the topic of capital gains and private-equity firms next year. And no wonder.

The 20 percentage-point difference between the 15 percent capital-gains rate that many Wall Streeters pay and the 35 percent income-tax rate paid by a surgeon at a hospital makes a tempting election-year target for Democrats.

The focus on this particular spread is a shame. What really matters about the capital-gains rate isn't its relationship to the income-tax rate. What matters to everyone is a capital-gains rate that is low.

You can see this in the economic numbers over the decades and also, occasionally, in the general culture. When the capital-gains rate is low, America feels like doing business. When the rate is high, the country turns its attention elsewhere.

Laugh all you like. There is a case to be made that the capital-gains rate affects everything from politics to sports, cars, religion and even relationships between the sexes.

Consider the record of the past century. From 1922 to 1933, the spread between the top long-term capital-gains rate and the income tax level was sometimes even larger, as wide as 60 percentage points, as Leonard Burman of the Urban Institute notes in "The Labyrinth of Capital Gains Tax Policy: A Guide For the Perplexed"

Once the capital-gains rate was reduced to 12.5 percent, the 1920s roared. Unemployment sank into the threes, twos, and even ones — a level so low that the 4.5 percent level we enjoy now looks unexceptional. Even anarchists gave up politics and purchased Model T's to drive girls around in.

Taxed Economy

A few years into the Depression, lawmakers raised the capital-gains rate to as high as an effective 23.7 percent, prolonging the economic agony. In this dark and moralistic period, politics seemed more important than economics, since there wasn't much economics going on.

The 1950s had a spread that makes today's look narrow: the top income-tax rate was more than 90 percent, whereas the capital-gains rate for top earners, effective and statutory, was 25 percent. The difference mattered less than the fact that at 25 percent, capital gains were still low enough that the Organization Man earned profits for his corporation.

That rate persisted into the early and mid-1960s, low enough to keep the country focused on business. The cinematic context that comes to mind here is 1967's"The Graduate," released just around the time the capital-gains rate began to edge up. What matters most, as a parent says at poolside, is "plastics" — the great new business. But Benjamin senses that the general outlook is weak, and turns to Mrs. Robinson.

On the Rise

In fact, the capital-gains rate was on the rise to an effective 45.5 percent by the early 1970s. Rashly, Congress pushed the effective capital gains up close to 50 percent. That postponed not only innovations, but also the extent to which existing innovations reached the consumer.

This frozen state is best captured not by Washington's data but by author Rick Moody in the "The Ice Storm," later made into a film. One man at a boozy party has a brilliant insight into how to solve an abiding problem, that of packaging breakables for shipping. What about using Styrofoam bits to pack with? If you do that, notes the man in wonder, "delicate stuff, stuff that can get tossed around by shippers, still arrives intact."

There ought to be high hopes for the idea: "it is just going nationwide, I see it, nationwide." But the whole Styrofoam-peanut pitch gets drowned out as the 30- and 40-something guests turn to a venture with greater possibility for immediate realization: wife-swapping.

Tech Boom

More recent decades offer yet more evidence for the value of lower capital-gains rates. When the famous Steiger Amendment slashed the capital-gains rate to 28 percent in the late 1970s, venture capital found its footing. As Chris Edwards of the Cato Institute writes on his Web log, the same financial structure that is now under assault by lawmakers helped fuel the growth of a number of companies, from Apple Inc. and Intel Corp., to Genentech Inc., Cisco Systems Inc. and thousands of others.

U.S. President Ronald Reagan cut the capital-gains tax to 20 percent, at least in his first term, and Treasury Secretary Robert Rubin, who copied Reagan, lowered it to 20 percent in the late 1990s. As for the spread, in 1986 a Reagan-Democrat compromise reduced that to a healthy zero. Both the long-term capital-gains rate and the top income-tax rate stood at 28 percent. The 1987 stock-market crash followed.

Why then the continued emphasis on the spread? There's an old definition of income, known among economists as Haig-Simons, under which wide spreads are viewed as damaging. The Haig-Simons theory finds frequent use nowadays, notwithstanding the 1987 crash. That is because it provides a reasonable pretext for an attack on the rich.

Burman noted in a conversation earlier this week that lowering the income tax, rather than raising the capital-gains tax, would narrow the spread just as effectively. But cutting the income tax probably isn't in Speaker Nancy Pelosi's plans.

If a capital-gains rate increase alone, however, makes it into 2008 law, the U.S. economy will become less competitive compared with other economies at a crucial time. And if you don't mind me saying, that's a spread that can affect a lot of relationships.

(Amity Shlaes, a senior fellow at the Council on Foreign Relations in economic history, is a Bloomberg News columnist. The opinions expressed are her own.

© Copyright 2007 Bloomberg

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