8 - Progressivity of capital gains taxation with optimal portfolio selection

Summary

Introduction

The debate over capital gains taxes has served as a focal point for the larger debate over the desired progressivity of the tax system. Some argue that a reduction in the capital gains tax rate predominantly benefits upperincome taxpayers. Others argue that taxpayers in all income groups receive capital gains, and that once-in-a-lifetime gains artificially distort the concentration of gains by income class. In addition to the concern over progressivity, there are debates on the efficiency consequences of capital gains taxes: the degree to which they hinder or promote saving and investment and their effects on portfolio behavior.

In this paper we present new data from the Internal Revenue Service on capital gains realizations between 1985 and 1989 as well as data from the Federal Reserve Board Survey of Consumer Finances (SCF) on stockholding. These data show a high concentration of stockholding and capital gains realizations in the highest income groups.

Next, we draw upon these data to examine distributional effects and portfolio responses to changes in the tax treatment of capital gains. A simple analysis of tax burden focusing only on tax payments is not an accurate indication of the burden of a tax. Taxes generally create costs beyond the dollar value collected by causing persons to change their behavior to avoid the tax. Economists have long noted the “lock-in” effect as one of these additional costs. Taxes also reduce the variance in after-tax returns; for risk-averse investors, this reduction is a benefit.