Understanding Capital Gains Taxes

So what are capital gains taxes?

To answer this question, it helps to break it down first. Capital signifies your investments, such as mutual funds, stocks, bonds, or real estate.

Because capital gains taxes aren't imposed until an asset is actually sold and gains are realized, they encourage those who have accumulated wealth to conserve it. This reduces the flow of venture capital, which is the lifeblood of new entrepreneurs. Capital gains taxes protect those who have inherited money because such recipients can live off their family's accumulated capital without having to pay tax on it. Thought of another way, capital gains taxes aren't a tax on the rich; they’re a tax on getting rich.

In an effort to help small business, entrepreneurship, long-term investment, and overall economic growth, Congress reduced the tax rates on capital gains in 2003 from 20 percent to 15 percent for most investments held 12 months or longer. The rate for investors in the two lowest tax brackets fell from 10 percent to 5 percent. These changes are effective through 2011. This followed a reduction in the top capital gains rate from 28 percent to 20 percent in 1997.

The Economics of Capital Gains Taxes

As you might expect, many oppose capital gains tax relief because they believe cutting the taxes further benefits the extremely wealthy. While this may be true, cutting the capital gains tax does present some benefits to the less than wealthy as well. Over the past century there have been five instances of substantive cuts in the capital gains tax, and in each instance the economy benefited:

• In the early 1920s, the top capital gains tax was slashed from 73 percent to 12.5 percent, which helped spark the solid economic growth experienced throughout the 1920s.
• In 1938, the capital gains tax rate was reduced from 23.7 percent to 15 percent. This helped the economy emerge from the Great Depression.
• Cuts in the capital gains tax in 1979 and 1981 spurred the economic recovery of the 1980s.
• The 1997 capital gains tax cut helped boost the economic recovery of the 1990s.
• The 2003 reduction in the capital gains tax helped the economy shrug off an underperforming economic recovery experienced after the 2001 recession.

However, there have also been instances in which capital gains tax cuts had a negative impact on the economy. For example, from 1968–1976 the capital gains tax rate rose from 25 percent to 49.1 percent, and within that time, average annual economic growth was a mere 3 percent. Also, the capital gains tax hike in 1987 resulted in underperforming economic growth of a mere 2.9 percent.

Capital Gains Taxes and Mutual Funds

When mutual funds profit by selling some of the stocks in their portfolio, they pass along the gains to their shareholders in the form of a capital gains distribution. The investors then have to pay the capital gains taxes on such distributions, which typically occur annually. Even though mutual funds don't distribute the gains, the shareholders still have to pay taxes on the fund's realized capital gains.

How Capital Gains Affect Businesses

The effect of capital gains on a business will depend on the nature of the business. If the business is an investment company, the effect could be significant because capital gains are an issue every time an investment asset is bought or sold. In other businesses, though, capital gains may not have a large effect on day-to-day operations.

Are capital gains the only policy issue impacting investment, entrepreneurship, and the economy? No, but they do matter a great deal. When the Tax Reform Act of 1986 increased capital gains taxes from 20 percent to 28 percent, venture capital investment stagnated until the taxes were reduced in 1997. Over the years, capital gains realizations and the taxes paid on those gains have tended to increase following a cut in the capital gains tax rate.