Capital Gain: What Obama Should Have Said

Misleading question, weak answer

By Kaye A. Thomas
Posted April 18, 2008

An exchange from the Democratic debate.

In the April 16 debate between the Democratic presidential candidates, Charlie Gibson asked Barack Obama a question about capital gains tax rates that was argumentative and misleading. That may sound like a criticism of Gibson, but it's not. Questions of this kind are appropriate as they test the candidates' ability to respond to arguments frequently offered against their positions. In this case, Obama wasn't well prepared (particularly considering the debate was held the day after tax day), and Hillary Clinton did no better when the ball shifted to her court.

Gibson began by noting that Obama has indicated an intention to raise the capital gains tax rate, and reviewed recent history: the rate fell from 28% to 20% under Bill Clinton in 1997 and fell further to 15% under George W. Bush. Then he said, "And in each instance, when the rate dropped, revenues from the tax increased. The government took in more money. And in the 1980s, when the tax was increased to 28 percent, the revenues went down. So why raise it at all, especially given the fact that 100 million people in this country own stock and would be affected?"

That's a good question, one the Democratic nominee is likely to face in the general election. It will be asked by Republicans and will appear on the editorial page of the Wall Street Journal and other newspapers.

After a brief hesitation, Obama began his response as follows: "Well, Charlie, what I've said is that I would look at raising the capital gains tax for purposes of fairness. We saw an article today which showed that the top 50 hedge fund managers made $29 billion last year -- $29 billion for 50 individuals. And part of what has happened is that those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That's not fair." He went on to talk about the need to reduce the deficit, completely ignoring the point that tax revenues went up when the tax rate went down.

Gibson pressed the point: "But history shows that when you drop the capital gains tax, the revenues go up."

Obama: "Well, that might happen or it might not. It depends on what's happening on Wall Street and how business is going." And he went on to mention the housing crisis and take a dig at what he saw as an inadequate response from John McCain.

Obama seemed to be groping toward a different issue, the ability of hedge fund managers to structure deals so the bulk of their profit is taxed at the lower rates reserved for capital gain. These structures are legal under current law but unfair because the true nature of the income is compensation, not capital gain. The profits should be taxed at the higher rates the rest of us pay on our wages, but a Republican filibuster late last year blocked legislation that would have closed the loophole. An increase in the capital gain rate wouldn't eliminate the problem but it would at least reduce the disparity. That's a side issue in the debate over whether to raise the tax rate on capital gains, however.

The question went over to Hillary Clinton, who also proposes to raise the capital gains rate, and who opined that "we've got to get back to an economy that works for everyone" and talked about how good the economy was in the late 1990s (i.e., when a Clinton was in the White House).

A better response

Obama might better have responded something like this:

Charlie, it may be true that 100 million Americans own stock, but most stock held by middle class Americans is in IRA or 401k accounts, where the capital gains rate doesn't apply. The tax rate matters for stock held outside these retirement accounts, and most of that stock is owned by extremely wealthy individuals. The bottom 60% of households own just 9%, while the top 10% of households own 70%. Over half of all capital gains go to households with income over $1 million. That's roughly two-tenths of one percent of the population getting more than half the benefit of the cut in the tax rate.

Tax revenue went up after these cuts partly because people anticipated them. Advisors told their clients to hold off selling anything for a gain until after the tax cut passed. Then we had a lot of people making these sales and the result was a boost in revenue, but that's a temporary effect.

Some say these cuts helped spur the economy. What they overlook is their role in spurring the stock bubble toward the end of the 1990s and the housing bubble in more recent years. These bubbles harmed the economy, and the harm was felt by many people who saw little or no benefit from the cuts in capital gain rates.

A response along those lines would have better answered the argument implicit in Gibson's question.

Two sides to the story

Those in favor of a low capital gains tax rate have reasonable arguments at their disposal. The long-term effect on the economy may be favorable enough to provide widespread benefit. To the extent it lifts stock values, a lower rate provides a benefit even for people who hold shares in retirement accounts where the rate doesn't apply. Furthermore, in a system that doesn't index gains for inflation, capital gains would be overtaxed without some kind of break.

The change in tax revenue that immediately follows a change in the capital gains rate is a bogus statistic, though. It's theoretically possible for the lower rate to lift the economy enough to provide a sustained increase in government revenues, but you can't make that case by looking at how taxpayers respond to the change in the short term.

Advocates of lower capital gains rates (and lower corporate tax rates, and other tax benefits for business) often cite the statistic that 100 million Americans own stock, implying that the middle class will receive an ample share of the benefit. Yet ownership of stock is highly concentrated in the hands of wealthy individuals, a small fraction of the population. The vast majority receive little direct benefit, or none at all. To borrow an analogy from John Kenneth Galbraith, the "100 million" argument is like justifying the cost of feeding more oats to the horses by pointing out that some will fall to the ground and be eaten by sparrows.