Compared with most other tax provisions, the potential revenue gain scored for an increase in capital gains taxes is strongly affected by behavioral responses assumed by the Joint Committee on Taxation (JCT) and the Department of the Treasury. As an illustration, the Obama Administration estimated in February 2010 that allowing the Bush tax cuts for capital gains to expire would have raised $16 billion of revenue in FY2019. Yet, based on Congressional Budget Office (CBO) projections in January 2010, the current effective capital gains tax was 13.3% in 2008 and would have increased to 17.9% in 2019; applying the differential in these rates to the realizations in 2019 would have produced a revenue difference of $40 billion. Although some of this differential could arise from different forecasts, assumptions about behavioral responses are the main reason for the reduction in projected revenues. To address these potential behavioral responses, some supporters of increasing taxes on capital gains (given that such gains comprise a significant part of the income of high-income individuals) have proposed applying mark-to-market rules to tax capital gains as accrued, which would eliminate the realization response for affected assets. Such an approach has a number of complexities, and to the extent that these changes aim to address the behavioral response, it is important to understand the limits this behavioral assumption imposes on options for increasing taxes on realized capital gains and the empirical basis for these estimated effects. Realizations responses in revenue projections by the revenue-estimating agencies (JCT and Treasury) were publicly discussed at the end of the 1980s, in the midst of a contentious debate. The analysis in this report suggests that the Obama Administration's projections and those of the JCT, absent a change in their realizations response, may likely understate revenue gains from allowing lower capital gains tax rates to expire. Capital gains realizations responses are typically expressed in the form of an elasticity, which is the percentage change in realizations divided by the percentage change in taxes. The higher the value of the elasticity, the smaller the revenue gain or loss from a capital gains tax increase or decrease. Thus a brief discussion is in order. Statistical estimates of realizations responses can be based on a variety of functional forms, but one of the most common functions causes the elasticity (percentage change in gains divided by a percentage change in tax rates) to rise proportionally with the tax rate. Many elasticities discussed at that time reflect that rate. To make the revenue implications clear, an elasticity of 0.3 would imply, for a small increase in the tax rate, that the revenue gained would be 70% of the revenue projected if there were no realizations response. Estimates based on individual taxpayer data ranged from 0.55 to 3.8. Gravelle's study noted that there was a limit to the realizations response in that, for a permanent elasticity, realizations could not exceed accruals (the change in the market value of assets). These timing responses are not appropriate for measuring a permanent response. JCT's current coefficient appears to be similar to the estimate used during the 1990 debate (although the elasticity was slightly higher in 1990, that appears to be due to the exclusion of small portfolio effects; without those, it would probably be around 0.76). The Treasury estimate has been reduced and is now of the same rough magnitude as the JCT assumption. The authors estimated an elasticity of 0.18 at an 18% tax rate, which implies a coefficient of one, and an elasticity of 0.22 at a 22% tax rate. The techniques used in the study should identify a permanent elasticity. "Capital Gains Taxation and Tax Reform."
Compared with most other tax provisions, the potential revenue gain scored for an increase in capital gains taxes is strongly affected by behavioral responses assumed by the Joint Committee on Taxation (JCT) and the Department of the Treasury. As an illustration, the Obama Administration estimated in February 2010 that allowing the Bush tax cuts for capital gains to expire would have raised $16 billion of revenue in FY2019. Yet, based on Congressional Budget Office (CBO) projections in January 2010, the current effective capital gains tax was 13.3% in 2008 and would have increased to 17.9% in 2019; applying the differential in these rates to the realizations in 2019 would have produced a revenue difference of $40 billion. Although some of this differential could arise from different forecasts, assumptions about behavioral responses are the main reason for the reduction in projected revenues.
Because these behavioral responses limit the potential revenue scored from a tax increase on capital gains and because of concerns that most income of very high-income individuals is in the form of capital gains (whether accrued or realized), proposals have been advanced to tax capital gains currently (as accrued) by marking to market publicly traded securities and imposing a look-back tax on difficult-to-value assets. Such a change faces a number of difficulties; thus it is important to understand the evidence of the behavioral responses. The analysis in this study suggests that the Administration's projections and those of the JCT, absent a change in their realizations response, may understate revenue gains from increasing capital gains tax rates.
Realizations responses in revenue projections by the revenue-estimating agencies (Joint Committee on Taxation and the Treasury) were publicly discussed at the end of the 1980s, in the midst of a contentious debate. The larger the absolute value of the elasticity (the percentage change in realizations divided by the percentage change in taxes), the smaller the revenue gain; with elasticities larger than one in absolute value, a loss would occur. Estimated elasticities in the literature prior to 1990 ranged from 0.3 to almost 3.8, leaving limited guidance for revenue-estimating agencies. JCT used an elasticity of 0.76, whereas Treasury used an elasticity of one.
Concerns were raised at that time that there were serious problems with this evidence. Perhaps the most significant concern was that the larger results from studies of individuals reflected a timing or transitory response (high-income taxpayers with variable income chose to realize gains when tax rates were temporarily low). This transitory response is not appropriate for assessing a permanent change.
Evidence and studies since that time suggest that the permanent elasticity is considerably lower than what appeared to be the case in 1990. The surge in realizations in 1986 as a capital gains tax rate increase was preannounced provided compelling evidence of the importance of a transitory response. A study of the limits of realizations (which cannot exceed accruals in the long run) suggested the elasticity (percentage change in realizations divided by the percentage change in the tax rate) could be no more than 0.5 in absolute value (evaluated at a 22% tax rate), and a midpoint of 0.25. A number of new econometric studies, using new techniques to isolate the permanent response, suggested elasticities of around 0.5 or less. Other recent studies suggested larger responses. The JCT appears to maintain its original assumption, while the Treasury response has been reduced to be similar to JCT's; both appear to exceed the realizations limit.
Simulations indicate that an increase in capital gains tax rates of five percentage points would raise slightly more than $40 billion on a static basis for 2019, about $30 billion using the 0.25 elasticity and $18 billion using the 0.5 elasticity. The JCT estimates would likely be around $10 billion, reflecting a 0.68 elasticity. Taxing gains on an accrual basis would eliminate this response in the long run and gain additional revenues on currently unrealized gains.