Taxing Workers Cutting capital gains taxes could hurt Silicon Valley in the long run

Hal Plotkin, Special to SF Gate
Wednesday, July 3, 2002

URL: sfgate.com/cgi-bin/article.cgi?file=/gate/archive/2002/07/03/capgain.DTL

There is an old saying that sometimes a cure can be worse than the disease.

Tech investors might be about to get a dose of just that type of bad medicine.

The sagging stock market — and tanked tech stocks in particular — are leading to renewed calls to eliminate capital-gains taxes, which are paid on profits made by selling assets such as stocks and bonds. Fifty members of Congress, including Rep. David Dreier (R-Calif.) and Sen. Joe Lieberman (D-Conn.), recently formed a bipartisan coalition aiming to do just that. They say the goal is to help the economy by making investing more attractive.

On first blush, doing away with capital-gains taxes — any taxes, for that matter — sounds pretty appealing. But wiping out capital-gains taxes entirely, or cutting them across the board for everyone, would make life much tougher on American workers and harm the competitiveness of U.S.-based tech firms over the long run.

Backers of repealing the capital-gains tax often say it is not just about greed. Capital gains are not income, they maintain, and should not be taxed as if they are. Instead, supporters say, the money in investment portfolios was already taxed when it was originally earned and no taxes should be due on any interest or appreciation generated by investments.

But several court decisions over the years have found that for purposes of the income tax, income is defined as not just wages, but any money that comes in — including interest, dividends and stock sale proceeds. The real question, which is coming to the fore once again, is whether everyone should pay taxes on their income, or whether only those who earn wages should pay them.

For instance, a relatively small number of Americans (California GOP gubernatorial candidate Bill Simon comes to mind) earn the bulk of their incomes from capital gains of one sort or another, often from inherited assets. If capital-gains taxes are eliminated, those individuals won’t owe Uncle Sam one thin dime in income taxes, ever. Many groups working for social justice believe it would be wrong, and just plain unfair, if Congress allows the Bill Simons of the world to pay less in taxes than young people or immigrants working their butts off at Jack-in-the-Box or McDonald’s.

But it’s not just about fairness, claim the backers of radical across-the-board capital-gains tax cuts, as well as those arguing for the repeal of the tax. Instead, they say it is about what works. Frequently, for example, they point to data that shows government receipts rising after some previous capital-gains tax cuts as investors rushed to sell assets at the new lower rates. That increased selling activity, they claim, not only boosts tax coffers (even though the rates are lower), it also frees more money for fresh job-creating investments.

But several other critical factors, such as the declining value of the dollar, which often accompanies periods of capital-gains tax cutting, are usually omitted from calculations offered by proponents of across-the-board tax cutting. When the dollar’s value is going down (as it is now), investors — particularly foreign investors — usually sell dollar-denominated assets. In other words, the sales of securities that followed previous cuts in the capital-gains tax rates might not have occurred only because those rates were cut.

Either way, it’s hard to see how eliminating the capital-gains tax entirely will boost government revenues. It’s certainly possible, of course, that if rich people don’t have to pay taxes, they might create more jobs with the money they save. By the same token, though, more jobs would be created if workers didn’t have to pay taxes, either. Companies could then use the 40 percent or more of their payroll expenses that go toward covering taxes on employees to expand their operations and hire more help. Clearly, the answer isn’t to favor one side over the other, but rather to balance the burden of supporting government between earned income and investment income in ways that keep both camps solvent and productive.

Other badly needed and far more effective cures for the current economic slump would involve encouraging more honest corporate leadership by strengthening and rigorously enforcing penalties for corporate fraud, putting accounting reforms in place that paint more accurate pictures of financial performance and increasing government support for technologies that could stimulate economic vitality, particularly in the areas of energy, communications and transportation.

Unfortunately, rather than considering some of these solutions, key leaders of both major political parties have in the past tripped over themselves in their rush to cut capital-gains taxes during times of economic distress. In Silicon Valley, the crusade to cut capital-gains taxes has long enjoyed bipartisan support. Valley resident Alan Cranston, then a Democratic U.S. senator, pushed through a key capital-gains tax reduction. Likewise, a former GOP member of the House of Representatives for the Valley, Tom Campbell, made calls for massive cuts in capital-gains taxes a centerpiece of his congressional efforts.

It might be that politicians of differing stripes (such as Campbell and Cranston) found genuine and honest agreement on the wisdom of capital-gains tax cuts. But the high cost of running for public office, particularly here in California, also seems to play a role. Campaign fund-raising is usually much easier whenever office seekers champion tax cuts for investors. That’s one reason we can expect to hear more talk of capital-gains tax reductions over the coming months, particularly if the economy continues to worsen while campaign costs continue to rise.

The most counterproductive outcome, which is highly possible, would be a total repeal of capital-gains taxes. If people who live off their investments don’t pay any income taxes, the full burden of supporting the federal government will fall squarely on the backs of American workers and employers, who are certain to buckle under that load over time.

Limiting taxation to earned income means that only working people will pay income taxes. So when the government needs more money, it will either raise taxes on the people who pay taxes — that is, workers — or borrow more, which is really a silent tax (one that hits workers hardest), because government borrowing pushes up interest rates and leads to higher costs for everything from business expansions to consumer goods and home and auto loans. Those rising costs, in turn, push up the cost of labor because people usually won’t work for less money than they need to survive. Higher wages are fine when they come about because of increased productivity. But they can be very damaging to the economy when they stem from escalating expenses imposed by the government.

Whenever that happens, the one thing we can count on is an acceleration of the vicious cycle that leads noncompetitive American companies to shed jobs to foreign markets, where lower labor costs are often a critical factor. The entirely predictable result of more job losses in the United States will be a ballooning federal deficit, which would push interest rates up even higher and further constrain economic growth.

This is a movie we have seen before. Whenever government spending outpaces tax receipts, Uncle Sam borrows more, which reduces credit available to the private sector. The lack of credit hits growth-oriented tech firms — which need capital to expand — particularly hard.

Unfortunately, despite the many problems already facing tech firms, as well as the federal government’s increasingly shaky finances, Washington’s political crowd seems unlikely to resist mounting pressures to do the wrong thing. Previous capital-gains tax cuts (which also coincided with economic recessions) brought long-term capital-gains tax rates below the tax rates paid on other forms of income. The next move would be to reduce them even farther or to eliminate them entirely.

One or two more precipitous drops in the major stock averages could be all it takes to turn the capital-gains tax-elimination bandwagon into a juggernaut.

In this climate, perhaps the best the average investor can hope for is a capital-gains tax cut that benefits smaller investors rather than one that permanently takes America’s wealthiest investors off the hook. One way that could happen, for example, is by exempting some capital gains from taxation — say, the first $5,000 to $25,000 annually — but leaving the tax intact for larger gains taken in any one year. Small investors would then get the encouragement some observers say is needed, while the richest Americans would not be allowed to completely avoid paying income taxes to the government that made their prosperity possible.

Unfortunately, that probably won’t happen. Instead, the mantra we can expect to hear over the coming months will sound very familiar to those who remember trickle-down economics. We’re going to be told (authoritatively, I’m sure) that the only available options are an across-the-board capital-gains tax cut or the outright elimination of the tax. The idea of cutting capital-gains taxes but doing so only for smaller investors, who were the main drivers of the last big advance in stock prices, has no major advocates on the national scene.

One reason for that is that small investors have little in the way of lobbying clout. That lack of political power suits the lobbyists who work for larger investors, including corporations, just fine. It allows those lobbyists to claim to be speaking on behalf of all investors. Politicians are then left with a choice: Either they vote for the investors, or they vote against them. It doesn’t take a rocket scientist to figure out how that one will turn out.

Unfortunately, with an election season at hand, the federal government is more likely to do what it often does: take the path of least resistance, in this case by passing massive, untargeted capital-gains tax reductions camouflaged as a way to help investors, tech firms and the overall economy.

American workers and their employers could be picking up the costly tab for that prescription for decades to come.

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