Capital Gains Tax Options: Behavioral Responses and Revenues

Jane G. Gravelle
Senior Specialist in Economic Policy

Among the expiring Bush tax cut provisions is a lower 15% rate for long-term capital gains and dividends, with a 0% rate for taxpayers with ordinary tax rates of 15% or less. With no change, capital gains tax rates will revert to a top rate of 20% (10% for those with a 0% rate). Dividends will be taxed at ordinary rates. For FY2010 (for example), Treasury has projected revenue gains from these provisions to be $16 billion for capital gains and $30 billion for dividends. 

President Obama has proposed to retain the 15% and 0% rates for lower- and middle-income taxpayers, but to tax both dividends and capital gains at 20% for married couples with income of $250,000 or more and single taxpayers with income of $200,000 or more. Because the increase in dividend tax rates was limited, about 80% of the projected $15 billion gain from this revision (for FY2019) is estimated to be from capital gains tax increases. 

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 Treasury Department. The analysis in this study suggests that the 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. 

Realizations responses were first added to revenue projections by the revenue estimating agencies (Joint Committee on Taxation and the Treasury) 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, and 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 during times that 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 could be no more than 0.5. And a number of new econometric studies, using new techniques to isolate the permanent response, suggested elasticities of around 0.5 or less. The JCT appears to maintain their original assumption, while the Treasury response has been reduced to be similar to JCT's. 

Although projected revenues for FY2019 would be smaller than that estimated in January 2010 by the Administration, due to the Medicare tax, the revenue gain from allowing the capital gains tax to rise could be up to twice as much as that projected by the JCT for FY2019 if the smaller responses estimated in more recent studies were applied. It is reasonable to expect revenue gains of $28 billion, rather than the $13 billion likely to be projected by JCT if they maintain their current realizations response assumptions, and the gain is unlikely to be less than $18 billion.


Date of Report: August 10, 2010
Number of Pages: 21
Order Number: R41364
Price: $29.95

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