Part II. Corporations Treatment of: Gains Losses Revenue Income from sale or from sale or Act year exchange of assets exchange of assets 1913-1928 1913-1931 Included with other Allowed in full income subject to against income full rate of any kind 1932 1932 do Losses from sales or exchanges of stocks and bonds held 2 years or less were limited to the gains from such sales. It was provided, however, that such losses disallowed in one year (to an amount not in excess of the net income) could be carried over and applied against gains from such transactions in the succeeding taxable year /1/ Other losses were allowed in full against income of any kind I.R.A. 1933 do Losses from sales or exchanges of stocks and bonds held 2 years or less were limited to the gains from such sales Other losses were allowed in full against income of any kind 1934-1936 1934- do Allowed only to extent of $2,000 plus capital gains FOOTNOTE TO TABLE /1/ The provision relating to the carry-forward of disallowed losses from sales or exchanges of stocks and bonds held two years or less was repealed by the National Industrial Recovery Act before it became effective. END OF FOOTNOTE
General Note Relating To The Carry-forward Of Capital Losses
Capital losses from sale or exchange of assets could not in general be carried forward to succeeding years under any of the Revenue Acts of 1913 to 1918.
Under the Revenue Act of 1918, however, capital losses on plant, buildings, machinery, etc., acquired by the taxpayer on or after April 6, 1917, and used in the production of articles contributing to the prosecution of the way entered into the computation of "net losses" /1/. The "net loss" provisions of this Act related only to "net losses" sustained in the period beginning after October 31, 1918, and ending prior to January 1, 1920. The 1918 law permitted the application of the "net loss", first against income of the preceding taxable year (involving a redetermination of the preceding year's tax and a refund or credit) and the application against the following year's income of any excess of "net loss" over income of the preceding year.
Beginning with the Revenue Act of 1921, the application of "net losses" to succeeding periods became a regular feature of our income tax laws until the practice was discontinued by the National Industrial Recovery Act of 1933. Capital losses (subject to somewhat different limitations for individuals and corporations) entered into the computation of such "net losses" and were carried forward for varying periods as follows:
Number of years that Extent that capital losses Revenue Act "net losses" were entered into the carried forward computation of "net loss" For For individual corporations 1921 2 Included, if capital assets are used in the conduct of trade or business regularly carried on by the taxpayer. 1924-1928 /2/ 2 Losses on assets held 2 years or less Included. Included. Losses on assets held 2 years or less Include only to Included. the extent of the capital gains. 1932 /2/ 1 Losses on assets held 2 years or less Included, except that losses from sales or exchanges of stocks and bonds were limited to gains from such sales. It was provided, however, that losses disallowed in one year (to an amount not in excess of the net income) could be carried over and applied against gains from such transactions in the succeeding taxable year. /3/ 1934-1936 None Losses on assets held over 2 years Same as 1924-1928 acts. FOOTNOTES TO TABLE /1/ "Net loss" (subject to certain exceptions and limitations) means the excess of the deductions allowed over the gross income. /2/ The deduction for "net losses" carried forward by taxpayers other than corporations applied first as a deduction in computing ordinary net income excluding capital net gains and any excess over ordinary net income in each year of the carry-forward period applied to the reduction of the capital net gains, if any. /3/ The provision relating to the carry-forward of disallowed losses from sales or exchanges of stocks and bonds held two years or less was repealed by the National Recovery Act before it became effective. END OF FOOTNOTES
IV. Critical Analysis Of Present Tax Treatment Of Capital Gains And Losses Of Individuals
If income taxes applicable to individuals were levied at a single uniform proportional rate, and if the rate remained unchanged, the fact that gains realized in a single year may represent those that had accrued over a long period of years would create no problem. The aggregate taxes paid by a taxpayer on a given amount of gain would be the same whether portions of that gain were realized each year, or whether the whole gain was realized in a lump sum in a single year.
Under a system of graduated progressive rates, however, the realization in a single year of gains that had accrued over five or ten years subjects such gains to higher taxes than are applicable to sources of income realized during the years of accrual.
The present tax treatment accorded the capital gains and losses of individuals was designed primarily to solve this problem, by including in taxable income capital gains and (subject to the limitation) losses to the extent of certain percentages which vary with the length of time assets are held. The percentages are as follows:
Percentage of gain Years or loss included asset held in income 1 or less 100 1+ to 2 80 2+ to 5 40 5+ to 10 30 Over 10 30
A. Equity With Respect To Gains
Arbitrary though the present system may be in many respects, it constitutes an improvement over the previous system in two important respects. In the first place, the taxation of capital gains is not divorced from the progressive individual income tax schedule. Secondly, all classes of income taxpayers enjoy favored treatment of their capital gains, and not only the upper income classes, as formerly.
To measure the degree to which the present treatment conforms to the requirements of equity, some standard must be agreed upon. Ideally such a standard might be found in the aggregate taxes that would have been payable if the realized capital gain had been reported in segments, year by year, as it in fact accrued, and subjected to the tax rates then in force. The tax under this standard would very with fluctuations in the individual's ordinary income, with changes in the tax rates, and with changes in the annual amounts of appreciation in value. The practical difficulties of applying such a such standard appear to be insuperable, for the present at least.
A more practicable approach to a standard of equity may be made by assuming that an average amount of capital gains had been realized evenly over the number of years during which the asset was held; that the individual's other income remained constant; and that the current tax rates were in force throughout the period. A fair tax on a realized capital gain under this standard would be determined by dividing the capital gain by the number of years during which the asset had been held, adding the average amount to the individual's other income in the year of realization, determining the tax applicable to this average amount, and multiplying this tax by the number of years during which the asset had been held.
Judged by this standard -- which may be called the "accrual basis" -- capital gains are now subjected to decidedly preferential treatment as compared with other forms of income. Concrete measures of the extent to which the taxes now imposed upon capital gains are less than those that would be imposed by the standard just described are presented for selected cases in Table I. (For tables, see Appendix A.) It will be observed that the present taxes range from 20 percent to 70 percent lower in these selected cases than the taxes which would be payable under the standard described.
If the effect of the present tax treatment of capital gains were merely confined to a uniform preferential treatment of this type of income, this could conceivably be justified on grounds of practical expediency, and on the further ground, perhaps, that our treatment of capital losses is unduly harsh. The fact of the matter, however, as is illustrated in the table, is that the present treatment, while decidedly preferential to capital gains in practically all cases, is whimsical in its effects; and its general tendency is to give disproportionate tax preference to individuals with large incomes.
The difficulty does not lie primarily in the specific step-down percentages contained in the present law. The fact of the matter is that it is inherently impossible, under a progressive rate system, to design any series of step-downs in the proportions of taxable capital gains which would yield results entirely consistent with the standard described above.
B. Inequity With Respect To Losses.
Capital losses, after application of the statutory percentages, are deductible only to the extent of $2,000 plus taxable capital gains, with no carry-forward of losses.
This treatment of capital losses is inequitable. In the first place, the limitation means that no consideration whatever is given excess losses in the current year. Thus, a taxpayer may be required to pay an income tax on ordinary income in spite of the fact that he has excess capital losses to an extent sufficient to more than offset his ordinary income. In the second place, the taxpayer is not allowed to carry forward capital losses against future capital gains. The widespread sense of injustice flowing out of this treatment impairs cooperation between taxpayers and the Government in the administration of the income tax. In the minds of many, the present treatment is so patently unjust as to be repugnant to all sense of fair play.
C. Encouragement Of Capital Gains As Source Of Income.
One of the most important criticisms levied against the present tax treatment of capital gains has been that wealthy individuals are discouraged from embarking their capital upon new enterprises. Large-scale ventures into new fields cannot commonly look to public financing to provide their capital requirements. Most such ventures require one or more men of large means who are willing to take the risks involved. What we may term the "enterprise capital" provided by such individuals performs a highly useful economic and social service; and it is precisely such individuals who are best fitted to assume the necessary risks. But the prospect that much of the gains, if any, will go to the tax collector, while the losses, if any, will be allowed only in part as a deduction against taxable income, it is contended, removes much of the incentive for "enterprise capital".
Now the most striking characteristic of our tax treatment of capital gains, in conjunction with the schedule of individual income tax rates, is that an extremely strong inducement is offered to wealthy individuals to make their new investments precisely in such manner as will cause their returns to take the form of capital gains. This may best be made clear by concrete examples.
Assume an individual with other surtax income of $200,000 who has $1,000,000 to invest. If he can find an investment which, over a period of 10 years, will return him a capital gain averaging only 5 percent per annum, compounded annually, he would discover upon calculation that his net return, after taxes, would be equivalent to a 12.8 percent annual yield on an ordinary income-producing investment. He would find that over a period of 5 years he would need to obtain an annual yield of 11.5 percent from an ordinary income-producing investment to equal the net return, after taxes, that he might obtain through a capital gain averaging only 5 percent per annum. Even on an investment for only 1 year (1 day should be added to each of these periods), a 5 percent capital gain would give him just as large a return after taxes as a 7.1 percent yield in interest, dividends, rents or royalties.
Similarly, a capital gain averaging 10 percent per annum, compounded annually, would give him the equivalent, after taxes, of annual yields of fully taxable income of 27.7 percent, 24.6 percent and 14.5 percent respectively, according as he held the capital gain investment for just over 10, 5, or 1 years.
He would need a capital gain averaging only 1.5 percent per annum, compounded annually, over a period of 10 years, to obtain the same net income, after taxes, that he would derive from a 3 1/2 percent bond; and even over a period of only 1 year and a day, a capital gain of 2 1/2 percent would equal his net yield after taxes from a 3 1/2 percent bond; etc.
These and other examples illustrating the preferential tax treatment now accorded income obtained in the form of capital gains, as compared with other forms of income, are presented in greater detail in Tables II, III, IV, and V. The clear conclusion of these considerations is that well-informed wealthy men possess a very powerful incentive under present law to take a large proportion of their total income in the form of capital gains.
D. Effect On Tax-exempt Investment.
There is no doubt that capital gains taxes, like any taxes on investment income, increase the relative attractiveness, other things being equal, of tax-exempt investments. But the fact is that capital gains themselves constitute, in effect, a partially tax-exempt type of income under present law. Exemption from income taxes is of greatest value, of course, to individuals subject to the highest surtaxes. An individual with $200,000 of other surtax net income need obtain a capital gain averaging only 3-7 percent per annum, compounded annually over a ten-year period, on a new investment of $1,000,000 to obtain the same net yield after taxes that he could obtain from a 3 percent wholly tax-exempt bond; and a capital gain averaging only 5 percent per annum would give him a net tax-free income averaging 4.1 percent per annum. (See Tables II, III, IV, and V.)
E. Variability In Revenue
The inclusion of capital gains and losses for purposes of determining the income tax base accentuates the instability of income tax revenues. This is true of the present and past treatment, and doubtless would be true under any of the hitherto untried plans. The fact that capital gains constitute an erratic source of income is not sufficient reason for affording them preferential tax status. It would be a mistake to design the character of capital gains taxation with stability of revenue as the primary objective. Stability of income tax revenues, if it be at all attainable, must be reached by stabilizing our entire economy, or by a system of averaging the tax base. It cannot be reached, whether capital gains are included or excluded in the income tax base, under a system of progressive income tax rates in an economy that is characterized by severe business depressions.
In such an economy, the desirability of stable Federal revenues is extremely doubtful. There are broad economic grounds for the position that, within limits, fluctuations in Federal revenues in response to fluctuations in business conditions are highly desirable. Federal Government finance is capable of providing one of the most important elements of flexibility in the economic structure. In periods of depression, when bank credit has been or is being contracted and other avenues of investment are temporarily unattractive to those with idle funds, an excess of Government expenditures over tax receipts, financed by debt instruments, serves the important function, among others, of moderating the decline in the Nation's purchasing power, and an excess of tax receipts over ordinary expenditures in prosperous times is capable of moderating booms.
F. Effect On Securities Markets /3/
There are three chief respects in which our present capital gains tax provisions may be said to influence the timing of capital transactions:
(1) Income taxes on capital gains may be POSTPONED, at the option of the taxpayer, by delaying the formal realization of such gains.
(2) Income taxes on capital gains may be REDUCED, at the option of the taxpayer, by deferring formal realization until one or more of the four "step-down" intervals provided in the law has elapsed.
(3) Income taxes on capital gains may be COMPLETELY AVOIDED, at the option of the taxpayer, by foregoing formal realization during his lifetime, leaving such realization to be accomplished by his heirs.
In analyzing the effects of these influences upon the decisions of the investors, it is important to bear in mind that though real, they are modifying rather than primary influences; and that they operate among a myriad of other forces.
1. Postponement Of Tax Liability
There can be little doubt that the mere fact that an individual may definitely postpone or avoid liability for additional income taxes by refraining from consummating a capital transaction, constitutes in itself a motive to so refrain. Capital gains taxes of the present character may be regarded, from this point of view, as a species of substantial transfer tax. Like brokerage commissions and stamp taxes, but far more heavily, in many cases, they interpose a cost, and therefore an obstacle, against the sale of capital assets.
Further, the proceeds of most sales of capital assets are converted into new investments. Most investors must face the consideration, therefore, that the superiority of their contemplated substitute investments is yet to be proved, whereas the additional tax liability arising out of the sale of the old investments is certain. A new investment must not only be more attractive than the old, but sufficiently more attractive, in addition, to offset the capital gains tax which the transfer will entail. The policies of trustees and managers of estates are sometimes decisively influenced by these considerations. Because these factors are hard to weigh, many investors are apt to place an irrationally heavy weight upon the tax factor.
The psychological obstacle to the realization of large capital gains by investors with substantial taxable incomes may easily be illustrated:
In 1933, an investor purchased 2,000 shares of Phelps-Dodge cohort stock at $10 a share. When the stock reached $58 a share in 1937, the owner concluded that it was time to sell, particularly in view of his belief that copper prices and perhaps business generally were due to decline. Before selling, the investor computed his prospective taxes. He estimated that his surtax net income from other sources would be $50,000. The sale of his Phelps-Dodge stock would give him $96,000 of profit, of which 60 percent, or $57,600, would be subject to income tax. His normal and surtaxes on the taxable portion of his Phelps-Dodge profit would amount to $29,012, equal to about 14 1/2 points in the price of the stock. The market price of his Phelps-Dodge stock could decline by 25 percent without the decline quite equaling the amount of tax he would have to pay if he sold before the decline. If he contemplated the purchase of a different stock with the proceeds of his sale, he would have to take account of the fact that after allowing for his tax he would have available only 75 percent of these proceeds for the substitute investment. Though persuasive to some investors, these grounds for delaying liquidation are not altogether sound, as is brought out in Section V. (Page 24)
Likewise, the existing or any other restrictions on the deductibility of losses on capital transactions influence the timing of the latter. On the one hand, the existing law, by limiting the deductibility of capital losses to the amount of taxable capital gains plus $2,000, provides a definite incentive to concentrate the realization of losses in years when capital gains are large and to defer the realization of capital losses in years when capital gains and other income are small. On the other hand, by applying the step-down schedule to the amount of capital losses deductible, the present law encourages an early realization of losses. In practice, these conflicting tendencies are further complicated by the fact that the very business and market conditions that favor the possibility of realizing large capital gains reduce the possibility of realizing large capital losses, and vice versa.
2. Reduction In Tax Liability Through Postponement Of Realization
The existence of tax differentials based upon definite time intervals should logically influence the timing of many capital transactions. Particularly where the gains are large, and subject to high surtax rates, the privilege of avoiding taxes on 20 to 70 percent of such gains by postponing legal realization for one to ten years may naturally be expected to provide a powerful induce-sent for such postponement.
The degree of this inducement is closely dependent upon the surtax bracket in which additional income will fall. An individual with a surtax net income of $10,000, who has an unrealized capital gain of $2,000 on a stock held for just over two years, would be subject to an additional income tax of $132 if he realized his gain immediately, and could look forward to a tax saving of only $44 if he delayed realization for an additional three years. An individual with a surtax net income of $100,000 with the same unrealized capital gain, would be liable to an additional tax of $744 if he sold the stock immediately, but could save $248 in taxes by delaying liquidation for an additional three years.
Some investors may also be influenced by the consideration that postponement of realization of capital gains until after the close of a taxable year gives them, in effect, a free loan, for an additional year of an amount equal to the taxes that would have been payable on the capital gains if realized; and that this allows them to maintain a larger position in the market.
3. Complete Avoidance Of Capital Gains Taxes
Capital gains taxes may be avoided completely if realization of gains is not made during an individual's lifetime and the assets incorporating gains are bequeathed to his heirs.
Any individual well past middle life who possesses securities or other properties acquired at costs substantially below the prices that he might currently realize thereon, is thereby provided with a distinct and powerful incentive to refrain from selling them. If he does sell them, he will be subject to income taxes on at least 30 percent of all the capital gains that he realizes, unless he has suffered offsetting losses. If he does not sell them, he and his heirs escape tax liability on such gains forever.
In addition, the ability to make gifts directly, or indirectly through trusts, as well as charitable contributions, in the form of assets incorporating capital gains, likewise provides a deterrent to realization, because the capital gains incorporated in the assets are not subjected to income taxes at the time of transfer.
G. Tax Avoidance On Capital Gains Increments Included In Property Transferred At Death, By Inter Vivos Gifts And In Charitable Contributions
At first glance, it may appear that the tax avoidance arising through the transfer at death of capital assets incorporating capital gains is largely offset by the higher total estate taxes which result because the total bequest is larger by the amount of the capital gains tax avoidance. It should be noted that the loophole cannot be completely sealed by this offset so long as the estate tax rates are under 100 percent.
The situation with respect to INTER VIVOS gifts is somewhat similar in character. An individual who divides among his children properties incorporating large unrealized capital gains is not subject to capital gains taxes on the gains included in the gifts. The children are likewise not subject to capital gains taxes in connection with these gifts, unless and until they liquidate the properties. What is more, the distribution of the gains among several individuals and, commonly, among individuals of smaller income than the transferor, reduces the aggregate tax liability upon the capital gains. As in the case of the estate tax, the avoidance of the tax on capital gains cannot be offset completely so long as the gift tax rates are under 100 percent.
In addition, an individual making donations to charity in the form of assets incorporating capital gains also avoids taxes because the law does not recognize that such transactions result in realization of capital gains by the donor; and the charitable and similar institutions are not subject to taxation.
V. Capital Gains Taxation And The Securities Markets
The most persistent objection voiced against capital gains taxes is the contention that they greatly obstruct the trade in securities and other capital assets. It is argued that many potential transactions that would otherwise be undertaken are postponed for varying periods, or indefinitely, to avoid or reduce taxation on the gains that would be realized in connection therewith. The mobility of capital and enterprise is thereby retarded.
It is also urged that when stock prices are rising, the liquidation of over-priced securities, which might check and moderate an unhealthy rise, is discouraged, thereby contributing to an exaggeration of the rise and to a sharper subsequent decline. In consequence, it is held, stock market booms and collapses are accentuated.
There is some measure of truth in these contentions; but it must be emphasized that, except in certain special cases, the scope and force of tax influences upon the sale of securities may be easily exaggerated. In general, neither the available empirical evidence nor analysis of the underlying factors supports the large claims often made in this connection.
A. General Limitations Upon The Tax Influence.
1. Immobility Of Mass Of Capital Assets
In practice, we know that the great mass of capital assets is owned by persons, natural or legal, whose continued ownership of such assets would be largely unaffected by the character of our capital gains tax provisions. This is not only true of most physical properties, but it is also true of the great mass of securities. A large proportion of the latter is held by controlling stockholding interests in the various corporations, and a large part of the remainder is held for long-term investment for the interest and dividend income.
2. Short-term Speculation Not Greatly Affected
Further, even the effectively mobile fraction of the country's capital assets is not uniformly sensitive to the character of our capital gains tax provisions. It is important to distinguish, in this connection, between traders, speculators, and investors in securities. The securities operations of traders are not directly affected by the capital gains tax provisions because it is of the essence of their function that their operations are extremely short-term in character -- well within one year. Gains from transactions in capital assets constitute their normal source of income; and such gains on the part of professional traders would presumably be taxed as ordinary income, as they are in England, even if taxes on capital gains generally were abolished. A substantial proportion of speculators in securities also seek to exploit short-term movements primarily; and the operations of such individuals are likewise relatively insensitive to capital gains tax provisions. Traders and short-term speculators in securities account for a very significant fraction of the total volume of trading in securities.
Data made available in recent years indicate that the operations of stock exchange members alone, among traders and speculators, bulk surprisingly large in the total volume of trading in listed securities. Thus, the figures compiled by the Senate Committee on Banking and Currency for the month of July 1933, disclosed that the percentage of members' trading in relation to all shares bought and sold on the New York Stock Exchange was 27.01 percent, and on the New York Curb Exchange, 27.48 percent, and on 27 other exchanges, 12.36 percent (Senate Report No. 1455, 73rd Congress, 2nd Session, pages 19-21). Likewise, the Securities and Exchange Commission, in its report of June 20, 1936, on the "Feasibility and Advisability of the Complete Segregation of the Functions of Dealer and Broker" (pages 12-13) noted that in the 25 weeks between June 24, 1935 and December 14, 1935, members' trading in all stocks on the New York Stock Exchange, exclusive of transactions by odd-lot dealers, totaled 24 percent of the reported purchases and sales; and that the average weekly percentage of the total trading accounted for by members of the exchange was also 24 percent. The proportion of the total trading on the New York Curb Exchange accounted for by members during substantially the same period was not greatly different from the proportion cited for the New York Stock Exchange.
3. Greater Importance Of Business Factors To Investors
Even among investors, it must be emphasized that tax factors operate in practice among a welter of other considerations, and that, by reason of this fact, they are commonly robbed of a great deal of their force. An individual who comes to the conclusion that the competitive position and profits prospects of the two leading American producers of tin cans are going to be undermined by the entrance into this field of the Owens-Illinois Glass Company and other important container manufacturers, is very unlikely, if well advised, to postpone for eight or nine months the sale of American Can or Continental Can common stocks in order to obtain tax exemption for an additional 20 percent of his possible profits from the sale of such stocks. A much smaller decline in the market price of the stock would more than offset the reduction in taxes. This is true in nearly all cases where the motive of the sale is withdrawal from a declining, threatened, or embarrassed industry or enterprise.
Assume an individual with other surtax net income of $50,000 who has an unrealized profit of $2,000 on 100 shares of Continental Can that he has held for just over 18 months. If this individual sells his stock immediately, $1,600 of his profit will be subject to income taxes of 35 percent, or $560. If he holds his stock for an additional six months, only $1,200 of his profit would be taxable, and the tax would be $420 -- a tax saving of $140. A decline of less than 2 points in the price of the stock would wipe out the tax advantage of holding.
The same considerations apply more generally. When owners of securities conclude that the business situation as a whole is deteriorating, or, more narrowly, when they conclude that the stock market faces a substantial decline, the possible tax economies of delaying liquidation are in most cases considerably less than the depreciation that seems imminent in the market value of securities. The cyclical and even some of the secondary fluctuations in securities prices are so great as to overshadow tax considerations on a purely rational basis; though there is little doubt that irrational repugnance to incurring an avoidable or postponable tax liability gives the tax consideration somewhat greater weight in practice than it would merit on a purely rational basis.
4. Contingent Tax Liability Of Unrealized Capital Gains
The importance of these market and business factors, even in the case of a wealthy individual who hesitates to realize large capital gains, may be illustrated by referring again to the example previously given (page 19) of an individual who purchased 2,000 shares of Phelps-Dodge stock in 1933 at $10 a share and faced the question of whether, in view of the income tax of $29,012 on his capital gains, he could afford to sell the stock at $58. It was pointed out as an illustration of the psychological obstacle to such sale that the stock could decline by slightly more than 25 percent before the depreciation would equal the tax liability that would be incurred by the investor as a result of the sale. The intelligent investor, however, would also take account of the fact that the continued holding of the Phelps-Dodge stock during a period when it depreciated by 25 percent would still leave him a large contingent tax liability, whereas the sale of the stock at $58 would discharge this contingent tax liability.
Unless the investor hopes to avoid capital gains taxes entirely by holding the stock until his death, or expects the existing capital gains tax provisions to be greatly relaxed or eliminated, or counts on the availability of future capital losses to offset his capital gain, he must regard his contingent tax liability on unrealized capital gains as a real factor.
5. Explanations Of Concentration Of Long-held Assets Among The Wealthy
Data obtained from income tax returns over a period of years clearly reveal that the bulk of the net capital gains realized by members of the upper income groups have been realized consistently on assets held for more than two years. The 1934 figures, (Table VIII) which are available in greater detail, show what was probably true in previous years -- that the great bulk of capital gains realized by members of the highest income groups was realized on assets held for very long periods. Although our capital gains tax provisions no doubt contribute to this result, it is extremely doubtful that they have been of decisive importance in this connection.
The most important of these factors is that very sizeable capital gains normally arise only over a fairly long period of years. The owner of a valuable piece of urban real estate can usually realize a net gain of several hundred percent, if he realizes such a gain at all, only by holding the property for a prolonged rise. In the same way, a man who multiplies his capital in an industrial enterprise by 20 or 30 times cannot normally realize such results except over a long period.
A sizeable proportion of the large capital gains realized by members of the highest income groups, moreover, is realized in connection with the sale to the public, after many years, of what had previously been family or other closely held corporations. Small machine shops, largely owned by single individuals, or a few partners, for example, have frequently grown into sizeable automobile accessory producers before their securities have been distributed, with the aid of investment bankers, to investors generally. The capital gains incorporated in such enterprises, when formally realized, are bunched in the year or years of sale to the public, though they had accrued over a period of many years.
These forces operating toward the concentration of long-held assets as the major source of capital gains among members of the higher income groups would appear to be the primary ones, and they would operate powerfully in the same direction, even if complete income tax exemption were accorded capital gains. To a considerable degree, the step-downs in the taxable proportion of realized capital gains, according to the length of time during which the asset is held, serve not so much, in practice, to cause individuals to delay liquidation as to confer tax benefits upon individuals who, for other reasons, would hold their assets for long periods of time in any event. And the chief beneficiaries of the present "step-down" treatment of capital gains are, in practice, individuals with large incomes.
6. Average Of Stock Prices Not Necessarily Affected By Realization
It should be emphasized that the level of stock market prices would not necessarily be lowered if a drastic reduction in capital gains taxes led to a greatly increased volume of realizing sales. If those who took advantage of the relaxation in capital gains taxes to realize their gains, purchased other securities with the proceeds of their sales, the increase in the demand for stock market securities in the aggregate would be just as great as the increase in the supply of securities. A significant reduction in the average level of stock market prices could be expected to follow a substantial lowering of capital gains taxes only if the latter induced an important fraction of large holders of stocks to liquidate without using the proceeds to buy other stocks. Such an effect is unlikely during a period of widespread recovery in corporate earning power.
The alleged moderating influence upon the rising trend of the securities markets of a drastic reduction in capital gains taxes is particularly debatable during a period of underlying business improvement. It is true that such reduction would have the technical effect of removing existing deterrents to the sale of particular securities by particular individuals holding large unrealized gains therein. But it would provide no deterrent whatever to the immediate reinvestment in other securities by these individuals of the proceeds of their sales. On the contrary, the very fact that the taxation of capital gains had been substantially reduced would make the stock market more attractive than ever. Stock market gains, which even now enjoy preferential tax treatment if the securities are held for more than one year, would be given an even more privileged tax status among the various sources of individual incomes.
B. Analysis Of The Effects Of Past Tax Treatment Of Capital Gains And Losses On The Securities Market
The evidence provided by the stock market history of the last 15 years reinforces the conclusions drawn from other considerations in indicating that the role played by the tax treatment of capital gains as a determinant of the speculative climate is not of major importance.
1. The Twenties
a. Overshadowing Importance of Non-tax Influences: It has already been observed (page 6) that the principal motivation for the optional exclusion of capital gains from ordinary income and the taxation of such excluded gains at a flat rate of 12 1/2 percent, as was incorporated in the Revenue Act of 1921, was the belief that high tax rates on capital gains were obstructing normal transactions in capital assets.
Now the influence of the alteration in tax treatment, if it was a significant influence, was only one of many factors that operated during this period to swell the volume of capital transactions and the volume of realized capital gains. The aggregate volume of bank deposits in the United States increased by more than $18 billions between June 30, 1921 and June 30, 1929, an increase of 50 percent. The Federal Reserve Board index of industrial production rose from 67 in 1921 to 119 in 1929, or by 78 percent. The middle Twenties, as everyone knows, saw a widespread wave of speculation in urban real estate; the later Twenties, an unparalleled volume of speculation in the stock markets. The period as a whole was marked by numerous large corporate mergers, rising corporate profits, and a stimulus to domestic industry created by our large foreign loans. The later Twenties was marked by the receipt of substantial amounts of foreign funds attracted to our markets in response to both the high rates of interest in our call money market and the rising trend of our securities prices; and it was marked by, among other relevant factors, the availability for stock market speculation of huge sums of capital raised by corporations and loaned out at call through New York banks, and, most of all, by a pronounced speculative temper.
It seems reasonable to believe that a careful historian who attempted to appraise the factors contributing to the rising volume of realized capital gains during the Twenties would give most of his attention to the factors cited in the preceding paragraph, and only a very small part to the changes in the tax treatment of capital gains.
b. The Rising Stock Market: The period of extraordinarily large capital gains may be said to begin with 1924. The Dow-Jones index of industrial stock prices in December of that year averaged 114.3, as compared with 94.1 in December 1923. Between December 1924, and December 1925, the monthly average of the daily figures of the Dow-Jones index of industrial stock prices rose from 114.3 to 154.3; and the total net profits from the sale of capital assets reported by individuals nearly doubled. Between December 1925 and December 1926, this index showed a relatively small net increase, 5 points, and there was a decline in 1926 in the total net profits from the sale of capital assets reported by individuals. In 1928, the year for which the largest volume of profits from the sale of capital assets was reported, the December average of this index was 280.8. In 1929, the year for which the second largest volume of such profits was reported, this index averaged 246.9 for December and 311.2 for the year as a whole.
It seems clear that the extraordinary volume of realized capital gains during the Twenties was primarily a function of the rising stock market and of the underlying factors that this market reflected.