Taking Sides – Taxing capital gains: Here’s a better way

It’s not too often that someone will publicly thumb their nose at the person who butters their bread. But cutting the capital gains tax is the kind of issue that forces even the best of friends to agree to disagree – or worse.

And so it was last week when Arthur Levitt took the podium at Schwab Institutional’s Impact 2001 conference.

During remarks to about 500 advisers at Seattle’s cavernous convention center, the former Securities and Exchange Commission chairman voiced strong opposition to any plan to cut the tax on capital gains.

Earlier in the day, the founder, chairman and co-CEO of Charles Schwab Corp., had stood before the same audience and urged exactly the opposite.

In another speech, former Secretary of State George Schultz echoed Charles R. Schwab’s thoughts.

Mr. Schultz’s position was perhaps understandable. He noted in a joking aside that he happens to be a director on Schwab’s board.

But what gives with Mr. Levitt?

After all, he is a denizen of Wall Street. He spent 26 years working in that bastion of capitalism, where opposing a cut in the capital gains tax is tantamount to blasphemy.

He’s as comfortable in Gucci loafers and pinstriped suits as any investment banker at Goldman Sachs, except when it comes to cutting the tax.

The issue is especially important in the wake of terrorist attacks on the World Trade Center and the Pentagon.

The already slowing economy is now reeling from the aftershocks of those heinous crimes, and lawmakers in Washington are rushing to cobble together an economic stimulus package that might help keep things from getting worse.

But a divisive split over the tax among Democrats, Republicans and the Bush administration is bogging down efforts to come up with a bill.

The controversy flared up in the days after the attacks as lawmakers and corporate lobbyists clamored for a wide array of special-interest tax breaks in the name of economic revival.

hitchhikers?

The debate took on a highly emotional tone after individuals – dubbed “hitchhikers” by some in the media – were accused of jumping on the patriotic bandwagon solely to advance their pet causes.

In one of those rare, politics-makes-strange-bedfellows moments, Mr. Bush sided with Democrats against a cut in the capital gains tax. The move was part of the president’s desire to foster bipartisanship in Washington following the attacks.

But now Republicans on Capitol Hill are vowing to press ahead with their own stimulus package, which includes cutting capital gains taxes.

According to Mr. Levitt, such a move would do nothing to help the economy in the short term and would almost certainly lead to a sell-off of equities, which is the last thing the stock market needs now.

What’s more, he said, cutting capital gains taxes would also create upward pressure on long-term interest rates by weakening the federal government fiscally at a time when its obligations are rapidly rising.

Mr. Schultz also made a key point. The economy’s ability to recover, he noted, is tied directly to the ability of investors to reallocate their capital to more-productive uses.

The tax, he said, is in effect a toll on the movement of capital. As such, it’s hindering its efficient reallocation and curbing the economy’s ability to recover.

If that’s the case, then why not this idea: reduce or even eliminate the capital gains tax in cases where individuals reinvest an amount equivalent to their realized gains within a certain period of time – say, three or six months.

If the individual chose to pocket the gains, then the profits would be taxed at the full marginal rate just like income. That way, there would be a strong incentive to keep the capital working in the market.

The idea is not without precedent. It’s similar to the way that profits from the sale of a home were once treated for tax purposes. Individuals had to reinvest them in a home of equal or greater value within a certain time to avoid paying tax on the gain.

Most of all, the idea would defeat the argument that cutting the capital gains tax is just another means for the rich to get richer. Such a victory is a worthy goal all by itself.