Revenue and Welfare Implications for a Capital Gains Tax Cut
Patric H. Hendershott
This paper uses a general equilibrium model to simulate both the
effects of a preferential capital-gains tax rate on total income tax
revenues and the effects of a revenue-neutral substitution between a capital
gains preference and marginal income tax rates on economic efficiency and
the distribution of income. In the simulations, a capital gains preference
increases efficiency by reducing tax distortions between untaxed assets
(household and state and local capital) and taxable business sector assets
and between realized and unrealized capital gains (the "lock-in" effect),
but reduces efficiency by increasing tax distortions between corporate
dividends and retained earnings and between financial assets that produce
capital gain income and those that produce ordinary income. Because the
model treats aggregate factor supplies as fixed, however, the simulations do
not capture the efficiency gain from reducing the tax distortion between
current and future consumption or the loss from increasing the tax
distortion between current consumption and leisure (or untaxed labor).
The net estimated welfare effects depend on two parameters: the
elasticity of capital gains realizations with respect to a change in the
capital gains tax rate and the elasticity of the dividend-payout ratio with
respect to a change in the tax cost of dividends relative to retentions.
With no payout response, the net welfare effect from a 15% maximum rate on
capital gains is positive for a wide range of realizations elasticities.
With a high payout elasticity, the net welfare effect is slightly positive
for high estimates of the realizations elasticity and slightly negative for
low estimates of the realizations elasticity. The welfare changes, both
positive and negative, mainly affect taxpayers with income of $50,000 and
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