TAXM FOUNDATION SPECIAL

March 1995 B Gains Taxation and Small House Small Business Committee Testimony

By J.D. Foster The following testimony was presente d I would like to emphasize to the Commit- Executive Director and by Dr. Foster before the House Small Bust - tee that the Foundation is not a Chief Economist ness Committee on February 22, 1995. "grassroots" organization, a trade association , Tax Foundation or a lobbying organization . We do not take po- Mr. Chairman and Members of the Com- sitions on specific legislation or legislative pro- mittee, my name is J .D. Foster and I am the Ex- posals. Our goal is to explain as precisely an d ecutive Director and Chief Economist of the clearly as we can the current state of fisca l Tax Foundation . It is an honor for me to ap- policy and the consequences of particular leg- pear before your Committee today on behal f islation in the light of the tax principles delin- of the Tax Foundation to discuss the federa l eated below, so that you, the policymakers , and its consequences for may make informed decisions . America's small . When it was established in the late 1930s , The Tax Foundation is a non-, non - the Tax Foundation's founding fathers set out partisan research and public education organi- certain principles of taxation which the Tax zation that has been monitoring fiscal policy at Foundation would promote and which woul d all levels of government since 1937 . We have guide our analysis of tax proposals . According approximately 600 contributors, consisting o f to these principles, a good tax system should : large and small corporate and non-corporat e • Be as simple as possible — complexity makes accurate tax compliance needlessly ex - pensive and diminishes the public's willing- ness to comply with the law ; • Not be retroactive — taxpayers must have confidence in the law as it exists entering Combined with the estate tax, which also into a transaction ; • Raise revenue, not micromanage the wealth, the capital gains tax is the economy with subsidies and penalties; t •Not be continually rewritten — frequent most important tax a small business mus change lessens citizen understanding of the contend with at the start of the business tax code and complicates long-term economic planning; and, and at the end of the entrepreneur's asso- • Be implemented recognizing the com- ciation with the business. petitive nature of the world economy.

I commend the Committee for holding this hearing on capital gains taxation and small businesses. A great deal has been written and businesses, charitable foundations, and indi- said about the effects of the capital gains tax viduals. Our contributors cover practically ev- and your efforts to work through this body o f ery region of the country and every industry work is certainly no small task . category. 2

A Tax History of a Small tax return must be high . The capital gains tax raises the before-tax return your new s Business are demanding and the control they insist o n To put the capital gains tax into perspec- exercising in order to make the capital infu- tive, consider the following short tax history o f sion. a small business. Suppose you had an idea for Fortunately, all goes well, the venture capi- a new product or service, or suppose you sa w talists make the , your business ex- a market opportunity missed by others. And pands rapidly, and profits continue to clim b suppose you decided to start your own busi- handsomely . But payroll taxes continue t o ness to take advantage of this opportunity, al l drain the flow you need to meet your in- the while knowing that the vast majority of vestors' demands, the income tax continues t o small businesses fail within the first couple of shrink your after-tax resources, and the capital years. gains tax continues to stunt your business' s Your first task is to raise the capital growth by limiting your ability to attract inves- needed to open your doors. As is well known , tors. Moreover, the income tax is starting t o the traditional capital markets are generally really bite, so you find yourself increasingly available only to established businesses, so yo u spending valuable management time in ta x talk to your local banker only to learn tha t planning to keep your effective tax rate under banks usually make loans to on-going busi- control . Pretty soon, this diversion of your en- nesses . He will make you the loan, however, if ergies is felt in terms of business opportunitie s you can collateralize the entire amount . Being lost or decisions made late . a citizen of limited means you turn instead to Opportunities abound and you need mor e your own savings, and to your family an d capital yet, but now you are large enough to is- friends to raise the seed corn that will give sue shares on one of the exchanges . your dream a chance . Once again, however, the capital gains tax is At this early stage, the only tax likely to af- hiking up the returns demanded by . fect your business is the capital gains tax . Any- The shares you issue don't bring as high a one lending capital, particularly for such a price as you might have hoped because th e risky venture as a new business, does so with capital gains tax reduces the after-tax return t o the expectation of a large return on his or her the investors. investment. The capital gains tax diminishes Many years later your business is a success , the after-tax of that return, thereby dis- you've had a good career, and you have jus t couraging the investment . met with a group from another business that Suppose you scraped together the capita l has made an offer to buy your shares in th e to rent some space, buy some equipment, pay business at a very fair price . What to do? If your workers, and open for business . If you you sell the shares, then you will owe an enor- are like most small businesses, your hopes fo r mous amount of capital gains tax . The alterna- turning a profit lie somewhere in the future. tive is to pass the business along to your son For now, all you need to worry about is cover- and daughter, but then they will be saddle d ing your costs, among which are the Social Se- with a large estate tax liability and the banker s curity tax, the Hospital Insurance tax, and th e aren't sure the business can withstand such a Unemployment Insurance tax which you must liability. collect based on your payroll whether you ar e in the black or deep in the red . In frustration , Epilogue you find these taxes draining the life blood of The moral of this story is that the capital your fledgling business—your . gains tax is a serious brake on business expan - Some time passes and your business turn s sion at every stage . Combined with the estat e a profit for the year . Now you get to start wor- tax, which also taxes wealth, the capital gain s rying about income taxes as your silent part- tax is the most important tax a small busines s ner, the federal government, begins to clai m must contend with at the start of the business its . and at the end of the entrepreneur's associa- As it turns out, you were right all along — tion with the business . there is a real opportunity here, but you need more capital . Still too small to turn to the The Capital Gains Tax and In- regular equity markets, you contact know n venture capitalists in your area or who are centives known to be interested in your industry. For- Capital is the net total of what individuals tunately, they are interested in making the in - have saved over their lifetimes. Individuals in- vestment, but the capital gains tax is again an vest, first, to preserve the value of their capita l issue. The risks remain high and so the after - against inflation and, second, to increase the

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value of their capital . Investing means pur- allow the investor to receive the after-tax re- chasing an . An asset's price is deter- quired . The difference between mined by the after-tax income stream it is ex- the pre-tax and the after-tax returns is calle d pected to generate, discounted to reflect ex- the tax wedge. Higher taxes on investment in- pected inflation, a minimal required rate of re- come raise the tax wedge and reduce th e turn, and the degree of uncertainty perceive d range of capable of yielding a suf- to be associated with the investment . In gen- ficient rate of return . Therefore, changes in eral, the asset price may vary, thereby produc- the taxation of capital income alter the capita l ing a capital gain or loss to the asset's owner, stock the economy can profitably employ , either through a change in the expected in- which, in turn, alters the rate of investment a s come stream, a change in the tax treatment of the actual capital stock is increased or de- the investment, or a change in the perceptio n creased to match the desired capital stock . of the underlying uncertainty associated wit h The capital gains tax is peculiar in many either the income or the tax treatment. respects when compared to other taxes o n At any time individuals have a relatively capital income, such as the taxation of corpo- risk-free investment alternative in the form of rate income, or of and in - federal securities . These securities are risk- come. The capital gains tax may be deferre d free in the sense that both the principal and in some instances, such as when the taxpayer the stated interest earnings are assured . In a sells a home and rolls any capital gain into th e no-tax world, the interest earned on federal se - purchase of a second home . The recognitio n of a capital gain arising in one tax year may also be deferred until some subsequent yea r when the underlying asset is actually sold . De- spite these and other differences, however, A capital gain may arise for many rea- the effect of the capital gains tax on invest- ment has one important feature in commo n sons. The implications for investors an d with other taxes on investment income—i t for tax policy vary case-by-case, so it i s raises the tax wedge and reduces the desired stock of capital nationally . important when considering capita l gains tax relief to understand which tax Anatomy of a Capital Gain A capital gain may arise for many reasons . disincentives are being abated. The implications for investors and for tax policy vary case-by-case, so it is importan t when considering capital gains tax relief to un- derstand which tax disincentives are being curities would be the product of the rate of in- abated . flation expected over the holding period of the and an after-inflation (real) rate of Inflation interest which is established by the market a s the minimum required to entice investors to Possibly the most dominant source of capi- hold the securities . Even federal securities , tal gains is the rise in asset prices, along wit h therefore, carry the risk that the inflation rate all other prices, due to inflation. Unlike all the or the market's required real rate of return wil l other sources of capital gain described below , increase and offer the potential of unexpected however, to the extent an asset price rises returns should either of those rates decline . along with the general price level, the asset Virtually all other investments carry a de- holder has reaped no real economic gain . The gree of risk exceeding that of federal securi- absence of any real gain when appreci- ties. To entice investors to make these othe r ate due to inflation is the source of the wide- investments, the expected rate of return must spread popular appeal for capital gains index- exceed that for federal securities . Investors es- ing. tablish the return they will require on a more risky investment by considering the inflatio n Corporate Retained Earnings expected over the period, the minimum rat e have long found that internal of return, and the degree of uncertainty about financing through retained earnings can b e the overall investment . These considerations very cost-effective . These earnings, which ar e establish a rate of return required by the mar- the residual after all expenses have been paid , ket on each investment . dividends are distributed, and previously is - When taxes are imposed, the required re - sued debt or equity is redeemed, are fre- turn on an investment increases sufficiently to quently re-invested in the , thereby 4

sustaining the current price of the company' s set price will decline reflecting the increase in shares. the risk of the investment . Suppose a company had 100,000 share s outstanding that were trading at $100 per Windfall Gains share at the beginning of the year . Suppose Frequently in making an investment an in- over the course of the year that the company vestor is aware of a wide range of possible out- had after-tax earnings of $12 per share . If the comes, some of which include exceptiona l tax rate on dividends and capital gains were 3 3 capital gains and losses. The investor may also percent, then over the course of the year th e be aware of the possibility of exceptional capi- share prices would tend to rise to about $10 8 tal gains and losses from sources that were en- per share. If the company declares a tirely unexpected . Such a windfall might arise , distribution of $12 per share, then on a pe r for example, if a farmer were suddenly to fin d share basis the shareholders will receive th e a large reserve of recoverable oil on his land , $12 distribution, pay tax of $4, and watch thei r while he risks a significant loss if he suddenly share prices return to $100, for a net 8 percent finds some rodents listed as endangered spe- return. Alternatively, if at the end of the yea r cies living in his fields . In each case, these the company decides to retain these $12 pe r windfalls are distinguishable from other share earnings for re-investment, then th e sources of capital gains because they are en- share prices will rise to $112. Shareholders tirely unexpected . will have received a 12 percent pre-tax return for the year in the form of unrealized capita l Capital Gains and Small Businesses gains which, when realized, will yield an 8 per - cent after-tax return . Investors in a small business hope for ex- traordinary returns to compensate for the hig h Capital Gains and Scarcity degree of risk inherent in their investments . While any of the described sources of capital Natural resource commodities such as gains may appear in a small business invest- land, petroleum, gold, etc ., also provide capital ment, clearly the only source that offers th e gains for their owners because of their scar - necessary and reasonable potential for achiev- city. At any point in time, there is a fixed sup - ing the desired rate of return is that due to ply of these commodities available to the mar- risk. Capital gains tax relief intended to ben- ket . Over time, as natural resources are de- efit small businesses should be sure to reduc e pleted, unless demand falls due to other force s the tax liability from such gains the most . the prices of these resources naturally rise t o reflect this growing scarcity . As these prices rise they produce capital gains for their own- Reforming the Capital Gains ers . Tax for Small Businesses While derivatives and fancy, high-risk fi- Returns to Risk nancial instruments get the headlines, few in- All investments carry some element of risk, vestments bear as much risk as an investmen t however the nature and degree of risk can var y in a small business . Consequently, these in- tremendously from investment to investment . vestments must offer a reasonable expectatio n Consider an asset that will either yield nothin g of extraordinary returns to lure investors' dol- or will return exactly $10,000 in ten years, an d lars. The capital gains tax raises the pre-tax re - suppose over the course of time that the inves- turns investors will expect . tor will be able to gauge with increasing cer- Capital gains tax relief may take the for m tainty the probability of the $10,000 payoff . of either a reduction in the tax rate, a simple Whatever the probabilities of the payoff at th e exclusion of taxable gain, indexation of the ta x beginning, the asset will begin the year with a base (generally, the purchase price of the as- price somewhere between one penny and set), or an increase in the amount of capita l $10,000 . loss that can be charged against ordinary in- Over time, as more information is acquire d come in a given year. Each form of relief about the probability of the payoff, the risk at- would improve a business's ability to raise eq- tached to the investment will rise and fall ac - uity capital . cording to the portent of the additional infor- In considering an investment in a small mation . Whenever the probability of reaping business, an investor will recognize that capita l the return increases, the price of the asset wil l gains tax liability will probably arise if the in - increase, reflecting the decline in risk . And vestment is successful. On the other hand, in whenever the return seems less likely, the as- the far more likely event that the business will

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not succeed and some or all of the initial in- tal gains relief. It is patently unfair to tax capi- vestment will be lost, the amount of capital tal gains due solely to inflation, particularly loss that may be claimed for the year may be when inflation is, itself, the product of govern- limited. The Internal Revenue Code allows the ment actions . For small business owners, how- taxpayer to use capital losses to offset capital ever, indexing often provides less relief from gains. However, if the losses exceed the gain s the capital gains tax than does a simple exclu- for the year, only $3,000 of the excess capita l sion. The mechanics of indexing are that th e loss may be used to reduce taxable ordinary in- purchase price of the asset is increased by th e come. Any excess capital losses over this percentage increase in the price level . This ad- s amount must be carried forward into the fu- justed basis is then subtracted from the sale . ture. price to determine the taxable capital gain Often, and perhaps typically, the friends Generally, the basis (or original value of th e and family who invest in a small business do business) is very low, so that the indexing ad- not have extensive portfolios that allow th e justment is applied to a relatively small type of asset management that would avoid amount . having to carry capital losses into future tax For example, suppose a business is wort h $25,000 when founded in 1974. In the inter- years . This can significantly reduce the vening years, the general price level has rise n present value of the capital loss and raise th e by a factor of 3, so the inflation-adjusted basi s effective tax cost of the investment. Since such a loss is a distinct possibility facing any for tax purposes would be $75,000 . If the small business investor, the constraint on the business is sold for $100,000, then indexing has protected the investor from owing capita l gains tax on purely inflationary gains and taxe s will only be owed on $25,000 in real capita l gains [$100,000 - $75,000] . In contrast, how- Recent Tax Foundation research . . . ever, if the taxpayer were allowed a 50 per- cent exclusion, then he would have a taxable shows that nearly 20 percent of all taxable capital gain of $37,500 [($100,000 - capital gains accrue to families with in- $25,000)x50 percent] . In this case, indexing is clearly preferable to a simple exclusion . comes below $50,000 annually, and tha t Suppose the final sales price were over half of all taxable capital gains accrue $250,000, instead of $100,000 as in the previ- ous example . In this case, under indexing th e to families with incomes below $200,000. taxpayer would have a taxable capital gain o f $175,000 [$250,000 - $75,000 in adjusted ba- sis], whereas a 50 percent exclusion would leave the taxpayer with a $112,500 taxabl e gain [($250,000 - $25,000 in original basis)x5 0 percent], which is clearly preferable to index- taxpayer's ability to reduce current taxes usin g . Moreover, as the final sales price in- capital losses raises the required return on the ing creases relative to the purchase price, the ta x investment even further . While it is often more relief from a simple exclusion becomes pro- popular to reduce the tax rate on capital gain s gressively more attractive than that from in- as they represent the returns to successful ac- tivity, from the standpoint of the investor, in - dexing. In passing, it is important to note that for creasing the limit on how much capital loss most taxpayers most of the time, indexing pro- can be charged in a given year to ordinary in- vides more relief than would a simple exclu- come can be every bit as valuable . . Only in rare cases when the tax basis is Suppose an investor loses $24,000 in prin- sion very small relative to the final sales price, i .e., cipal on an investment and the investor has n o as occurs for the investor in a successful small capital gains that may be realized to offset th e business, is a simple exclusion less preferable. capital losses . With a $3,000 annual limit , eight years would pass before the taxpaye r Virtually all other criticisms of indexing, such would be able to exhaust the capital losses . In as those dealing with complexity or with th e present value terms, therefore, this $24,000 possibility of tax sheltering, are either incor- capital loss is worth only about $19,000 at rect or grossly exaggerated . today's interest rates . Indexing capital gains for inflation i s Tax Fairness widely recognized as the most fair and mos t In recent years the issue of tax fairness ha s theoretically correct means of providing capi- made reasonable debate about the efficacy of

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capital gains tax relief nearly impossible . For in the federal tax code where disincentives example, indexing capital gains for inflation i s have been created whose removal would both widely regarded as fair and at least theoreti- help small businesses and reduce th e cally correct tax policy even by those wh o government's interference in the marketplace . have reservations about indexing on othe r The short history of a small business de - grounds. Nevertheless, many Members of Con- scribed above should indicate some ways in gress and some segments of society oppose which a change in tax policy would foste r capital gains tax relief in general, while sup - small business success . For example, capital porting indexing in particular . It follows that gains relief would make it easier for small busi- opposition to capital gains relief predomi- nesses to expand . Payroll tax relief, however , nantly relates to real gains . would be most beneficial for businesses whe n General opposition to capital gains tax re- they are first starting out or whenever they are lief derives from a desire to equalize the distri- in financial distress because the payroll tax cre- bution of wealth through tax policy. Obvi- ates a serious drain on vital cash flow . Many ously, the wealthy will receive most of the forms of income tax relief would help small capital gains in society in pure dollar terms . businesses, including raising the amount of However, the importance of capital gains an d capital expenditures that may be expensed in a capital gains relief may be greater for lower - given year; making the Research and Experi- and middle-income families than it is for upper- mentation Tax Credit permanent ; and givin g income families because these gains, whe n all taxpayers the ability to deduct their healt h they arise, may represent a far greater share o f insurance premiums whenever they do not en - the family income than they do for wealthy joy employer-provided insurance . families. Recent Tax Foundation research sup- ports this supposition . This research shows Tax Complexity that nearly 20 percent of all taxable capital Among the many burdens a small business - gains accrue to families with incomes belo w man must face is compliance with the federal , $50,000 annually, and that over half of all tax - state, and local tax codes . Too small to hire able capital gains accrue to families with in - professional help the small businessman must comes below $200,000 . proceed as best he can through the tax form s Finally, while it is appropriate to conside r and regulations, all under threat of severe pen- whether a specific tax policy or change in alty. Tax Foundation research indicates that policy is fair, it is important to place these mat- the average business with sales of $1 million o r ters within the context of the overall tax less (which represents over 80 percent of th e policy and even within the overall economi c corporations in America) must spend ove r policy of the government . Capital gains relief $5,000 annually complying with the federal ta x is proposed for two solid economic policy rea- system alone. Tax reform efforts that would sons—to increase the rate of saving and invest- simplify the tax code, thereby freeing bot h ment in the United States, and to increas e time and financial resources for more produc- wages and employment . tive activities, would be equivalent to explicit The capital gains tax represents an explicit tax relief from the small businessman's per- choice in economic policy favoring a high de- SPECIAL BRIEF spective, and yet could be achieved with n o is published occasionally by gree of income redistributionism at the ex- loss in federal tax receipts . the Tax Foundation, an pense of a stronger economy and a more pros- independent 501(c)(3) perous people . The net result may or may not organization chartered in the Conclusion District of Columbia. be a more "equitable" distribution of the fruits of our economy, but it is a peculiar sense of While small businesses have much in com- Individual issues $5. fairness that would choose such a distribution mon with their larger brethren in terms of tax concerns, one matter which distinguishe s The Tax Foundation, a when the cost of such a policy is that all mem- nonprofit, nonpartisan bers of society have less income and less them is their ability under normal circum- research and public wealth. stances to access the nation's capital markets education organization, has to acquire the seed corn necessary to develo p monitored tax and fisca l and expand . Another aspect which tends to activities at all levels of Other Policies for Encouraging government since 1937. distinguish small businesses is the prospect o f Small Business very great returns if the business flourishes , ©1995 Tax Foundation A basic principle of Tax Foundation analy- and the possibility of losing much or all o f Tax Foundatio n sis is that the tax code should not be used to one's investment if the business does not suc- 1250 H Street, NW micro-manage the economy . While such an ceed. In each case, properly crafted capital Suite 75 0 operating rule would disqualify certain tax pro- gains tax relief would ease these burdens on Washington, DC 2000 5 posals, there are more than enough instances small businesses tremendously . (202) 783-2760