The Ideal Capital Gains Tax Reform

Warren Buffett recently enraged the right by chastising Congress for “coddling” millionaires and billionaires. In a widely quoted op-ed, he urged lawmakers to “raise rates immediately on taxable income in excess of $1 million,” including capital gains. Buffett is right, but not entirely. The ideal reform would make some capital gains tax-free.

President George W. Bush cut the levy on long-term gains to 15 percent. By comparison, the federal income tax alone is 25 percent on the wages of middle-class workers. Including payroll taxes and Medicare, income from work is commonly taxed at more than twice the rate as income from wealth.

Advocates of tax breaks on capital gains claim that investments in the stock market grow jobs and grow the economy. For all but a trace amount of the billions of shares that change hands every day, that's patently untrue. Almost none of the money that flows through Wall Street goes to companies or grows jobs; it simply grows portfolios.

Except for the exceptions.

Small companies with big dreams use initial public offerings (IPOs) to help make those dreams take root and flourish. Later on, companies sometimes issue secondary offerings that raise capital for further expansion.

Investing in offerings like these really does spur the economy. The money goes not into portfolios, but to companies that put it to use and create jobs. The tax code – which now makes no distinction between true investments in companies and personal investments in portfolios – should recognize and reward the difference. Capital gains from true investments should become tax-free; capital gains from aftermarket investments should be taxed at the same rate as ordinary income.

Buffett's call for higher taxes on ultrahigh incomes said nothing about taxing wealth income at the same rate as work income. For that, we turn to the recent recommendations of two bipartisan panels, and to a Republican icon.

Ronald Reagan's Tax Reform Act of 1986 levied equal taxes on capital gains, dividends and ordinary income such as wages. In exchange, Reagan won another round of marginal rate cuts and a reduction in tax brackets. His speech at the signing ceremony called the bill “a sweeping victory for fairness” and “the best job-creation program ever to come out of the Congress.”

Reagan's tradeoff – lower marginal rates in return for equal taxes on all income – is strikingly similar to the one proposed by both of the blue-ribbon deficit-reduction bodies that weighed in late last year. The chairmen's report of President Obama's fiscal commission (Simpson-Bowles) and a plan from the Bipartisan Policy Center (Rivlin-Domenici) both called for lower marginal rates. Likewise, both came down in favor of equal taxes on all income.

In 2011, for the second straight year, a special bipartisan panel has been charged with putting America's fiscal house in order. The new Congressional “supercommittee” has an extra incentive: the deal that raised the national debt ceiling mandates across-the-board spending cuts unless ways are found to lower the ten-year deficit by at least $1.5 trillion.

The committee can borrow from Simpson-Bowles and Rivlin-Domenici. It can embrace Ronald Reagan. If it does, one provision that might re-emerge is the return of basic tax fairness: the same rates on capital gains, dividends and wages.

And while tax breaks routinely deserve to be taken away, there's one exception that deserves to be put in place. Capital gains from investments in job-creating IPOs and secondary offerings should be made tax-free.