Capital Games?

By Daniel Gross

March 20, 2001

The market giveth and the market taketh away. Investors large and small have learned this homily in the past year. Washington politicians -- on both sides of the aisle -- may soon be singing from the same hymnal.

Republicans believe the declining markets will boost momentum for President Bush's tax cut, now referred to by Bush spokesman Ari Fleischer as an "economic recovery" plan.

Democrats believe the Nasdaq meltdown will make the public more likely to embrace their plans to use the "surplus" to pay down debt and invest in social programs like Medicare.

But the death of the 1990s bull market may make both alternatives a harder sell. That's because the government has become addicted to the bountiful -- and relatively painless -- capital gains taxes that have flown into federal coffers: some $416 billion between 1993 and 1999. Unfortunately, contrary to the current projections that budgeteers are banking on, capital gains taxes could fall rather than rise from their record levels in the next few years.

Democrats and Republicans base their competing plans in large measure on estimates by the Congressional Budget Office that the U.S. economy will generate a $5.6 trillion surplus between fiscal years 2002 and 2011. Of course, these projections will almost certainly be wrong. (Government budget experts may be the only people who have more faulty long-term visibility than dot-com executives.)

The U.S. has gone from running an annual deficit of $290 billion in 1992, to an estimated annual surplus of $124 billion in 1999. Why? Massive increases in the amount of taxes paid by individuals; corporate income taxes remained relatively static in the 1990s. As the CBO notes, the boom in taxes remitted by Joe and Jane Public stemmed from "higher realizations of capital gains and increases in the effective tax rate."

In 1991, according to the CBO, capital gains taxes brought in just $27 billion, accounting for 6% of individual tax receipts. Over the course of the decade, receipts of this wonderfully progressive levy grew sharply, both in real terms and as a percentage of total receipts -- even after President Clinton reluctantly signed a capital gains tax cut in 1997. In 1998 and 1999, capital gains brought in a whopping $84 billion and $98 billion, respectively. In 1999, 11% of all taxes paid by individuals came in the form of capital gains taxes.

Now, capital gains can be triggered by everything from flipping a stock to selling a business. But, the CBO noted, "The higher realizations of capital gains stemmed largely from the sharp rise in stock prices." Indeed, in years when the markets and the economy rise, capital gains taxes flow into Washington like a mighty river. When the market indices and the economy stumble, capital gains taxes trickle in like a parched desert stream. The last time the markets and the economy hit a prolonged rough spot, capital gains payments ran dry. Capital gains taxes fell 20% in 1990 and slumped another 17% in 1991. Receipts remained flat in 1992, when the current expansion began, and have risen every year since.

Given this history, and the markets' recent performance, one would expect fewer rather than more capital gains taxes to be paid in fiscal years 2000, 2001 and 2002 than in previous years. But the Nostradami at the CBO expect precisely the opposite: For fiscal 2000 (October 1999 through September 2000), the agency believes capital gains taxes soared 20% from 1999's record, to $118 billion, or 12% of total individual tax receipts; in fiscal 2001, they should rise another 9%, to $129 billion, and then fall just 3% in 2002 to $125 billion.

Does this sound right? On the aggregate, U.S. investors had far more losses than gains on stock trades in 2000. The same holds for the first few months of 2001. Quick. Everybody who expects to record 50% more capital gains this year than you did in 1998 raise your hand.

In fact, it's fair to assume that the capital gains taxes paid in fiscal 2000 and 2001 will fall short of both the 1999 total and the current projections. (As for 2002, that's anybody's guess.) Ditto for corporate income taxes. Add in higher-than-expected costs for unemployment insurance, spiraling Medicare costs and declines in the highly taxed ordinary income triggered by the exercise of options, and the operating surpluses we've enjoyed could quickly narrow.

Also, if the markets and the economy continue to muddle along, we may find ourselves barely breaking even in 2001. And if it appears that we are headed back to an era of deficits, ambitious plans for slashing taxes or boosting spending will be about as popular as Pat Buchanan at my grandparents' West Palm Beach retirement home.

There's a lot more fluffery in the CBO's rosy surplus projections, which can be found at its Web site. For example, the estimates include some $450 billion in "estate and gift taxes" over the 10-year period -- a tax Bush has proposed to eliminate. But that's a topic for another column.

If the market doesn't come roaring back, and soon, we may find that the short-term expectations for capital gains tax receipts may be about as wishful -- and as grounded in reality -- as the price targets dished out by sell-side analysts.

The market giveth and the market taketh away

Copyright: 2001 TheStreet.com

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