(FORTUNE Magazine) – Few policy proposals put as warm a glow in the hearts of American business leaders, entrepreneurs, and investors as the idea of cutting the tax rates on capital gains. Lower capital gains taxes reduce the cost of capital because they increase its after-tax return. From this flow all kinds of beneficent effects, including increased national output, more investment, higher asset prices--and, of course, larger profits for investors. James L. Mann, chief executive officer of SunGard Data Systems, a computer service firm with 1994 revenues of $440 million, speaks for the consensus in corporate America when he says, "It's good for the economy, good for my business, and good for me." The view from Wall Street is just as unequivocal. Bullish as his company's trademark Texas longhorns, Merrill Lynch's chief investment strategist Charles Clough states, "Past capital gains cuts have led to investment booms, and presumably there'd be nothing different this time."

What is very differ ent from even a few months ago is the political landscape. As the smoke clears from the battle that was Election Day 1994, congressional Republicans sound like the 19th-century Senator who declared that "to the victor belong the spoils." Cutting the capital gains tax rate is high on their agenda. They fought bloodily and vainly for it during their years in the political wilderness. In the Contract With America, the party platform that served them so well last fall, they promised to lower the top rate from 28% to 19.8% and index future gains against inflation so that you'd pay tax only on your real ones. They have vowed to pass the contract within the first 100 days of the new Congress, which end, as luck would have it, just before April 15. And they feel passionately about it. Question: What does Bill Archer, the Texan who'll have dominion over all tax legislation as chairman of the House Ways and Means Committee, see when he thinks of the capital gains tax? Answer: "A vacuum sucking up our capital savings into the general Treasury."

Given the mood of manifest destiny, the chances for some kind of change in the capital gains tax are excellent, although there will be many a wrangle and politicking aplenty along the way. Opposition to capital gains tax cuts has become a sacrament for the liberal wing of the Democratic Party, personified by the new House minority leader, Richard Gephardt (D-Missouri). He's promised he will be "bitterly attacking" the "trickle-down terrorists" of the new Republican majority. But a significant number of Democrats favor cuts. South Dakota Senator Thomas A. Daschle, for instance, has signaled his willingness to compromise. At the very least, the Republicans will wind up getting the capital gains tax indexed to inflation. And they could easily get that and the reduction in rates--everything, in fact, that they promised in the contract. One possible compromise: a variable cut, with the lowest rates available only on gains from investments held for several years.

To put our cards on the table, For tune's belief is that a cut in the capital gains tax would be a modest but important improvement in the U.S. tax code. The arguments against it are for the most part thin; the arguments in favor have heft. And although there are better ways to reform the tax system in theory--they include some of the more ambitious plans for reforming or rewriting the tax code now being promoted by congressional Republicans--comprehensive tax reform is at best a couple of years off and far from a sure thing. The capital gains tax cut is here and now.

Over the years many politicians from both parties have proposed such cuts as a means of spurring savings and investment, and today's top 28% rate is not unusually low by historical standards, as the time line shows. Back in 1963, President Kennedy called unsuccessfully for a cut when the top rate was only 25%. His proposal would have capped it at 19.5%, within a whisker of the 19.8% rate the Contract With America calls for. Kennedy also proposed closing the loophole that forgives capital gains tax at death--something most definitely not in the contract.

The debate got downright vituperative after 1986, when the capital gains tax was hiked to its current rate. This was part of the Reagan Administration's grand tax-reform compromise that eliminated loopholes in return for the promise that all individual tax rates would be capped at 28%. Conservative economists warned in vain that the 1986 act would create a more hostile environment for savings and investment. The overall bargain soon unraveled as Congress, in cahoots with the Bush Administration, pushed top income-tax rates back up. Republicans have been itching to cut the capital gains tax ever since. Bush promised to do so in his 1988 campaign and almost succeeded. The House passed such a bill in 1989, and a majority of Senators, as many as 58, were ready to vote in favor. But a filibuster led by then-Senate Majority Leader George Mitchell headed off a Senate vote. Mitchell used a lot of legislative muscle and political arm-twisting to defeat the bill. "He made L.B.J. look like a timid schoolboy," recalls Mark Bloomfield, president of the American Council for Capital Formation, which has led the lobbying for the tax cut.

Well, what goes around, comes around--as they like to say on Capitol Hill. Now that the capital gains tax cut is back with a vengeance, here's a quick refresher on arguments pro and con. COMPLEXITY. The strongest argument against coupling a cut in the capital gains tax rate with indexing future gains is that doing so would increase the already fearsome complexity of the U.S. tax system. This argument would be even stronger, of course, if Congress hadn't already undone the simplification promised by the 1986 tax reform act's single top tax rate. Even with the current spread between the top rates for ordinary income and capital gains--39.6% vs. 28% --the Internal Revenue Service expends a heap of energy trying to ensure that taxpayers don't illicitly convert one kind of income into the other.

THE DEFICIT. Another serious argument against a cut is that it would reduce government revenue and tend to widen the budget deficit. Despite some modest improvement in the past few years, the all-too-often-forgotten deficit is still seen by many economists, policymakers, and business folk as one of the nation's worst long-term problems. Here we get to the murkiest and most contentious dispute within the capital gains controversy. Extravagant boosters of cuts claim they will produce higher tax revenues. They reason that when capital gains tax rates go down, investors are more likely to take their profits and pay taxes on them. Opponents refuse to admit that taxes lost in the rate cut will be replaced by those on increased profit taking.

Both sides tend to preface their claims by saying, "History proves..." But whenever you encounter that phrase, it is usually safe to replace it, as the 19th-century English historian and cleric Bishop William Stubbs pointed out, with, "I propose to assume without a shred of evidence..." History is, in fact, of little help in predicting the result of capital gains tax cuts. George R. Zodrow, an economics professor at Rice University who is proudly unaligned with either faction, recently reviewed the voluminous economic literature on capital gains taxes in a 108-page article for New York University's Tax Law Review. He concluded that the results of the shelffuls of empirical studies purporting to show the revenue effects of the tax changes "are quite tenuous" and warns that "one should be exceedingly careful in attempting to draw policy implications from this literature." It is safe to say, however, that lower capital gains taxes do tend to encourage investors to sell.

THE ECONOMY. Would-be tax cutters sometimes argue that the improved climate for savings and investment following a capital gains tax reduction would improve the larger economy, increasing growth and consequently generating higher tax revenue. This is the essence of a current controversy about whether the government should use so-called dynamic scoring, which attempts to capture the macroeconomic effects of policy changes, when forecasting the revenue effects of proposed policy changes (see Economic Intelligence). There's nothing wrong with the basic idea here, but few mainstream economists think the impact of a modest cut would be immediate enough to produce a dramatic change in the overall economy within the five-year horizon of the budget planners. In a preliminary study, DRI/McGraw-Hill, the nation's biggest forecasting firm, plugged the Republican's capital gains tax proposal into its model of the U.S. economy and estimated that GDP would be 0.2% higher per year (about $14 billion on a GDP base of $7 trillion), on average, if the cut passed.

FAIRNESS (Part I). The case that the Dick Gephardts of the world will make against cutting the capital gains rate rests on the more incendiary issue of economic fairness. But their concept of fairness is narrowly drawn. The familiar charge is that a capital gains tax cut would be a giveaway to the rich paid for by the poor and middle class.

Yes, they are partly right. Cutting capital gains taxes does benefit wealthy taxpayers disproportionately, and you don't have to be an economist to know why: This group owns a disproportionately large share of the nation's investments. But to say that the rich would benefit doesn't necessarily mean that poor and middle-income people would be worse off. As we've seen already, it's far from clear that the capital gains tax cut will cause much of a drop in government revenue. But the populists would be correct only if a shortfall in tax revenues were made up by increasing taxes on the working poor. If it were made up with across-the-board spending cuts, as the Republicans promise, they'd be wrong.

Finally, a capital gains tax cut that benefits the wealthy is not limited to the wealthy. Several analyses done at the time of the Bush capital gains proposal showed the bulk of the tax benefit going to high-income taxpayers. One study showed two-thirds of the saving going to taxpayers with incomes of $200,000 or more. But the flip side of that statistic is that the other one-third would go to people making less than $200,000. Focusing instead on the number of individual taxpayers who would benefit from a capital gains tax cut gives a very different perspective. Some 70% of the returns reporting capital gains in 1990 were for taxpayers with incomes of less than $75,000.

FAIRNESS (Part II). Proponents of a capital gains tax cut have solid fairness arguments of their own. First, the capital gains tax is grossly unfair when coupled with price inflation. (Ordinary income taxes have been indexed for inflation since 1985.) Harvard economics professor Martin Feldstein, a crusader for lower capital gains taxes, notes that an investor who bought a diversified portfolio of stocks in 1973 for $10,000 and held it for 20 years while it earned an average 7.4% a year would have seen its value grow to $42,019. If he or she sold it, the 28% capital gains tax bill on the nominal $32,019 profit would be $8,965. But adjusting for inflation, our hapless investor actually realized only a $9,474 gain. In short, the capital gains tax eats up all but $509 of the investor's real profit. The inflation portion of the gain, complains Feldstein, "is not real income, and it shouldn't be taxed."

The second inequity of the current capital gains tax is the way it combines with the income tax system to penalize business income and investment. The total of the two taxes results in a 53.2% tax rate on corporate profits reinvested by corporations. In other words, the company pays $35 in income taxes per $100 of gross profits. The remaining $65 increases the value of the stock and is therefore considered a capital gain. As such, it is taxed at the 28% rate, which equals $18.20, giving a grand tax total of 53.2%. Few other countries tax investment gains as onerously as does the U.S. Most nations tax corporate income either at the company level or when the investor receives it, but not both. In fact many, including Germany, Hong Kong, Belgium, and the Netherlands, impose zero taxes on an individual's long-term capital gains.

America's double taxation has an additional perverse effect. While companies get no tax break when they plow earnings back in the form of retained earnings, they do get one if they borrow, since interest expenses are tax deductible. This favors the kinds of established companies with predictable cash flows that can qualify for bank financing, and which have lots of physical assets that can serve as collateral for loans. But it penalizes the entrepreneur in need of startup capital and companies that depend on intellectual rather than physical capital. Says James Poterba, a public finance professor at the Massachusetts Institute of Technology: "Cutting capital gains taxes would particularly stimulate investments in the kinds of risky enterprises that traditionally generate returns in the form of capital gains." A final point from George Hatsopoulos, CEO of Thermo Electron, an instrument maker with estimated 1994 revenues of $1.5 billion: "By having the differential, you make investments flow into equities that produce growth, and you give an advantage to companies that think long term."

The impact of the capital gains tax cut would ripple quickly through the financial markets. Most Wall Streeters agree the tax cut would benefit stocks because after-tax returns would be higher. They differ only on whether the effect would be mild or powerful. Roger Brinner, chief economist at DRI/McGraw-Hill, figures that the capital gains tax cut the Republicans proposed in their Contract With America would lower the overall cost of capital by 0.7%. Other things being equal, that would raise the stock market's price/earnings ratio by about a point, from its recent range of around 15 to more than 16. By the year 2000, the S&P 500 index could be about 610, instead of the 570 forecast without the rate cut.

Of course, the future is uncertain, and any impact of a tax cut would be swallowed alive by the Big Event, a recession, say. But the fact that the gain from a tax cut would be modest shouldn't argue against making the change. Those tenths of a percentage point add up to significant improvements in living standards over the decades, and one thing the U.S. surely needs to do is increase its savings and investment. Say you were reviewing your personal finances, facing a typical menu of uncertainties, risks, and opportunities. Now imagine you find a way to boost, even slightly, your current income, retirement funds, savings, and productivity all at once with no major offsetting costs. You would, of course, just do it. What's to lose?