THAT GOOD NEWS ABOUT CAPITAL GAINS YES, YOU HEARD RIGHT: PRESIDENT CLINTON AGREED TO PRETTY MUCH DO AWAY WITH THE CAPITAL GAINS TAX FOR HOMEOWNERS. THERE'S EVEN HOPE FOR A BROADER CUT.
By ROB NORTON

(FORTUNE Magazine) – One of the unforeseen and pleasant consequences of the presidential election is that for the first time in a decade, we may see a significant reform of the capital gains tax. President Clinton in late August signed on to the idea of exempting capital gains on home sales from taxes--subject to some not-too-burdensome conditions. It's great news for taxpayers: At least one of the multitude of economic distortions caused by our jerrybuilt tax code will vanish, and it won't even cost the government much lost revenue. Even more important, it could foreshadow the kind of broader cut in the capital gains tax that could significantly improve the economy's efficiency.

Here's why there's hope: One of the several and sometimes contradictory faces Clinton presents to the public has been that of the pro-business, pro-capital pragmatist. If he moves, as expected, in his second term toward a more centrist style of governance (the quick postelection departures of Robert Reich and Harold Ickes were encouraging), no single initiative would better win over Republicans and conservative Democrats than a big cut in the capital gains tax. Republicans have agitated aggressively for it ever since the tax rate went up in 1986.

Clinton's campaign promise is to exempt capital gains up to $500,000 from taxes for couples selling a home once every two years. (Under current law, taxpayers get a one-time, $125,000 exemption at or after age 55.) Instead of having their gains locked up in housing, people would be free to sell a home and spend the proceeds or invest them in the financial markets or in business ventures. The cost to the government would be small because homeowners faced with the tax rarely cash out their gains today. Clinton's preliminary budget projections show that it would cost only $2.4 billion over the next five years, and some outside analysts think even that estimate is high. Clinton reportedly considered a broader capital gains cut before signing on to the home sales exemption.

A more sweeping reduction in capital gains tax rates makes sense for the same reasons, as well as for others. Investors today go to great lengths to avoid recognizing capital gains (especially because at death, the gains pass tax-free to their heirs). Thus--as is the case with housing--the tax keeps capital tied up in old assets instead of letting it flow to where it could be used more efficiently in the economy.

One of the great achievements of capital gains reform would be to lessen the unfairness caused by the combination of capital gains taxes and rising prices. In periods of high to moderate inflation--the 1970s and 1980s, for instance--the capital gains tax, since it is levied on after-inflation gains, can easily wipe out most of an investor's profits. Harvard economist Martin Feldstein has calculated that a taxpayer who bought a diversified portfolio of stocks in 1973 for $10,000, held it for 20 years while it earned an average 7.4% return, and then sold it, could have been left with a measly real profit of $509 after paying capital gains taxes. Ordinary income taxes, in contrast, have been indexed for inflation since 1985.

The capital gains tax also combines with the income tax system to severely penalize business income and investment, since corporate profits are first taxed at the company level, and then hit again when they show up as capital gains for the companies' investors. Economists who've modeled the effects of a significant capital gains tax cut have concluded that it would result in a major reduction in the cost of capital for American business.

Real capital gains tax reform will still face powerful opposition. Populist, left-leaning Congressman and Senators have long opposed it reflexively--as a sin against fairness--since it would benefit wealthy taxpayers disproportionately. (They own, after all, a disproportionate share of capital.) But a capital gains tax cut wouldn't benefit only the wealthy. A study by the Tax Foundation, a Washington research group, found that taxpayers earning under $200,000 annually (in 1992 dollars) had paid two-thirds of all the capital gains taxes in the half-century between 1942 and 1992.

Could it be that--just as it took Richard Nixon, cold warrior par excellence, to reestablish relations with Communist China--it will take Bill Clinton, bane of the GOP, to reform the capital gains tax? Whether or not the arguments for efficiency and growth can carry the day in Clinton's second term remains to be seen. But the proposal to eliminate capital gains taxes on home sales certainly isn't a bad point of departure.