Chris McIsaac

With the so-called Buffett Rule making its way through tax policy circles, the question of how and whether to tax capital gains is once again on the front burner in Washington, D.C.

A new paper by the Arizona Chamber Foundation, Unchain the Gain: Capital Gains Tax Policy and Arizona’s Investment Climate, finds that by undertaking capital gains tax reform, Arizona could spark economic growth in the state.

A capital gain is the gain realized when an investor sells an investment for more than its original purchase price. The Internal Revenue Service gives capital gains a more favorable tax treatment than it does regular income. For example the top income tax rate is 35 percent, while the top capital gains tax rate is 15 percent.

In the past 15 years, the federal government has twice cut taxes on capital gains. Bill Clinton cut the top rate from 28 percent to 20 percent in 1997. President Clinton’s successor, George W. Bush, in 2003 brought the top rate down to 15 percent. One a Democrat, the other a Republican, yet both on the same page on capital gains tax cuts.

Five of the Republican presidential candidates have gotten in on the act, too, proposing to eliminate taxes on capital gains altogether.

The push to cut taxes on capital gains has also garnered support in state capitols. The Foundation paper finds that eight states provide preferential tax treatment for capital gains income. For example, New Mexico in 2003 cut its capital gains tax in half along with instituting a phased-in reduction of the state income tax. In the years following the tax overhaul, New Mexico outperformed the rest of the country in the growth of personal income.

Arizona, however, is among the majority of the states that does not give preferential tax treatment to capital gains, treating capital gain income like ordinary income. In 2011, the state did enact a new reform that, beginning in 2014, will allow capital gains derived from investments in businesses with less than $10 million in assets to be fully excluded from the state’s income tax.

What’s the rationale for taxing capital gains at a reduced rate compared to income taxes?

First, the Foundation paper points out that capital gain taxes are also inflation taxes. An investment that goes from, say, $100 to $120, is taxed on the full 20 percent increase in value. But in reality, some of that gain is attributable to inflation, not a pure increase in the underlying value of the asset. Lower capital gains rates reduce, but do not eliminate, the impact of the inflation tax.

Second, with higher capital gains taxes comes a “lock-in” effect. People are hesitant to cash-in on an investment out of fear of the tax implications, which in turn leads to a misallocation of capital in the economy. Investors prefer to park their money away for long periods of time rather than risk taking a big tax hit.

In order to free up capital in the Arizona economy and make the state a more attractive place for investment, the Legislature and governor should look closely at capital gains tax reform. By aligning the state’s capital gains tax policy more closely with that of the federal government, we could begin to address some of the distortions and disincentives created by treating capital gains as regular income.

Job creation takes capital. Unfortunately, in this era of economic uncertainty, too much capital is on the sidelines. We need to look for ways to unleash that capital into the economy.

In the 2011 legislative session, the Legislature and governor showed a willingness to think big when it comes to increasing the competitiveness of Arizona’s economy. By enacting a once-in-a-generation reform package, the state sent a clear message to job creators that Arizona is fertile ground for job growth. The state can continue to burnish its reputation for being jobs-friendly by unlocking pent up capital and encouraging new investment through capital gains tax reform.