How Much Did Capital Gains Contribute to 1990s Budget Surpluses?

I like the way Derek Thompson of The Atlantic characterizes an op-ed in the Wall Street Journal this morning as a “column/slash/GOP strategy memo.” Unfortunately, much of what appears on the Journal’s editorial page these days falls into this category—how else to explain why GOP political hack Karl Rove has a column there?

What Thompson specifically objects to in the column is its statement that the budget surpluses of the late 1990s can somehow be attributed largely to a cut in the capital gains tax rate that was passed by a Republican Congress in 1997 and signed into law by Democrat Bill Clinton. This is not really a debatable topic because we have precise data upon which to base our analysis.

First, we know that between 1996 and 2000 federal revenues rose by two percentage points of GDP, from 18.9 percent to 20.9 percent. However, outlays also fell by almost the same amount, from 20.3 percent of GDP to 18.4 percent. Therefore, the total reduction in the deficit was 3.8 percent of GDP, from -1.4 percent in 1996 to +2.4 percent in 2000.

According to Treasury Department data, tax revenues from capital gains realizations rose from $66.4 billion in 1996 to $127.3 billion in 2000. Converting these figures to percentages of GDP, we see an increase from 0.85 percent to 1.28 percent, an increase of 0.43 percent.

Therefore, the increase in capital gains revenues accounted for a little over 20 percent of the total increase in federal revenues and just over 10 percent of the total change in the deficit between 1996 and 2000.

In any case, it’s silly to attribute all of the increase in capital gains revenues to the economic effects of reducing the tax rate. Undoubtedly, some portion of the increase was due to an unlocking effect as people sold assets acquired over many years when the rate fell, but obviously there were a lot of other things going on as well, such as the growth and spread of the Internet.

I think it’s a good idea to keep the capital gains tax rate as low as possible, but I am tired of hearing Republican partisans attribute virtually magical powers to changes in the capital gains tax.