Capital gains taxes are likely
to fall
Dr Richard
Appel
December 3, 2004
One of
the cornerstones of President Bush's earlier and much debated
tax cuts, was the substantial tax reduction on long term capital
gains. These were reduced to a maximum of 15% from their 20%
level in recent years, which in turn replaced the 28% rate that
had long been a mainstay of our tax code.
In general, everything owned for personal or investment purposes
is considered a capital asset. Capital gains profits or losses
accrue from the sale of items within these categories. They can
be in real estate, in art, in stocks and bonds, in collectibles
or in a myriad of other asset classes. Most nations treat capital
gains in a more favorable fashion than they do ordinary income.
This is income that is derived from employment or the participation
in some enterprise. The primary reason why many governments bestow
lowered tax burdens upon capital items is because investments
in a number of these segments can directly and positively influence
a country's economic health.
The advancement of a nation state is largely fostered through
the development and growth of its various industries. Since the
acquisition of capital is among the primary requirements needed
to stimulate this occurrence, companies of all sizes must be
able to readily access capital in order to succeed. They may
use the acquired funds to build or refurbish their factories,
add to their inventories, for acquisitions or the purchase of
new equipment, for the research and development of new ideas,
to increase their workforce, or for numerous other reasons. It
is the general increase in business generated from the wise use
of capital that is responsible for the economic growth of an
entire people. One can liken the rain that nurtures a seed and
allows it to sprout, to the capital needed by a business that
is necessary to enable it to grow.
Governments that stifle public investment in the business sector
tend to produce stagnant or moderate growth for their nation.
This can be best witnessed in the general low growth rates of
socialistic or communistic governed societies. Conversely, if
a country's government encourages its citizenry to provide working
capital to its enterprises, they will give their economy the
greatest opportunity to flourish.
When a nation's citizens have the ability to benefit from successfully
investing in an area offering limited taxation, they will tend
to migrate towards it. To my mind this is quite natural because
it reflects the desire of all individuals to do what is in their
own best self interest. This in fact is one of the primary reasons
behind the inception of and the ongoing nationwide U.S. housing
market boom.
The U.S. Tax Code governing the taxation of primary dwellings
was changed in mid-1997. This resulted in the elimination of
personal capital gains obligations on the initial profit on residences,
when an individual or a couple sold their home. The first $250,000
in capital gains for a single person and $500,000 for a married
couple became exempt from any and all federal taxes. Other than
in a few areas prior to that announcement, the U.S. housing market
was rather lackluster.
When people realized that they could actually not only enjoy
owning a home but could profit from its price appreciation, the
movement from apartment life towards home ownership ensued. In
fact, this exodus escalated as the housing boom unfolded. Further,
purchasing a second home became more prevalent throughout our
nation. An additional dwelling was looked upon as another vehicle
from which to profit in the rising real estate market. In essence
people could have their cake and eat it too, without being burdened
with the capital gains tax liability that accompanied most other
investments.
The only requirements that investors had to satisfy was that
their homes had to be the primary residence of an individual,
or at minimum one spouse, for at least two of the prior five
years. This was relatively easy to achieve even if a single person
or couple had two dwellings. They could live in one home for
two years while renting the other. When they sold the first abode
and pocketed their tax-free profit, they could move into
their other one for the following two years, and would again
qualify for the favorable tax exemption.
The reason why I believe that we will likely be favored with
further reduced capital gains taxes in the not too distant future
is due to our government's desire to stimulate our nation's economy.
There are a number of leading indicators and anecdotal evidence
that suggest that our economy is expanding, albeit it at a reduced
pace. However, there are just as many others that lead me to
believe that our nation may be poised to again enter a period
of economic turmoil which has the potential to be quite severe.
The U.S. dollar as viewed through the action of the U.S. Dollar
Index began its present decline from its 120 peak in early 2002,
and yesterday breached 82. This is an incredible 31% parity fall
in the space of only two and one half years. In fact, it fell
to a greater degree against numerous currencies such as the euro.
Yet, not only did the significance of this amazing, broad collapse
go virtually unnoticed until recently by the media, but it's
expected effect has done little to stimulate our economy.
Foreigners make decisions to acquire our goods and services based
upon the cost of our items in their own currencies. Something
that cost 100 euros when the dollar was trading at $0.83 per
euro declined to about 62 euros given today's euro vs. dollar
exchange rate. A euro is presently worth about $1.33. Normally,
even a far smaller increase in the euro's purchasing power vis
a vis the dollar would have caused a rush of euro zone purchases
of American goods and services. However, given the great competition
and lower prices offered by the various Asian countries, a significant
desire to acquire dollar denominated goods has not yet materialized.
Additionally, the ability of most European Economic Community
countries to purchase foreign goods has fallen. This is due to
the weakening economies suffered by many of their members.
Despite the regular official commentary that the U.S. economy
is doing well, I believe that great doubt pervades our administration
and Federal Reserve about its true state and its future. During
the past few years we have experienced rock bottom interest rates
and an unprecedented high level of monetary stimulation. Further,
the cost of many goods sold in America have stagnated or declined.
Additionally, taxes have been lowered during the same period.
The combination of these occurrences in the past would have generated
a significant jolt to our country's economic performance. Yet,
despite all of the fiscal and monetary machinations that have
been implemented, the economy has been able to do little better
than hold its own.
Our government and Fed officials recognize that confidence in
the future of the economy is weakening and that any economic
or financial misstep has the potential to frighten consumers
into reducing their purchases. If such an event transpires it
has the likelihood of effectively knocking the legs out from
under our already fragile economy. A sharp decline in stock or
housing prices, rapidly rising interest rates, a significant
reduction in foreign purchases of U.S. goods, or some other surprise
are all that is needed to trigger such an event.
The reason for President Bush's desire to reduce capital gains
taxes during his first term of office was to stimulate the economy.
Now, he realizes that all of his and the Federal Reserve's efforts
have been insufficient to jump start a concrete economic recovery,
and have only acted to forestall a recession.
Recognizing the tenuous state of our business sector and now
that he can again focus on the economy, I believe that President
Bush will quickly act to introduce and push through legislation
that will further lower U.S. capital gains taxes. This will alter
the actions of investors in a number of important ways, and will
have the potential to positively impact our economy. First, it
will place more money in the hands of our citizenry. They will
either spend it, which will help stimulate the economy through
their purchases, or they will save it. The latter will increase
the capital pool available to businesses and will also help improve
their lot. Next, it will entice investors to either maintain
or increase their investments in common stocks. This may help
support stock prices at their current levels, or at least hopefully
soften any approaching broad stock market decline. Further, it
will promote greater availability of capital to our nation's
companies. With a similar result as I described above caused
by the elimination of capital gains on housing, I believe that
investors will act upon the reduced tax incentives and offer
an increased amount of venture capital to our country's businesses.
This will enhance their prospects and thereby add impetus to
the growth of our economy.
President Bush's initial capital gains reductions only affected
long-term capital gains. Short term gains which are investments
held for less than one year and a day, remained taxed as ordinary
income. When the holding period for long-term capital gains treatment
was increased from six months and one day to its present duration
a few years ago, it appeared obvious that it was motivated by
the government desired to keep investors holding onto their common
stocks. I believe that this ploy has outlived its usefulness.
Further, if our officials continue to treat short and long-term
gains differently, I believe that they will be missing a major
opportunity to enhance any long-term rate reductions that they
might institute. By reducing and treating both long and short-term
capital gains similarly, with little or no hold period separating
the two, they will likely free up an avalanche of money flowing
into the U.S. investment arena. It worked in the housing market
and I am confident that it will also benefit the economy and
stock markets.
Given the tenuous nature of our economic and financial systems,
combined with President Bush's well known desire to use capital
gains tax reductions to solve this looming problem, I believe
that it is highly likely that the new year will bring with it
favorable capital gains tax changes that will benefit us all.
For these reasons, I believe that it is now prudent to undertake
all investment decisions with that potential in mind.
The above
was excerpted from the December 2004 issue of Financial Insights
© November 28, 2004.
December 3. 2004
Dr Richard
Appel
contact
website: Financial
Insights
Appel Archives.
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