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Abstract

Previous theoretical analyses of the capital gains tax have suggested that investors have considerable opportunity to avoid the tax. Yet, past empirical work has found relatively little evidence of such activity. Using a previously unavailable panel data set with a very large sample of high-income individuals, this paper aims to bring the theory and evidence closer together by examining the behavior of individual taxpayers over time.

Though confirming past findings that avoidance of tax on realized capital gains is not prevalent, we do observe that tax avoidance activity increased after the passage of the Tax Reform Act of 1986, and that high-income, high-wealth and more sophisticated taxpayers were most likely to avoid tax. However, the efficacy of tax avoidance strategies depends on being able to avoid tax for long periods, and we find that most tax avoidance is of relatively short duration. Thus, the effective tax rate on realized capital gains is very close to the statutory rate in all years and tax brackets.

Introduction

In the United States, capital gains taxes long have sparked interest among economists and policy makers. The Taxpayer Relief Act of 1997 contains the latest changes in the taxation of capital gains. The Act lowers the tax rate on most gains and makes the tax rate dependent on holding period. As before, gains on assets held for at least a year qualify for long-term treatment and a maximum tax rate of 28 percent, well below the maximum rate on ordinary income. In addition, assets held for at least 18 months qualify for a maximum tax rate of 20 percent, and assets held for at least five years (and purchased after the year 2000) will face a top rate of just 18 percent. The Act also exempts from tax almost all gains from sales of owner-occupied housing.

Other provisions of the Act are aimed at reducing tax avoidance associated with the already-favorable treatment of capital gains. These include changes that lessen the favorable tax treatment on real estate investments through a change in recapture provisions, and elimination of the ability of investors to hedge open positions by "shorting against the box" (taking an offsetting short position) without realizing their locked-in gains. Such restrictions build on those introduced by the Tax Reform Act of 1986 that limited the ability of taxpayers to deduct losses associated with real estate investments and other "passive" investment activities.

This legislation, which reduces capital gains tax rates in general but also seeks to eliminate certain advantages of holding assets subject to capital gains taxation, reflects an underlying tension in how the capital gains tax is perceived. On the one hand, a low rate of capital gains tax is seen as facilitating the efficient turnover of investor portfolios and a spur to venture capital investment and entrepreneurship. On the other hand, the favorable rate of tax and the ability of investors to time realizations is understood to generate opportunities to avoid not only capital gains taxes, but other taxes as well. The continued existence of the annual $3,000 limit on capital loss deductions reflects the perceived need to limit such activity.

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