The Lock-In Effect

The major explanation for the lower tax collections at higher tax rates is the lock-in effect. The lock-in effect is generally conceded even by opponents of a capital gains tax cut. The realizations of capital gains decline when tax rates on gains are increased. When the capital gains tax rate is low, the ratio of unrealized capital gains falls (i.e., investors are more likely to sell their assets). After the increases in the capital gains taxes, the unrealized capital gains ratio rises. Clearly, investors are highly sensitive to the rate of capital gains tax when determining whether to sell stock holdings and other assets.

Since selling is taxed and possessing is not, high capital gains taxes encourage investors to hold rather than sell - thereby avoiding the tax indefinitely. Assets that are held until death avoid capital gains taxes altogether.

When investors lock in their assets this way, government loses revenue it would have gotten if tax rates were lower, and the capital market loses efficiency because the flow of assets to those who value them the most is impeded.

Economic Effect: More Investment

Capital gains taxes affect investment decisions. In particular, they reduce the amount of capital available for investments with higher risk potential, such as new start-ups and companies in emerging sectors. As a result, the capital gains tax tends to be a direct tax on the entrepreneurship that all economists recognize as essential to growth.

The Case for Lower Tax Rates

The vast majority of assets have value only because they are expected to produce future income. For example, bonds will produce interest income and stocks will produce dividends and retained earnings. Since this income will be taxed as it is realized, there is no need to tax the owners of these assets at the time the assets are bought and sold. It impedes the efficient transfer of assets from those who value them less to those who value them more, and it makes investments in all income-producing assets less attractive.

In sum, if one accepts the notion that a capital gains tax cut promotes economic growth then even the most pessimistic possible fiscal scenario is no loss of tax revenue from a tax rate cut. The more likely effect would be a substantial and permanent rise in revenues.