reduced tax rates on investment income and capital gains.

The

top tax rate on long-term capital gains has thus been reduced from just under 50 percent to 20 percent.

These recent changes in the U.S. tax Code brought the taxation of capital gains closer to that of our international competitors. However, our capital gains tax rates and holding period requirement to qualify for long-term capital gains tax treatment are still relatively harsher than those of most of the major industrialized countries. Table I attached gives international comparisons in the taxation of capital gains.

Early in the 1978 debate on the need to cut capital gains taxes, skeptics said that such measures would do little for capital formation and would erode government revenues. However, since 1978, considerable evidence of the salutary effects of reductions in taxes on capital gains has been

documented.

First, since lower capital gains taxes increase the rewards for risk taking, it is understandable that those investment activities that involve the most risks, such as venture capital investment, would feel the sharpest impact of the change. In fact, the amount dedicated.to organized venture capital investment entities expanded from an average of $70 million per year in the years 1969 through 1977 to an average of just under $1 billion per year in the years 1978 through 1982, with total dedications of $1.3 billion in 1981 and $1.7 billion in 1982. This is the nation's seed capital, from which hundreds of new companies are started each year.

substantially.

Second, the performance of the equity markets has improved The nine-year depression in equity values which began in 1969 when tax rates on individual capital were raised significantly ended early in 1978, when the trend toward lower taxes on capital began. Since the end of 1977, the

value of corporate equities at market has risen 83 percent; over $820 billion has been added to this value. Other economic factors have most certainly been responsible for some of the recent increase, including the improved outlook for lower inflation, lower interest rates, and prospects for economic improvement. Yet gains throughout 1978-80 took place in spite

of worsening inflation and rising interest rates. The common thread throughout the period has been the progressive reduct on in tax rates on individual capital.

Third, new capital raised through initial public stock offerings climbed out of a lengthy depression in late 1978, and dramatic gains took place in 1979-81. Due to a less favorable stock market during much of 1982, there was some fall-off in that year, but offerings picked up sharply toward its close, and in the first six months of 1983.

Initial and periodic infusions of equity capital are critical for the successful development of new, young, and rapidly growing companies and for their capacity to generate new job opportunities. But many mature and large companies need to raise additional amounts of equity capital as well. The lengthy depression in equity values from which we are now

emerging forced many companies to rely heavily on debt, particularly short-term debt. If these companies can replace some of this debt with equity, they will be in a better position to expand their facilities and their work forces as business improves. To the degree that the sale of equity can replace debt and meet the new financing requirements, some of the upward pressure will be taken off both short- and long-term interest rates which would further brighten the prospects for

recovery.

Finally, opponents of lower capital gains taxes argued in 1978 that the reduction would cost the Treasury over $2 billion in revenue. The facts show that taxes paid on capital gains increased from $9.3 billion in 1978 to $11.5 billion in 1979, to $12.2 billion in 1980, and $11.6 billion in 1981.

In addition, economists have prepared simulations

comparing the taxes actually paid with the taxes that would have been paid under the old law. Recent research by Dr. Gerald E. Auten, a Treasury Department tax policy consultant, in a paper commissioned by the American Council for Capital Formation: Center for Policy Research, compared the capital gains taxes, actually paid under the new law with taxes that would have been paid under the old law.1/

Dr.

Auten's results

An

1/Auten, Gerald E., "The Taxation of Capital Gains: Evaluation of the 1978 and 1981 Tax Cuts for Capital," New Directions in Federal Tax Policy for the 1980's (Cambridge, Massachusetts: Ballinger Publishing Company, forthcoming).

indicate that under the new law, capital gains tax revenue was $1.2 billion higher in 1979, $1.8 billion higher in 1980, and $1.3 billion higher in 1981 than it would have been in the absence of the capital gains tax reductions.

The evidence thus far also indicates that so-called "fat cats" are paying more capital gains taxes than ever before. Those with incomes over $100,000 included $11.7 billion of net capital gains in adjusted gross income in 1979, an increase of 72 percent over the $6.8 billion reported in 1978. IRS data show the net gain included in income rose to $12.7 billion in 1980 for the high income group.

These facts make a convincing case in favor of reductions in capital gains taxes. But, have we gone as far as we can to ensure the maximum benefit to the American economy from such tax reductions? In our judgment, the answer is "no."

The Next Step

Recognizing the critical nature of the capital gains tax, the American Council for Capital Formation has long advocated a full range of legislation designed to reduce this tax. Much now remains to be done, including indexing the basis of capital assets for inflation, reducing the holding period for long-term capital gains, cutting the corporate capital gains tax rate of 28 percent so that it is equal to the maximum rate for

individual capital gains, and further reducing the capital gains tax rate for individuals and corporations.

We commend Senator Armstrong and Congressman Archer for their initiative in introducing legislation to offset the effects of inflation on capital assets. We congratulate Senator Armstrong on his successful effort on the Senate Floor in 1982 to amend the Senate Finance Committee version of the Tax Equity and Fiscal Responsibility Act to include his provision to index the basis for capital gains.

The Armstrong-Archer bill is long-overdue for enactment. Inflation distorts the taxation of capital gains as well as other forms of capital. Inflation is particularly harsh in its impact on capital gains because it distorts not only the real values of the tax brackets and exemptions, but also the measurement of both capital and income. Capital mi smeasurement occurs when a taxpayer purchases in one period and sells in another. He has real capital gain only if the transaction leaves him "better off." Properly measured, the capital increment should be the amount by which sales proceeds exceed the amount required to "stay even.

If the taxpayer purchases an asset for $100 and sells after there has been 20 percent inflation, he must receive at least $120 to stay even. Only the excess over $120 is real income. But for tax purposes, capital gain is mismeasured as the excess over $100, notwithstanding that the first $20 of any excess is not real, but illusory.

If the illusory gain is large compared with the real gain, the effective tax rate can be multiplied many times over.

If,