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Working Paper No. 187 | March 1997

Real Estate and the Capital Gains Debate

The recent budget agreement contains a capital gains tax cut. The principal justification for reducing the capital gains tax rate relies on the efficiency-equity trade-off. The capital gains tax is designed to increase equity by taxing the wealthy, but advocates of rate reduction claim that the tax has the side effect of decreasing efficiency because it discourages productive investment. The argument is that the tax structure errs on the side of equity so much that it has reduced the efficiency of the economy to the point where there is less wealth for everyone, and so a capital gains tax cut is needed to get the economy moving.

Research Associates Michael Hudson and Kris Feder call attention to a neglected aspect of the capital gains debate: two-thirds of capital gains are taken on real estate—that is, on unproductive investment. An investment in real estate merely changes ownership of existing wealth; it does not produce wealth. Any capital gains on the appreciation of land value are not a reward for productivity but a windfall for whoever happens to own the land. Yet the capital gains tax treats a return from the appreciation of land the same way it treats a return resulting from improvements to land or from business investment. Such a tax structure is both inefficient (because it rewards unproductive investment at the expense of productive investment) and inequitable (because it rewards some of the wealthiest individuals at the expense of everyone else). There is an efficiency-equity trade-off on productive investments such as capital, but not on fixed assets such as land. Therefore, Hudson and Feder argue, we should not decrease the capital gains tax unless we first separate returns to business investment from returns to real estate speculation and tax real estate at a higher rate.

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Author(s):
Michael Hudson Kris Feder

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