Flawed Foundations : A Re-Examination of the Reason and Purpose Behind the Capital Gains Tax Preference

The favorable taxation of capital gains has seen extensive ex post celebration and condemnation, but the ex-ante reason for the taxation’s enactment has largely been forgotten. This Article, written one hundred years after the capital gains tax preference was first enacted in 1921, responds to this gap by re-examining legal history to ask two simple questions: why does the capital gains preference exist as a matter of law and what can be learned from why it was enacted? I find that Congress was presented with two options to address the problem of high tax rates on capital gains yielding surprisingly little revenue in the early 20th century. The first option was to adopt broader, foundational changes to the taxation of capital gains to make the tax harder to avoid, while the second was to simply enact a low, preferential tax rate that taxpayers would willingly pay. They chose the second option, and I present data from the IRS Statistics of Income to provide some empirical evidence that the lower rates did yield greater revenue. The story behind the capital gains tax preference is important for current policy discussions since tax law is still grappling with the legacy of Congress’ decision to tax capital gains at reduced rates rather than fix the underlying problem that a realization-based income tax is easily gamed by taxpayers. If policymakers wish to impose higher tax rates on capital, they must reverse the decision taken in 1921 by both raising rates and changing how the law conceptualizes capital gains altogether. By only raising rates, Congress may find itself faced with the same string of issues that led to it enacting the capital gains tax preference in the first place