February 26, 2002                                                                           

Dan L.Crippen, Director
Congressional Budget Office
Second and D Streets, SW
Washington, DC 20515

Dear Dr. Crippen: 

            I am writing to you because I am concerned that the projections for capital gains tax revenue in the Economic and Budget Outlook: Fiscal Years 2003-2012 substantially overstate the gains that can be plausibly projected. This is attributable to the fact that the methodology CBO uses for these projections ignores three important factors that are likely to effect capital gains realizations in the coming decade: 

1) CBO projects that profit growth over this period will be less than half its historic average, 

2) the price to earnings ratio in the stock market is currently more than 60 percent above its long-term average, making a further downward correction likely, and 

3) the share of U.S. financial assets held by foreigners is increasing rapidly, which should make a smaller percentage of domestically generated capital gains subject to taxation in future years. 

As a result of not taking into account these factors, the projections are likely to overstate capital gains tax revenue by several hundred billion dollars over the projection period. While CBO has adjusted its projections of capital gains realizations downward in this year’s Outlook -- lowering projected revenues by $142 billion -- the most recent projections for capital gains are still inconsistent with CBO's projections for the economy, leading to a substantial overstatement. 

            Before addressing these issues directly, it is worth noting that CBO projects that realized capital gains will be far higher relative to GDP than they have been historically. The table below shows the projected realizations for 2001 through 2012 both in dollar terms and as a percentage of GDP. By comparison, capital gain realizations over the period from 1952 to 1998 averaged 2.8 percent.[1]  While some factors would push towards a higher rate of realizations than normal, such as a lower capital gains tax rate than the average over this period, there are other important factors pushing in                        

                        Projected Capital Gain Realizations

                      (billions)                       Share of GDP

2001                $500                            4.9%
2002                                $476                            4.6%
2003                                $476                            4.3%
2004                                $479                            4.1%
2005                                $483                            3.9%
2006                                $492                            3.8%
2007                                $504                            3.7%
2008                                $520                            3.6%
2009                                $539                            3.6%
2010                                $561                            3.5%
2011                                $581                            3.5%
2012                                $604                            3.4%

[Capital gain realization projections are taken from The Economic and Budget Outlook, table 3-6, GDP projections from table 2-2.]

the opposite direction. The most significant item in this category would be the growth of stock holdings in tax deferred retirement accounts, such as 401(k)s. The gains from these holdings will eventually be taxed as normal income, at the point when money is withdrawn. The share of financial assets held in these accounts has been growing rapidly, a process that should accelerate with recent changes that have allowed for larger contributions to tax deferred accounts.[2] 

The other important factor that would lower the ratio of taxable realized capital gains to GDP is the rise of home ownership. The vast majority of gains on owner occupied housing are exempt from taxation. By contrast, gains on rental units are generally subject to taxation. With the rate of homeownership rising throughout most of the last four decades, the percentage of residential real estate where capital gains are subject to taxation will be far lower over the next decade than it has been over the last forty years. With the growth of  tax deferred accounts, and the increase in homeownership rates, there is little reason to assume that capital gains will be a higher share of GDP in the future, than in the past, even though the capital gains tax rate is slightly lower than its average over the 1952-98 period. 

            The table below compares the CBO projections of capital gains tax revenue with the revenue that would be collected if capital gains realizations were equal to 2.8 percent of GDP over the decade, the same as their average over the period from 1952 to 1998. The projections assume the same tax rate on these realizations as the CBO projections. The table shows that the cumulative difference in capital gains tax revenue between CBO’s projections and projections

                                                Projected Capital Gain Taxes

                        CBO                        Historic Average                   Difference

(billions)

2001                $115                            $66                                          $49
2002                $98                              $60                                          $38
2003                $95                              $62                                          $33
2004                $95                              $65                                          $30
2005                $95                              $72                                          $23
2006                $96                              $74                                          $22
2007                $98                              $74                                          $24
2008                $100                            $78                                          $22
2009                $104                            $81                                          $23
2010                $108                            $86                                          $22
2011                $112                            $90                                          $22
2012                $116                            $96                                          $20

Total               $1232                          $904                                        $328

[The CBO projections for capital gains tax revenue appear in The Economic and Budget Outlook, table 3-6. The historic averages are calculated as described in the text using the GDP projections from table 2-2.]

that assume capital gains realizations will be equal to their historic average share of GDP is $328 billion over the projection period. 

            However, even the assumption that capital gains realizations, over the next decade, will be equal to the historic average share of GDP is questionable given the other projections in the most recent Outlook. Most importantly, the Outlook projects that after-tax corporate profits will grow at an average nominal rate of 3.5 percent annually over the period from 2000 to 2012.[3] By comparison, nominal profits grew at a 7.5 annual rate over the period from 1952 to 2000. (Since nominal gains are the basis of taxation, it is appropriate to use nominal profit growth for this comparison.) 

With projected profit growth that is less than half its historic average, the price of stocks and other assets would have to rise far more rapidly than the growth of corporate profits, in order to provide the same ratio of capital gains to GDP as in past decades.[4] While this can happen for any period of time, it is unusual for it to happen for a period as long as a decade. Furthermore, it is inappropriate for CBO to implicitly assume this sort of increase in the ratio of asset prices to corporate profits without some explanation that could justify such a change in historic patterns. Presumably, CBO would not project that the price to earnings ratios will rise indefinitely. 

It would be more plausible to assume that asset prices rise at the same pace as corporate profits or approximately 3.5 percent annually, rather than their 7.5 percent average rate over the past half century. Since the current ratio of asset prices to corporate profits is approximately 60 percent higher than its historic average, the slower growth of asset prices should translate into capital gains realizations that are approximately 78 percent of their historic average, measured as a share of GDP ([3.5/7.5]*1.6 = 0.778).[5] The table below shows a set of projections of capital gains tax revenues that assumes the ratio of realized gains to GDP is 77.8 percent of its historic level and that revenue falls accordingly. The difference over the projection period is $523 billion.
 

                                                Projected Capital Gain Taxes  

                        CBO                Revenue Assuming Gains             Difference
                                             Track Projected Profit Growth

(billions)

2001                $115                            $47                                          $68
2002                $98                              $48                                          $50
2003                $95                              $51                                          $44
2004                $95                              $56                                          $39
2005                $95                              $58                                          $37
2006                $96                              $58                                          $38
2007                $98                              $58                                          $40
2008                $100                            $61                                          $39
2009                $104                            $63                                          $41
2010                $108                            $67                                          $41
2011                $112                            $70                                          $42
2012                $116                            $75                                          $41

Total               $1232                          $709                                        $523

The assumption that asset values will only rise as rapidly as the projected growth rate of corporate profits does create another problem, in a context where projected profit growth is so slow. The total return on stock is the dividend yield (including share buybacks) plus capital gains. Since the price to earnings ratio in the market is already far above its historic average of 14.5 to 1, the dividend yield is far below its historic average.[6] The pure dividend yield is currently just 1.36 percent (Economic Report of the President, 2002, Table B-95), but it would be approximately 2.0 percent when share buybacks are included. A nominal growth rate of 3.5 percent translates into a real growth rate of 1.0 percent given CBO’s projected inflation rate of 2.5 percent. This translates into a total real return on stock of 3.0 percent. This return is far below the average real return of 7.0 percent that stocks have produced over the last century. It also provides no risk premium on the return available on government bonds. With a projected nominal interest rate of 5.8 percent, ten year bonds would provide a real return of 3.3 percent. The assumption that stocks would provide no risk premium relative to bonds over the next decade seems implausible on its face. 

This leaves a third possibility, if the CBO projections of profit growth are accepted as accurate. Over the next decade, stock prices will have to fall significantly from their current levels. This decline would raise the ratio of earnings to the share price, which would allow the dividend yield to move closer to its historic average, which would allow total returns to be closer to their historic average. The required decline in stock prices could be quite large. If real capital gains averaged 1.0 percent, then a 6.0 percent dividend yield would be needed to maintain the historic rate of return on equities. This could only be accomplished if the price to earnings ratio declined to 10 to 1, which would imply that stocks lost approximately 60 percent of their current value. 

However, the decline in share prices that is needed to restore a long-term balance to financial markets is probably somewhat smaller than this calculation implies. In the longer term, it is likely that profits will grow at the same pace as GDP, which is close to 2.0 percent annually in CBO’s longer-term projections. Also, investors may be willing to accept a risk premium that is less than the historic 4.0 percent gap between stocks and long-term bonds, if they don’t view stocks as being as risky as in the past. Nonetheless, if the CBO projections of profit growth are assumed to be accurate, then it will be necessary to have a large decline in stock prices in order to restore a reasonable risk premium. 

During the period when the stock market is correcting, the ratio of capital gains to GDP will be far below its historic average. After the correction has been completed, the ratio would revert back closer to its historic average, although it would still be lower, if the projected rate of profit growth is slower than its historic average. Exactly how far the market will correct, and the timing of the correction, cannot be accurately predicted. But, in order to derive projections of capital gains revenue, CBO should at least make an explicit set of assumptions on the nature of a correction -- and provide an analysis of the sensitivity of these projections to alternative paths for the market. This would at least provide Congress with an understanding of the issues involved and a plausible range of projections of capital gains revenue. 

Needless to say, any revenue projection of capital gains tax revenue that assumed that the stock market would decline over much of the next decade would be considerably more pessimistic than the one that appears in the current Outlook. If stock prices rose at a rate of approximately 0.9 percent annually, it would bring the price to earnings ratio back to its historic average by 2012, if the CBO projections of profit growth prove accurate. [7][8] This rate of growth of stock prices would lead to lower capital gains tax revenue than is projected in the table, possibly raising the size of the overstatement by several hundred billion dollars. 

The last factor that does not appear to have been taken into account in the CBO projections of capital gains is the increasing portion of U.S. assets that is owned by foreign corporations or individuals. This is a direct result of the large current account deficits that the United States has been running in recent years. In 2000, the United States net international indebtedness position increased by $662.1 billion ((Economic Report of the President, 2002, Table B-107). While full year figures are not yet available, with the trade deficit numbers to date, it appears that net indebtedness increased by a comparable amount in 2001. While the Outlook does not explicitly present projections for the trade deficit, its analysis seems to assume that it will not change significantly, relative to GDP, through the ten-year projection period. (Since the projections imply that the United States will be growing faster than the major purchasers of U.S. goods, the only way in which the trade deficit could be corrected is with a large [20-30 percent] decline in the value of the dollar. A decline of this magnitude would imply an increase in the rate of inflation of between 1.5-2.3 percentage points [assuming a 50 percent passthrough from currency devaluation on the price of imported goods]. The inflation projections do not appear to be factoring in this sort of decline in the dollar.  

The table below shows the projected net indebtedness of the United States assuming that trade deficit remains constant as a share of GDP at its pre-recession level. The projected levels of indebtedness are shown in both dollar terms and measured as a share of the total financial assets held by the household and non-profit sectors. It is assumed that both the value of foreign holdings and the value of United States financial assets increase at a nominal rate of 5 percent a year. 

             Net Foreign                  Combined Financial Assets             ForeignAssets/Domestic
             Asset Position              Household and Non-Profit Sectors   (column 1/ column 2)

(billions)

2001        $2,657                  $30,404                                    8.7%   
2002        $3,159                  $31,923                                    9.9%
2003        $3,709                  $33,520                                  11.1%
2004        $4,307                  $35,196                                  12.2%
2005        $4,959                  $36,956                                  13.4%
2006        $5,667                  $38,804                                  14.6%
2007        $6,435                  $40,744                                  15.8%
2008        $7,267                  $42,781                                  17.0%
2009        $8,168                  $44,920                                  18.2%
2010        $9,143                  $47,166                                  19.4%
2011        $10,195                $49,525                                  20.6%
2012        $11,332                $52,001                                  21.8%

The increasing share of foreign holdings of U.S. assets is relevant to projections of capital gains tax revenue because the gains associated with these holding generally will not be subject to taxation in the United States. For example, increased profits for Daimler-Chrysler would be expected to boost the values of its shares in Germany, but it would not lead to significant capital gains which would be subject to taxation in the United States. Through most of the period 1952-98 the United States was a large net creditor. This meant that not only were the overwhelming majority of capital gains due to business activity in the United States subject to domestic taxation, but a large amount of capital gains due to foreign business activity was subject to domestic taxation as well. Now that the United States has become a net debtor nation, and its level of indebtedness is expected to increase substantially over the next decade, the amount of gains subject to domestic taxation is likely to decrease substantially relative to the gains that should be generated by the U.S. economy. This simple extrapolation implies that less than 80  percent of the gains generated in the U.S. economy will be subject to domestic taxation by 2012. In other words, the CBO projections could be overstating the amount of gains subject to domestic taxation by 20 percent at the end of the projection period. 

Obviously, an accurate projection would require assessing more carefully which U.S. assets foreign investors are likely to hold, and whether these assets are likely to generate capital gains. In addition, some capital gains on foreign owned assets will be subject to domestic taxation. Nonetheless, given the growth of the net indebtedness of the United States, which is implicit in the CBO projections, it is no longer possible to ignore the increase in foreign ownership of U.S. financial assets in projections of tax revenue. 

In summary, the CBO's projections of capital gains tax revenue are likely to still be substantially overstated, even after the large downward adjustment made in the most recent Economic and Budget Outlook. Assuming that stock prices grow at the same rate as CBO projects profits will grow would reduce projected capital gains tax revenue by close to $500 billion over the projection period. If there is a correction in the stock market, restoring historic price to earnings ratios, then the overstatement of tax revenue will be considerably larger. Finally, the fact that the net indebtedness of the United States is increasing rapidly implies that a much larger portion of U.S. financial assets will be foreign owned at the end of the projection period. As a result 20 percent, or more, of domestically generated capital gains could escape taxation by the end of the projection period. 

I hope that you will have the opportunity to give these issues some consideration. If you have any questions on the points I have raised, I would be happy to discuss them with you.                                                           


Regards,


Dean Baker, Co-Director   

cc:
Senator Kent Conrad
Senator Pete V. Domenici
Representative Jim Nussle
Representative John Spratt