No new tax cuts: George Bush is finally fighting for a capital-gains cut, right? Read the fine print.

AT FIRST BLUSH President Bush's State of the Union message looked like a winner. Reversing his high-tax 1990 budget, the President's 1992 State of the Union speech clearly articulated an expansionary fiscal message with a series of across-the-board tax cuts--and a regulatory freeze. Delivered in a serious and firm manner, the President's speech was clearly aimed at economic recovery.

True enough, some of the tax-cut proposals, especially the temporary reduction of withholding rates, are rather gimmicky. So is the accelerated depreciation investment-tax allowance, which would last only one year, roughly equivalent to a 1 percent temporary investment tax credit rather than a more sizable permanent reduction in the cost of business capital. And the Administration failed to reduce the cost of labor or make it easier for small-business owners to hire new workers by rolling back the payroll-tax rate or by dropping the 15 percent lower- and middle-income tax bracket by a few percentage points.

This said, the Bush package does provide important tax relief to savers, first-time homebuyers, uninsured health-care recipients, and inner-city housing tenants and minority small businesses. But standing at the center of the pro-growth initiative was the President's unexpected announcement of a 15.4 percent capital-gains tax rate. It signaled an important victory for Jack Kemp, Vin Weber, Bob Kasten, and other supply-siders who had lobbied hard in the run-up to the State of the Union.

On the surface this proposals looked like great medicine to cure the economic ills of the U.S. By lowering the cost and raising the return on capital, the proposed capgains tax reduction of nearly 50 percent would have spurred new business start-ups, created much need new jobs, raised real-estate values, and substantially lowered the budget deficit. At a time when the banker's credit crunch still inhibits prospects for economic recovery, deep capital-gains tax relief might have generated as much as $350 billion in capital realizations--essentially providing the economy with an enormous bank loan.

But what the right hand giventh, the left hand is apparently poised to taketh away. Buried away in the fine print of the details published by the U.S. Treasury is a sentence that says that the 45 percent capital-gains exclusion would be added back into income for alternative minimum tax (AMT) purposes. In effect, a good many investors would face a capgains rate close to 24 percent rather than 15.4 percent as a result of AMT. Indeed, for some taxpayers the AMT provision would actually raise the marginal tax rate on capital gains to 30 percent.

The AMT was introduced in the 1986 Tax Reform Act and set at a rate of 21 percent, which was raised to 24 percent as part of the 1990 Ominibus Budget Reconciliation Act. The purpose of AMT was to ensure that supposedly high-income individuals (including those enjoying a onetime capital gain) paid a certain minimum percentage of income in taxes.

To compute an individual's minimum tax liability, a taxpayers has to add back so-called "tax preferences" into taxable income. These preferences include most deductions and personal exemptions--the major exceptions being interest on a mortgage used for purchase of a home and charitable contributions. From this total, the taxpayer deducts a $40,000 exemption to arrive at his income for AMT purposes. If his AMT income is above $150,000, this $40,000 exemption is scaled down by $1 for each $4 of income above $150,000 and completely eliminated for incomes above $310,000. This is equivalent to the marginal AMT rate being pushed up to 30 percent for incomes between $150,000 and $310,000.

Bush's proposal is for the 45 percent capital-gains exclusion to be treated as a tax preference and added back into income for AMT purposes. Consequently, if a capital-gains realization represents a sizable portion of a person's income in any year, that person could be caught in the AMT net and pay a marginal capgains rate of 24 percent. What's more, ordinary income plus capital-gains realizations which add up to between $150,000 and $310,000 generate a marginal capgains rate of 30 percent as a result of the phaseout of the $40,000 exclusion, almost twice the stated rate in the President's proposal.

Consider the case of Joe and Mary Six-Pack, who earn $60,000 a year and are undecided whether or not to sell their family business and realize a onetime capital gain of $100,000. The Six-Packs are married with two children and do not itemize their deductions. If they do not realize their gain, their adjusted gross income is $60,000 and their taxable income is $43,800 (their AGI less $16,200 in personal exemptions and the standard deduction). This puts them in the 28 percent bracket and the Six-Packs would pay $7,610 in total taxes.

If Joe and Mary realize the gain of $100,000, they would have to add $55,000 (the non-excluded portion of their capgain) to their taxable income. This would be taxed at 28 percent (or $100,000 X 15.4 percent), resulting in an additional 415,400 in taxes and total taxes paid of $23,010 (=$15,$00+$7,610). If there were no AMT or of the $45,000 capital-gains exclusion were not treated as a tax preference, that would be the end of the story.

Unfortunately it is not. For AMT purposes the entire gain is treated as income, resulting in AMT income of $160,000. Since this is $10,000 over the income level at which the $40,000 AMT exemption begins to be phased out, the Six-Packs lose $2,500 from the $40,000 AMT exemption. Thus for AMT purposes their taxable income is $122,500 (=$60,000+100,000--$37,500) and their tax is $29,400 (24 percent of $122,500).

So Joe and Mary pay an additional $6,390 in taxes as a result of the operation of AMT, resulting in $21,790 of taxes paid or an average capgains rate of 21.8 percent. However their marginal rate on additional capital gains is even higher. Suppose the sale resulted in an additional capital gain of $1,000. They would have to pay $240 in AMT, plus they would lose another $250 from the $40,000 exemption, which would add a further $60 to their tax bill. The resulting $300 paid on a marginal gain of $1,000 is a marginal capgains rate of 30 percent.

The Reality

SO THE Bush proposal does not cut the capital-gains rate on large realizations by anything like the 45 percent that is advertised. Instead, the change is likely to push many people into AMT if they realize large capital gains, strongly discouraging people from realizing capital gains.

Since the capital-gains tax is paid only when the gain is realized and avoided altogether if the asset is passed on as an inheritance, many people will simply choose to keep them locked up in their current form. There will be no flood of realizations such as in 1986 when investors had their last chance to realize gains at a 20 percent rate before the capgains exclusion was eliminated by the 1986 Tax Reform Act, or the tripling of realizations (from $50 billion to $160 billion) when the capital-gains tax rate was reduced in two steps from 48 percent (1978) to 20 percent. (1981).

Nor will the economy receive the sort of incentivized growth acceleration many were hoping from higher capital returns. At present there are roughly $2.5 trillion in unrealized capgains. This capital will not be rechanneled into new and more profitable directions because of the AMT provision. So the surge in new business creation, so vital for new jobs, may not materialize.

A true 15.4 percent capgains rate would amount to a 45 per cent reduction in the present rate. Realizations might then have doubled from $160 billion in 1988-89 to over $300 billion in 1992-93. This would have provided a tremendous shot in the arm for the economy, which in turn mighthave grown by at least 3.5 per cent to 4 per cent, roughly in line with the eight prior recoveries of the post--World War II period. With this kind of recovery growth, the budget deficit under Bush's policy assumptions could have been virtually eliminated by 1997.

However, with only a minor capgains tax cut, realizations will probably rise by only a small amount, perhaps another $20 billion per year. Under these circumstances the anemic average 2,9 per cent real GDP recovery rate in the OMB economic assumptions seems just about right, and it makes virtually no dent in the longer-run deficit outlook. Indeed fighting fot a measly 4 per cent drop in the capital-gains tax rate, or perhaps none at all, at the political risk of a major income-tax rate hike to 38 to 40 per cent, is a game which is clearly not worth the candle.

Mr. Kudlow is Chief Economist and Senior Managing Director of Bear, Stearns & Co.