This report analyzes how responsive taxpayers are to changes in capital gains taxes. Capital gains occur when an asset increases in value as measured by the price of the asset minus the basis, which is generally the cost at which the asset was acquired. Capital gains are a form of income and subject to tax, but only when the asset is sold and the gain is realized. Thus, taxpayers have some control over when capital gains taxes are paid and at what rate by choosing when to sell an asset and realize capital gains. All else equal, a decrease in capital gains taxes should encourage taxpayers to sell assets and realize gains. Likewise, an increase in capital gains taxes should discourage taxpayers from selling assets and realizing gains. How much individuals respond to a decrease or an increase in capital gains taxes can be quantified using the economic concept of an elasticity, which in the context of this analysis measures the percentage change in realizations divided by the percentage change in the capital gains tax rate. In theory, the capital gains tax elasticity ranges from negative infinity to zero; the larger the elasticity is (in absolute terms), the more responsive taxpayers will be. In turn, the more (or less) responsive individuals are to capital gains taxes, the lower (or higher) tax rates should be to minimize economic distortions and maximize tax revenue. The analysis in this report suggests that the maximum long-run (or permanent) capital gains elasticity is between -0.29 to -0.45, with an estimate at the midpoint of positive transaction costs of -0.34. At a -0.34 elasticity, the revenue-maximizing tax rate would be 65%. This estimate for the capital gains elasticity assumes that in the absence of taxes and transactions costs all gains would be realized every year. This assumption is almost certainly too high, as there are numerous reasons aside from taxes and trading costs that would cause individuals to retain assets. If instead it is assumed that only 80% of gains would be realized, the maximum elasticity ranges from -0.22 to -0.16 for positive transactions costs, with an estimate at the midpoint of positive transactions costs of -0.19. A change in the capital gains tax rate may produce smaller revenue effects than would be estimated by simply applying the tax rate change to currently observed realizations. If individuals respond to a tax cut by realizing more gains or to a tax increase by realizing fewer gains, this change in realizations can offset some portion of the static revenue effects (the revenue in the absence of a behavioral response). The share of revenue offset by the realization’s response corresponds to the elasticity, which at the midpoint elasticities presented in this report would be between 19% and 34%. The common statistical approach in the literature for estimating the permanent capital gains elasticity has yielded wide variations in the magnitude of this effect, from -0.22 to -0.98. The major reason that high elasticities were found in some earlier studies is that the elasticity probably reflected in large part the short-run (or transitory) elasticity, which arises when taxpayers time their realizations for periods when their tax rates are lower. Although the variations have narrowed in more recent studies as researchers refined their approaches, these measures indicate that the offset from a tax increase can be as small as 22% and as large as 98%, while the corresponding revenue-maximizing tax rate can be as high as 100% and as low as 22%. The analysis in this report uses an approach that differs from the common statistical methodology and is based on the simple observation that there is a boundary on the realization response: realizations over time cannot exceed accrued gains. The larger the existing realizations are relative to accruals, the smaller any potential realizations response can be. Estimates of realizations relative to accruals over the period 1987-2023 indicate that realizations are approximately 60% of accruals, although there is some variation owing to uncertainties, primarily the magnitude of noncompliance. These estimates are paired with the estimates of taxes and transactions costs, and the common functional form used for estimating the realizations response, to yield an estimate of the size of realizations in the absence of these taxes and transactions costs.
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