An Analysis of the Tax Treatment of Capital Losses
An Analysis of the Tax Treatment
of Capital Losses
Updated October 20, 2008
Thomas L. Hungerford
Specialist in Public Finance
Government and Finance Division
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
An Analysis of the Tax Treatment of Capital Losses
Several reasons have been advanced for increasing the net capital loss limit
against ordinary income: as part of an economic stimulus plan, as a means of
restoring confidence in the stock market, and to restore the value of the loss
limitation to its 1978 level. Under current law, long-term and short-term losses are
netted against their respective gains and then against each other, but if any net loss
remains it can offset up to $3,000 of ordinary income each year. Capital loss limits
are imposed because individuals who own stock directly decide when to realize gains
and losses. The limit constrains individuals from reducing their taxes by realizing
losses while holding assets with gains until death when taxes are avoided completely.
Current treatment of gains and losses exhibits an asymmetry because long-term
gains are taxed at lower rates, but net long-term losses can offset income taxed at full
rates. Individuals can game the system and minimize taxes by selectively realizing
gains and losses, and for that reason the historical development of capital gains rules
contains numerous instances of tax revisions directed at addressing asymmetry. The
current asymmetry has grown as successive tax changes introduced increasingly
favorable treatment of gains. Expansion of the loss limit would increase “gaming”
opportunities. In most cases, this asymmetry makes current treatment more generous
than it was in the past, although the capital loss limit has not increased since 1978.
Capital loss limit expansions, like capital gains tax benefits, would primarily
favor higher income individuals who are more likely to hold stock. Most stock
shares held by moderate income individuals are in retirement savings plans (such as
pensions and individual retirement accounts) that are not affected by the loss limit.
Statistics also suggest that only a tiny fraction of individuals in most income classes
experience a loss and that the loss can usually be deducted relatively quickly.
One reason for proposing an increase in the loss limit is to stimulate the
economy, by increasing the value of the stock market and investor confidence.
Economic theory, however, suggests that the most certain method of stimulus is to
increase spending directly or cut taxes of those with the highest marginal propensity
to consume, generally lower income individuals. Expanding the capital loss limit is
an indirect method, and is uncertain as well. Increased capital loss limits could
reduce stock market values in the short run by encouraging individuals to sell.
Adjusting the limit to reflect inflation since 1978 would result in an increase in
the dollar limit to about $8,000. However, most people are better off now than they
would be if the $3,000 had been indexed for inflation if capital losses were
excludable to the same extent as long-term capital gains were taxable. For higher
income individuals, restoring symmetry would require using about $2 in long-term
loss to offset each dollar of ordinary income. Fully symmetric treatment would also
require the same adjustment when offsetting short-term gains with long-term losses.
This report will be updated to reflect legislative developments.
Gregg A. Esenwein was an original coauthor of this report.
Current Income Tax Law............................................2
Historical Treatment of Capital Losses.................................3
1913 to World War II...........................................3
World War II through the 1950s..................................4
The 1960s through the 1970s.....................................4
The Tax Reform Act of 1986 to the Present.........................5
Analysis of the Treatment of Capital Losses Under Current Law.............6
List of Tables
Table 1. Capital Losses by Asset Type, 1999............................9
Table 2. Capital Losses by Income Class, 2006.........................10
An Analysis of the Tax Treatment
of Capital Losses
Since the enactment of the individual income tax in 1913, the appropriate
taxation of capital gains income has been a perennial topic of debate in Congress.
Every session, numerous bills are introduced that would change the way capital
gains income is taxed. Congress has also shown a continuing interest in the tax
treatment of capital losses. With the financial turmoil and the volatile stock market,
many have proposed increasing the limit on capital losses that can be deducted
against ordinary income (the loss limit). For example, Representative Mark Kirk
introduced the Middle Class Investor Relief Act (H.R. 7123) on September 29, 2008,
which would increase the loss limit to $20,000 from its current $3,000. More
recently, Senator McCain proposed increasing the loss limit to $15,000.1
A limit on the deductibility of capital losses against ordinary income has long
been imposed, in part because gains and losses are taxed or deducted only when
realized. An individual who is actually earning money on his portfolio can achieve
tax benefits by realizing losses and not gains (and can hold assets with gains until
death when no tax will ever be paid). The loss limit prevents this selective
realization of losses from being a significant problem.
The problem of losses is further exacerbated by the current tax system, where
the treatment of capital gains and losses is asymmetrical. Long-term gains are taxed
at a maximum rate of 15%. Long-term losses are deductible without limit against
short-term capital gains and net long-term losses are deductible against $3,000 of
ordinary income. Both short-term capital gains and ordinary income can be taxed at
rates of up to 35%. This differential allows taxpayers to time their gains and losses
so as to minimize income taxes. (For example, by realizing and deducting losses in
one tax year at 35% while waiting until the next tax year to realize and pay taxes on
gains at 15%). Increasing the net capital loss deduction would increase the rewards
of gaming the system.
The empirical evidence indicates that capital gains income is heavily
concentrated in the upper income ranges. It is probable that large capital losses are
also concentrated in the same income ranges. Taxpayers in the middle income ranges
tend to hold capital gains producing assets as part of tax favored retirement savings
plans. The assets in these plans are not affected by the net loss restrictions. As a
1 See Laura Meckler, “McCain Puts New Tax Cuts on the Table,” Wall Street Journal,
October 15, 2008, p. A12.
consequence, the benefits of increasing the net loss deduction would tend to accrue
to taxpayers in the upper income ranges.
It is also unclear whether increasing the net loss deduction would stimulate the
economy. Economic analysis suggests that measures to stimulate the economy should
focus on spending or on tax cuts likely to be spent, that will directly increase
aggregate demand. An expanded deduction for capital losses has a tenuous
connection to expanded spending; thus, presumably, the argument is that such a tax
benefit will benefit the stock market. However, it is not at all certain that an increase
in loss deduction would increase the stock market; it might increase sales of poorly
performing stocks and depress these markets further.
This report provides an overview of these issues related to the tax treatment of
capital losses. It explains the current income tax treatment of losses, describes the
historical treatment of losses, provides examples of the tax gaming opportunities
associated with the net loss deduction, examines the distributional issues, and
discusses the possible stimulative effects of an increase in the net loss deduction.
Current Income Tax Law
Under current income tax law, a capital gain or loss is the result of a sale or
exchange of a capital asset (such as corporate stock or real estate). If the asset is sold
for a higher price than its acquisition price, then the sale produces a capital gain. If
the asset is sold for a lower price than its acquisition price, then the sale produces a
Capital assets held longer than 12 months are considered long-term assets while
assets held 12 months or less are considered short-term assets. Capital gains on
short-term assets are taxed at regular income tax rates. Gains on long-term assets
sold or exchanged on or after May 6, 2003, and before January 1, 2009, are taxed at
a maximum tax rate of 15%. For these assets, the maximum long-term capital gains
tax rate is 0% for individuals in the 10% and15% regular marginal income tax rate
Losses on the sales of capital assets are fully deductible against the gains from
the sales of capital assets. (Losses on the sale of a principal residence are not
deductible and losses on business assets are treated as ordinary losses and deductible
against business income.) However, when losses exceed gains, there is a $3,000
annual limit on the amount of capital losses that may be deducted against other types
Determining the amount of capital losses under the federal individual income
tax involves a multi-step process. First, short-term capital losses (on assets held less
than 12 months) are deducted from short-term capital gains. Second, long-term
capital losses (on assets held for more than 12 months) are deducted from long-term
capital gains. Next, net short-term gains or losses are combined with net long-term
gains or losses.
If the combination of short-term and long-term gains and losses produces a net
loss, then that net loss is deductible against other types of income up to a limit of
$3,000. Net losses in excess of this $3,000 limit may be carried forward indefinitely
and deducted in future years, again subject to the $3,000 annual limit.
Historical Treatment of Capital Losses
Historically, Congress has repeatedly grappled with the problem of how to tax
capital gains and losses. Ideally, a tax consistent with a theoretically correct measure
of income would be assessed on real (inflation-adjusted) income when that income
accrues to the taxpayer. Conversely, real losses should be deducted as they accrue
to the taxpayer. However, putting theory into practice has been a difficult exercise.
Since 1913, there has been considerable legislative change in the tax treatment
of capital gains income and loss. To provide perspective for the current debate, a
brief overview of the major legislative changes affecting capital losses follows.
1913 to World War II
Between 1913 and 1916, capital losses were deductible only if the losses were
associated with a taxpayer’s trade or business. Between 1916 and 1918, capital
losses were deductible up to the amount of any capital gains, regardless of whether
the gains or losses were associated with a taxpayer’s trade or business. From 1918
to 1921, capital losses in excess of capital gains were deductible against ordinary
The Revenue Act of 1921 significantly changed the tax treatment of capital
gains and losses. Assets were divided into short and long-term assets. Short-term
gains were taxed at regular income tax rates and excess short-term losses were
deductible against ordinary income. Long-term gains were eligible for tax at a flat
rate of 12.5%. Net excess long-term losses were deductible against other types of
income at ordinary income tax rates which, including surtax rates, went as high as
This system created an asymmetrical treatment of long-term gains and losses.
Excess long-term losses could be deducted at much higher tax rates than the rates
applied to long-term gains. This asymmetry was rectified by the Revenue Act of
This approach remained in effect, with only minor modifications, between 1924
and 1938. The Revenue Act of 1938, however, introduced changes in the tax
treatment of gains and losses from the sale of capital assets. Gains and losses were
classified as short-term if the capital asset had been held 18 months or less and long-
term if the asset had been held for longer than 18 months.
Short-term losses were deductible up to the amount of short-term gains. Short-
term losses in excess of short-term gains could be carried forward for one year and
used as an offset to short-term gains in that succeeding year. The carryover could not
exceed net income in the taxable year the loss was incurred. Net short-term gains
were included in taxable income and taxed at regular tax rates.
For assets held more than 18 months but less than 24 months, 66.66% of the
gain or loss was recognized. For assets held longer than 24 months, 50% of the gain
from the sale of that asset was recognized and included in taxable income. Net
recognized long-term losses could be deducted against other forms of income without
limit. This treatment, however, introduced a new inconsistency into the tax system
because while only 50% of any long-term capital gain was included in the tax base,
World War II through the 1950s
The next significant change in the tax treatment of capital losses occurred during
World War II. The Revenue Act of 1942 changed the tax treatment of capital losses
in two significant ways. First, it consolidated the tax treatment of short- and long-
term losses. Second, it established a $1,000 limit on the amount of ordinary income
that could be offset by combined short- and long-term net capital loss. Finally, it
created a five-year carry forward for net-capital losses that could be used to offset
capital gains and up to $1,000 of ordinary income in succeeding years.
Once again, this change introduced an inconsistency into the tax treatment of
gains and losses because it allowed taxpayers to use $1 in net long-term losses to
offset $1 in net short-term gains. Since only 50% of a net long-term gain was
included in taxable income, including 100% of a net long-term loss created an
asymmetry. For instance, if a taxpayer had a net long-term loss of $100, then it could
be used to offset $100 of net short-term gains. Symmetrical treatment of long-term
gains and losses, however, would allow only 50% of a net long-term loss to be
deducted against net short-term gains ($100 of net long-term loss could only offset
$50 of net short-term gain). This asymmetry was corrected in the Revenue Act of
The 1960s through the 1970s
The Revenue Act of 1964 repealed the five-year loss carryover for capital losses
and replaced it with a unlimited loss carryover. Net losses, however, were still
deductible against only $1,000 of ordinary income in any given year.
The Tax Reform Act of 1969 also removed a dichotomy in the tax treatment of
long-term gains and losses that had existed since 1938 by imposing a 50% limitation
on the amount of net long-term losses that could be used to offset ordinary income.
Under prior law, even though only 50% of net long-term gains were subject to tax,
net long-term losses could be deducted in full and used to offset up to $1,000 of
ordinary income. The 1969 Act repealed this provision and established a new 50%
limit on the deductibility of net long-term losses, subject to the same $1,000 limit on
ordinary income (hence, it took $2 of long-term loss to offset $1 of ordinary income).
In addition, the law specified that the nondeductible portion of net long-term losses
could not be carried forward to be deducted in succeeding years.
The Tax Reform Act of 1976 increased the capital loss offset against ordinary
income. Under prior law, net capital losses could offset up to $1,000 of ordinary
income. The 1976 Act increased the capital loss offset limit to $2,000 in 1977 and
$3,000 for tax years starting after 1977.
The Revenue Act of 1978 reduced the tax rate on long-term capital gains income
by increasing the exclusion from tax for long-term capital gains from 50% to 60%.
The 1978 Act, however, did not reduce the limit on the deductibility of net long-
term losses. Hence, while only 40% of long-term gains were included in the tax
base, 50% of losses were excluded from the tax base.
The Tax Reform Act of 1986 to the Present
The Tax Reform Act of 1986 repealed the net capital gain deduction for
individuals. Both short-term and long-term capital gains income were included in
taxable income and taxed in full at regular income tax rates. Regular statutory
income rates under the act were reduced from a maximum of 50% to 33% (28%
statutory rate plus a 5% surcharge).
The tax treatment of capital losses was changed by eliminating the 50%
limitation on deductibility of net long-term losses. Losses could be netted against
gains and any excess losses, whether short or long term, could be deducted in full
against up to $3,000 of ordinary income. Net losses in excess of this amount could
be carried forward indefinitely.
Gradually changes were made that caused capital gains to be tax favored again.
When tax rates were revised in 1990 to eliminate the “bubble” arising from the
surcharge, a maximum rate of 28% was set for capital gains, slightly lower than the
top rate of 31%. When tax rates were increased in 1993 for very high income
individuals (adding a 36% and 39.6% rate), this 28% top tax rate on long-term gains
was maintained, causing a wider gap between taxation of ordinary income and capital
gains income. The growing asymmetry between taxes on capital gains and losses
was not addressed.
The Taxpayer Relief Act of 1997 was the latest major change in the tax
treatment of capital gains and losses. It established the current law treatment of gains
by lowering the maximum tax rate on long-term capital gains income to 20% (and
creating a 10% maximum capital gains tax rate for individuals in the 15% tax
bracket). The act did not change the tax treatment of capital losses.
Analysis of the Treatment of Capital Losses
Under Current Law
The tax treatment of capital gains and losses has changed repeatedly over the
years. Some of the legislative changes that occurred in the past were attempts to
reestablish symmetry between the tax treatment of capital gains and capital losses.
Under current law, asymmetries between the tax treatment of capital gains and losses
remain. Currently, net long-term losses are deductible against net short-term gains
without limit. This rule introduces inconsistences because net long-term gains are
taxed at a maximum rate of 15% while net long-term losses can be deducted against
short-term gains which can be taxed at rates up to 35%. Additionally, net long-term
losses can be deducted against up to $3,000 of ordinary income even though the
maximum rate on ordinary income is 35% while the maximum rate on long-term
gains is 15%.
The recent downturn in the stock market has prompted some analysts to suggest
increasing the net capital loss limitation as a means of softening the downturn for
some investors. However, simply increasing the loss limitation would tend to
increase the dichotomy between the tax treatment of gains and losses. Given these
suggestions, a review of the rationale behind the net loss limitation may prove
The loss limitation was originally enacted because taxpayers have control over
the timing of the realization of their capital gains and losses. They can elect to sell
assets with losses and hold assets with gains, thus minimizing their capital income
tax liabilities. When capital gains income is taxed more lightly than other types of
income, allowing capital losses to offset other income without limit increases a
taxpayer’s ability to minimize income taxes by altering the timing of the realization
of gains and losses.
For example, consider the case of a taxpayer who, on the last day of a tax year,
wishes to sell two assets. The sale of the first asset would produce a long-term gain
of $20,000 while the sale of the second asset would produce a long-term loss of
$20,000. If the taxpayer sold both assets in the same tax year, then the two sales
would net to zero and there would be no taxes owed on the transactions.
However, if there were no loss limitation, then the taxpayer could significantly
reduce his taxes by realizing the gain this tax year and postponing the realization of
the loss until the next tax year (or vice versa). Realization of the $20,000 long-term
gain in the current tax year would cost the taxpayer $3,000 in federal income taxes
(15% maximum long-term capital gains tax rate times the $20,000 capital gain). By
waiting and taking the loss the next tax year, the taxpayer could reduce his federal
income taxes by $7,000 (35% maximum tax rate on ordinary income times the
$20,000 long-term loss). Hence, with no capital gains loss limitation, the taxpayer
could reduce his net federal income taxes by $4,000 simply by changing the timing
of the realizations of gains and losses.
It should be noted that current law allows for an unlimited carry forward of
excess losses. Hence, taxpayers do not forfeit the full value of excess losses because
they can deduct those losses in future years. The actual cost to the taxpayer of
forgoing the full loss in the current year is the interest that would have been earned
on the additional tax reduction that would have been realized had there been no
excess loss limitation.
For example, consider a scenario where a taxpayer has a net long-term capital
loss of $20,000. If there were no loss limitation, the taxpayer could deduct the entire
loss against other income in the first year and, assuming the highest marginal tax rate
of 35%, reduce his income tax liability by $7,000 ($20,000 times 0.35).
Now consider the situation with a $3,000 annual loss limitation. If the taxpayer
had no net capital gains in any subsequent year, then it would take the taxpayer seven
years to deduct the full $20,000 capital loss ($3,000 loss deduction for six years and
a $2,000 loss deduction in the seventh year). Once again assuming the taxpayer faces
the highest marginal tax rate of 35% (and that the rate does not change over the seven
year period) the taxpayer will reduce his taxes over the period by $7,000.
Since money has a time value, however, the $7,000 in tax savings taken over
seven years is not as valuable as the $7,000 in tax savings taken in the first year when
there was no loss limitation. If an interest rate of 5% is assumed, then the present
value of the $7,000 in tax savings over seven years is $6,118. So under this worst
case scenario, in present value terms, the annual capital loss limitation would reduce
the tax savings in this example by approximately $882.
It is also worth noting that if the tax rate on long-term gains and loses were
symmetrical at 15%, then the full deduction of a $20,000 net long-term loss would
reduce the taxpayer’s income tax liability by only $3,000 ($20,000 loss times 15%
tax rate). Hence, even with the annual loss limitation, taxpayers with net long-term
capital losses receive more tax savings under the current system than if there were a
symmetrical tax rate on long-term gains and losses. (In the preceding example where
the $20,000 was deducted at regular income tax rates over seven years the present
value of the tax savings was $6,118 versus a $3,000 tax savings if there were a 15%
symmetrical tax rate on both capital gains and losses). In most cases, the current
system, even without indexing the $3,000 loss for inflation, is more generous than
the system that existed in 1978.
The empirical evidence establishes that capital gains are concentrated at the
higher end of the income range. In 2006, the last year that aggregate tax statistics are
available, the top 3% of taxpayers with over $200,000 in adjusted gross income
earned 91% of schedule D capital gains.2 It has also long been recognized that these
concentrations are somewhat overstated because large capital gains realizations tend
2 Internal Revenue Service Statistics of Income, Individual Income Tax Returns, 2006.
Generally, capital gains and losses are reported on schedule D. Under certain
circumstances, capital gains (if there are no losses) can be reported directly on the form
to push individuals into higher brackets and an annual snapshot can overstate the
concentration. One way to correct for this effect is to sort individuals by long-term
average incomes which requires special tax tabulations. The most recent study to do
so (using a somewhat different measure of income, but reporting by population share)
indicated that the top 1% who earned over $200,000 from 1979-1988 received 57%
of gains, and the top 3% who earned over $100,000 received 73% of the gains.3 By
interpolation, we can see that about two-thirds of gains are received by the top 2%
of the income distribution.
The distortion relating to gains works in the opposite direction in the case of
losses, understates the share of losses going to high income individuals, and may be
much more serious. Thus, looking at losses by income class may not be very
meaningful. For example, the top 3% accounted for about 30% of losses.4 However,
there are significant losses in very low income classes that are almost certainly people
whose incomes are normally high. For example, another 10% of losses are realized
by individuals with no adjusted gross income. Since gains are normally much larger
than losses, this distortion can be quite serious and calculations such as these
probably do not tell us very much. A better calculation is the permanent capital gains
share, which suggests, as noted above, that about two-thirds of gains are realized by
individuals in the top 2% of the permanent income distribution, and a similar finding
is probably appropriate for losses.
There are other reasons to expect that lower and middle income taxpayers are
unlikely to be much affected by the expansion of capital losses. First, relatively few
low and middle income families directly hold stock. About 14% of families with
income below $75,000 directly own corporate stock and about 35% of families with
income between $75,000 and $100,000 directly own stock. Secondly, many of their
assets are held (and are increasingly being held) in tax favored forms. In 2001, 29%
of equities held by individuals were held in pensions (either private or state and
local); moreover about of 8% of stock is held in individual retirement accounts.
Assets held in these accounts are not affected by loss restrictions because in the case
of traditional IRAs and pension plans the original contributions have already been
deducted from income. Hence, any possible loss on the original investment has been
pre-deducted from taxable income. In the case of Roth IRAs, since gains on
investments are not subject to tax upon withdrawal, losses on investments should not
be deducted from income.
Another 7% are held in life insurance plans which are also not subject to tax.
Altogether, these assets account for over 40% of equities and they are likely to be
proportionally much more important for the middle class.5 In addition, moderate
income taxpayers are more likely to hold equities in mutual funds that have mixed
portfolios and typically do not report losses because they hold so many types of
stocks. Only about 25% of distributions from mutual funds are reported on tax
3 Leonard E. Burman. The Labyrinth of Capital Gains Tax Policy: A Guide for the
Perplexed. (Washington D.C., The Brookings Institution, 1999).
4 Internal Revenue Service, op cit.
5 Data from the Board of Governors of the Federal Reserve, Flow of Funds Accounts, June
returns because the remainder of distributions occur in pension and retirement
The major sources of realized capital losses for 1999 (the latest year for which
this information is available) are shown in Table 1. The largest source of losses is
the sale of corporate stock, which accounts for 61% of losses reported in 1999. Other
securities (for example, mutual fund shares and options) accounted for another 15%.
In general, most of the capital losses are realized on assets that are predominantly
owned by higher income taxpayers.
Table 1. Capital Losses by Asset Type, 1999
AssetAmount (millions)Percent of Total
Bonds $3,707.6 2.0%
Partnership, S corporation$7,242.83.8%
Source: Janette Wilson, “Sales of Capital Assets Reported on Individual Income Tax Returns, 1999,”
SOI Bulletin (Summer 2003), pp. 132-145.
Most taxpayers with incomes below $200,000 do not file a schedule D and thus
have no capital losses (see Table 2).7 In contrast, over 90% of taxpayers with income
over $1 million file a schedule D. Direct evidence from tax returns does suggest that
only a small fraction of taxpayers experience a net capital loss (less than 7% in total).
Excluding the “No Income” class, about 6% have any loss at all. Even among very
high income taxpayers, less than 20% report a net capital loss on their schedule D.
These shares would probably be even smaller for population arrayed according to
6 Congressional Budget Office, The Contribution of Mutual Funds to Taxable Capital
Gains, CBO Memorandum, October 1999.
7 In all, 86% of taxpayers with income below $200,000 do not file a schedule D.
Table 2. Capital Losses by Income Class, 2006
Adjusted GrossPercentagePercentage ofAverageSchedule DAverage
IncomeFilingFilers with aLoss (lessLoss
5-10 6.8 2.8 $3,736 $2,062
10-15 7.0 2.9 $3,981 $2,129
15-20 7.2 3.2 $5,321 $2,188
20-25 7.3 3.2 $4,414 $2,110
25-30 8.2 3.4 $3,584 $2,030
30-40 9.4 3.7 $5,451 $2,079
40-50 13.0 5.0 $3,960 $1,997
50-75 17.8 6.8 $4,037 $2,092
75-100 25.3 9.6 $4,226 $2,152
100-200 39.7 14.4 $5,425 $2,191
200-500 67.6 22.0 $8,851 $2,448
500-1,000 84.8 22.3 $15,373 $2,633
1,000-1,500 90.8 20.9 $19,779 $2,699
1,500-2,000 92.3 19.0 $27,788 $2,767
2,000-5,000 94.5 16.5 $36,656 $2,786
5,000-10,000 96.7 12.6 $60,634 $2,829
10,000 or more98.28.4$226,061$2,826
Source: Author’s calculations based on Internal Revenue Service Statistics of Income, Individual
Income Tax Returns, 2006.
Taxpayers with net capital losses can deduct up to $3,000 against ordinary
income, but about 60% are subject to the loss limit and have to carryover the excess
losses to subsequent years. Evidence indicates that of individuals who could not
deduct their losses in full, two thirds were able to fully deduct losses within two years8
and more than 90% in six years. A recent study concluded that in 2003 more than
half of the benefit of raising the exclusion to $6,000 would be received by tax filers
8 Burman, The Labyrinth of Capital Gains, op cit.
with incomes over $100,000, who account for 11% of tax filers.9 Thus, the evidence
suggests that raising the capital loss limit would benefit a relative small proportion
of high income individuals.
The primary objective of recent economic proposals is to stimulate the economy.
Normally a tax benefit that favors individuals with high permanent incomes (as does
a capital gains tax cut) is a relatively ineffective way to stimulate the economy
because these individuals tend to have a higher propensity to save, and it is spending,
not saving, that stimulates the economy. The most effective economic stimulus is
one that most closely translates dollar for dollar into spending.10 Direct government
spending on goods and services would tend to rank as the most effective, followed
by transfers and tax cuts for lower income individuals.
One argument that might be made for providing capital gains tax relief is that
it would increase the value of the stock market and thus investor confidence. Indeed,
such an argument has been made for a capital gains tax cut in the past. Such a link
is weaker and more uncertain than a direct stimulus to the economy via spending
increases or cuts in taxes aimed at lower income individuals. Indeed, it is not
altogether certain that capital gains tax relief would increase stock market values —
the evidence is mixed. Stock markets rise when increases in offers to buy exceed
increases in offers to sell. Capital gains tax revisions may be more likely to increase
sales than purchases in the short run through an unlocking effect, and this effect11
could be particularly pronounced in the case of an expanded capital loss deduction.
Although these benefits may stimulate the stock market because they make stocks
more attractive investments, they also create a short-term incentive to sell — and an
incentive to sell the most depressed stocks. Thus, if the method of stimulating the
economy is expected to work via an increase in stock prices, such a tax revision
whose effect is expected via a boost in the stock market could easily depress stock
prices further. Overall, it is a uncertain method of stimulating the economy.
9 William G. Gale and Peter Orszag, “A New Round of Tax Cuts?” Brookings Institution,
10 For a further discussion of this issue, see CRS Report RS21136, Government Spending
or Tax Reduction: Which Might Add More Stimulus to the Economy?, by Marc LaBonte;
CRS Report RS21126, Tax Cuts and Economic Stimulus: How Effective are the
Alternatives?, by Jane G. Gravelle; CRS Report RS21014, Economic Effects of Permanent
and Temporary Capital Gains Tax Cuts, by Jane G. Gravelle; and CRS Report RL34349,
Economic Slowdown: Issues and Policies, by Jane G. Gravelle, Thomas L. Hungerford,
Marc Labonte, Edward V. Murphy, N. Eric Weiss, and Julie M. Whittaker.
11 Increases in capital loss limits increase the expected rate of return on stocks and would
therefore eventually be expected to push up demand and raise prices, although the extent
to which tax benefits on future losses actually affect the investment decision is not certain.
Note, however, that any price effects would be temporary; in the long run, investment and
rates of return would adjust and stock prices should reflect the value of underlying assets.
Several reasons have been advanced to increase the net capital loss limit against
ordinary income: as part of an economic stimulus plan, as a means of restoring
confidence in the stock market, and to restore the value of the loss limitation to its
An increase in the net capital loss limit may not be an effective device to
stimulate aggregate demand. In the short run, an increase in the loss limitation could
produce an incentive to sell stock, which could depress stock prices and erode
confidence even further. Furthermore, the empirical evidence suggests that the tax
benefits of an increase in the net capital loss limitation would be received by a
relatively small number of higher income individuals.
The restoration of the value of the loss limitation to its 1978 level is more
complicated to address, but two important comments may be made. First, there is no
way to determine that a particular time period had achieved the optimal net capital
lost limitation, although historically, the loss limit has been quite small. Second,
while correcting the $3,000 loss limit to reflect price changes since 1978 would
increase its value to about $9,500 in 2007 dollars, net long-term capital losses are
generally treated more preferentially than they were prior to 1978 because of the
asymmetry between loss and gain, which was never addressed during recent tax
changes. Restoration of historical treatment would also require an adjustment for
asymmetry. This problem with asymmetry has been growing increasingly important
through the tax changes of 1990, 1993, 1997, and 2003. Raising the limit on losses
without addressing asymmetry will expand opportunities to game the system.
Achieving full symmetry in the system requires that the tax rate differential
between short and long-term gains and losses be accounted for during the netting
process. The current rate differential is approximately two to one (35% maximum
tax rate on ordinary income and short-term capital gains versus an 15% maximum
tax rate on long-term capital gains). Given this rate differential, symmetry could be
achieved in the netting process through the following steps:
!In the case of a net short-term gain and a net long-term loss, $2 of
net long-term losses should be required to offset $1 of short-term
gain. If a net loss position remains, $2 of long-term losses should be
required to offset $1 of ordinary income up to the net loss limitation.
Any remaining net loss would be carried forward.
!In the case of a net short-term loss and a net long-term loss the
simplest way is to begin with short-term losses which can be used on
a dollar for dollar basis to offset ordinary income. If short-term
losses exceed the limit they would be carried forward along with all
long-term losses. If net short-term losses are less than the loss
limitation, then $2 of net long-term loss can be used to offset each
$1 remaining in the net loss limitation. Any remaining net long-term
loss would be carried forward.
!In the case of a net short-term loss and a net long-term gain each $1
of net short-term loss should offset $2 of net long-term gain. Any
net loss remaining should offset ordinary income on a dollar for
dollar basis up to the net loss limitation. Any remaining net loss
would be carried forward.
Although the netting principles outlined above may appear complicated, they
are no more complicated to implement on tax forms than the current netting
Another method for achieving symmetry would be to institute a tax credit of
15% (or whatever the maximum capital gain tax rate is) for capital losses. The tax
credit could be capped and the cap could be indexed to inflation. This will benefit
taxpayers in the 10% and 15% tax brackets because the maximum capital gains tax
rate is 0% for these taxpayers (until 2011). But these taxpayers mostly do not report
capital gains and losses. This is the basic approach taken between 1924 and 1938