The 2001 and 2003 tax relief measures approved by Congress and signed into law by President George W. Bush gave a substantial and much-needed boost to small business, entrepreneurship, investment, economic growth and job creation.

Unfortunately, though, these tax cuts were passed as temporary measures. Of course, tax cuts with expiration dates have the potential to go sour. That is, they pass the expiration date and turn into tax increases. Such looming threats create uncertainty in the marketplace and restrain the potential positive impact that tax relief can have on the economy.

The 2003 tax package included a reduction in the top capital gains tax rate paid by individuals from 20% to 15%. The lower rate fell from 10% to 5%, and is scheduled to decline to 0% in 2008. This followed a reduction in the top capital gains tax rate from 28% to 20% in 1997. If current law is not changed, though, the capital gains tax rate will increase from 15% to 20%, and the lower rate from 0% to 10% starting in 2009. It is crucial that the capital gains tax cuts be made permanent.

After all, the economy needs individuals willing to undertake the formidable risks of investing their sweat and/or capital in innovation, invention, and new and expanding businesses. But capital gains taxes raise the costs of such enterprises -- diminishing potential returns, and thereby reducing the incentives for risk taking, and restraining economic growth. Sound economic reasoning tells us that reducing the capital gains tax will benefit investment and entrepreneurship.

And a capital gains tax cut is not just good news for entrepreneurs and investors, but for labor as well. Contrary to the old labor-against-capital argument, labor is powerless without capital. That is, people need places to work and tools with which to work. So, by reducing the capital gains tax, labor reaps rewards too.

It also needs to be understood that capital gains taxes represent a form of multiple taxation. Individuals pay taxes on income they earn, and then choose to either save, invest, or consume their after-tax dollars. The federal government generally does not tax consumption, but most certainly does tax the returns on saving and investing. This creates a bias in favor of consumption over investment.

Given these facts, it should not be surprising that economic growth has been influenced by changes in the capital gains tax. Over the past century, for example, there have been five instances of substantive cuts in the capital gains tax. In each case, the economy benefited.

• In the early 1920s, the top capital gains tax was slashed from 73% to 12.5%, thereby helping to spark the solid economic growth experienced during the 1920s.
• In 1938, the capital gains tax rate was reduced from 23.7% to 15%. This helped the economy emerge from the Great Depression, as growth shifted to a solid path in 1939, 1940 and 1941.
• Cuts in the capital gains tax in 1979 and 1981 (with the top rate eventually dropping from 49.1% to 20%) played a part in spurring the economic recovery experienced in the 1980s.
• The 1997 capital gains tax cut worked to shift a below-average economic recovery in the 1990s to a rather robust one.
• The 2003 reduction in the capital gains tax helped shrug off an under-performing recovery experienced after the 2001 recession, and pushed the economy to a higher level of economic growth.

Meanwhile, there also have been instances where an increase in the capital gains tax had a negative impact on the economy.

• The capital gains tax rate steadily rose from 25% to 49.1% over the period 1968 to 1976, and over that time average annual real economic growth under-performed the post-World War II average - registering 3.0% vs. the 3.5% post-war average.
• With the capital gains tax hike in 1987 came slower economic growth. From 1987 to 1996, real annual GDP growth again under-performed - averaging only 2.9%.

The benefits of a lower capital gains tax are not in serious economic dispute. It's just basic economics.

Removing a looming capital gains tax increase would be a big plus for investment, entrepreneurship and the economy. Congress and the White House need to make the 2003 capital gains tax cut permanent, and to do so as soon as possible.

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This column may be reprinted with appropriate credit.
 

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.