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As part of the 1997 Balanced Budget Act, Congress and President Clinton cut the top tax rate on capital gains to 20 percent. Capital gains are profits on the sale of investments such as stocks and real estate. Tax rates on ordinary income go up to 39.6 percent. Further reductions in the capital-gains rate are scheduled for future years.
Enthusiasts of the capital-gains tax break believe it will help the economy by stimulating savings and investment. That is debatable. (See a Slate article arguing otherwise; also see this Slate "Dialogue" on the subject.) But one form of investment this new law undoubtedly will stimulate is tax shelters. Shelters are financial arrangements designed primarily or entirely to reduce taxes. They were largely eliminated by the 1986 tax reform, which ended the special break for capital gains. Now they are back, as the following examples demonstrate.
What is wrong with tax shelters? Leave aside critical questions of fairness and revenue lost to the Treasury (which must be made up by borrowing or by increasing taxes on other people). Consider only the effect of tax shelters on the overall economy. Shelters hurt the economy in two ways. At best they waste resources on lawyers and accountants designing complicated but economically meaningless arrangements. At worst they redirect investment capital from uses that make economic sense to those that don't. In the early 1980s, for example, the tax system made it profitable to build office buildings even if you had no hope of renting them out. The result was downtowns full of "see through" towers, and a real-estate glut from which some cities are still recovering.
How does a tax shelter work?.