What are capital gains taxes and how could they be reformed?

The Vitals

Over the past 40 years, the distributions of income and wealth have grown increasingly unequal. In addition, there has been growing understanding that the United States faces a long-term fiscal shortfall that must be addressed, at least in part, by raising revenues. For these and other reasons, proposals to raise taxes on wealthy households have received increased attention in recent years. One approach to both reduce inequality and raise revenue is to reform the taxation of capital gains. One prominent proposal would be to tax capital gains as they accrue instead of waiting until an asset is sold, an approach sometimes known as “mark-to-market.”

• In 2018, the top 1% of households obtained 69% of realized long-term capital gains; the top 20% received 90% of the gains.

• Eliminating the ‘step-up in basis’ at death would raise $105 billion over 10 years.

• Capital gains taxes on accrued capital gains are forgiven if the asset holder dies creating a so-called “Angel of Death” loophole.

A Closer Look

What is a capital gain?

A capital gain is the increase in the value of an asset over
time. If you buy stock for $100 and its value rises to $300, you have accrued a
capital gain of $200. More technically, a capital gain is the difference
between an asset’s current value and its “basis.” The basis is the cost to the
owner: the sum of the purchase price, commissions, and fees, less any
deprecation of the asset over time. If you sell the stock for $300, the $200
gain is said to be “realized.” If you hold on to the stock, the gain is
“unrealized.”

The overwhelming majority of realized capital gains go to
the highest income households. In 2018, the top 1 percent of households ranked
by income obtained 69 percent of realized long-term capital gains; the top 20
percent received 90 percent of the gains (Tax
Policy Center 2018).

How do we tax capital gains now?

The federal income tax does not tax all capital gains. Rather, gains are taxed in the year an asset is sold, regardless of when the gains accrued. Unrealized, accrued capital gains are generally not considered taxable income. For example, if you bought an asset (e.g. a share of stock) for $100 ten years ago, and it’s worth $300 now and you sell it, your taxable capital gain would be $200 in the current year, and zero in the previous years.

This “taxation upon realization” approach has two advantages: relative ease of valuation and likelihood of investor liquidity. For the purpose of determining the capital gain, and then assessing tax liability, the value of the asset is simply the sale price. After realizing the gain, the selling investor should be able to use the money received for the asset to pay the capital gains tax.

Two other features of current capital gains taxation are noteworthy.

First, the tax rate on realized capital gains is lower than the tax rate on wages, if the asset was held for at least a year before selling. Realized capital gains face a top statutory marginal income tax rate of 20 percent plus a supplemental net investment income tax rate of 3.8 percent, for a combined total of 23.8 percent. Wages face a top marginal tax rate of 37 percent, plus a Medicare tax rate of 2.9 percent and a supplemental tax of 0.9 percent, for a combined rate of 40.8 percent.

Second, capital gains taxes on accrued capital gains are forgiven if the asset holder dies—the so-called “Angel of Death” loophole. The basis of an asset left to an heir is “stepped up” to the asset’s current value. Here’s an example: if your uncle bought an asset for $100 and sold it the day before he died at $300, he would owe capital gains tax on the $200 gain. If, instead, he held onto the asset until death and bequeathed it to you, you would receive the asset with a new basis of $300, not $100. No tax on the $200 capital gain is ever paid. If you eventually sell the asset for $350, you would have a basis of $300 and hence pay tax on capital gains of $50.

What are the problems with the way we tax capital gains now?

Although taxation on realization provides advantages with
respect to liquidity and valuation, it also creates several problems. The
underlying problem is that the current system does not tax a household’s
economic income, which is the sum of the household’s consumption and the change
in its wealth during the year. By this standard, all capital gains that occur
in the year in question should be included—whether realized or unrealized.

Taxation on realization creates what is called a “lock-in”
effect. When the tax rate on capital gains is constant with respect to the
holding period, investors are financially rewarded for deferring the sale of
the asset for as long as possible. Under taxation upon realization, the
effective after-tax return rises with the length of the holding period, even if
the pre-tax return and tax rates are constant.

For example, compare a stock producing a 10 percent annual
return (and, let’s assume, no dividends) and a bond that produces 10 percent
interest each year. Assume that both the capital gains tax rate and the ordinary
income tax rate are 30 percent. After one year, the bond would generate a 7
percent after-tax return. Similarly, if the stock were sold and the capital
gains tax were paid, the stock would generate the same after-tax return of 7
percent.

Over longer periods, however, the stock would perform
better—that is, the effective tax rate on the stock would fall relative to the
bond, because taxation upon realization delays the ultimate tax payment. For
example, if the stock continued to accrue 10 percent per year and then was sold
after 10 years, the effective return after paying capital gains taxes would be
7.8 percent, while the after-tax return on the bond would still be 7 percent. (The
calculation for the after-tax value of the stock is given by the expression
{((1+r)^T)-1)}(1-t) + 1, where r is the annual pre-tax rate of return, T is the
holding period, and t is the capital gains tax rate. The average annual
after-tax rate of return is that expression taken to the 1/T power, less 1.)

Lock-in encourages investors to retain their assets when the
economy would benefit from a change in investment. In addition, lock-in
subsidizes underperforming assets; investors will hold onto assets (say, an
underperforming business) for longer than socially ideal to lower their
effective tax rate.

Taxing capital gains on realization also drives tax
sheltering. Investor use of existing assets as collateral for loans is one
example of a tax shelter that deferral taxation allows. Loans on new assets,
paid back with tax-deductible interest, are guaranteed by assets accruing
capital gains. Investors can make a profit while paying off a loan, even if the
pre-tax return on the newly purchased asset is the same as the interest rate on
the loan, because of the collateral asset’s growth.

All of the practices described above are consequences of
taxing realized capital gains instead of accrued gains. The other key features
of the existing capital gains tax—preferred rates and basis step-up at
death—interact with taxation on realization in problematic ways. The lower tax
rates on capital gains than other forms of income encourage taxpayers to
classify income as capital gains rather than as wages, and they make sheltering
options more attractive. In addition, the “Angel of Death” loophole vastly
increases the lock-in effect and appeal of sheltering.

Together, deferral taxation and basis step-up give investors
enough discretion over whether and when to cash in assets that policymakers
need to keep the capital gains rate relatively low. A variety of studies
suggest that with deferral taxation and basis step-up, the revenue-maximizing
tax rate is in the range of 28–35 percent (Gleckman
2019). At higher rates, investors would choose to hold on to assets rather
than realize them, causing capital gains tax revenues to fall.

Another issue is that capital gains are not indexed for
inflation. For example, if you bought an asset for $100 a few years ago and it
is worth $300 now, the nominal capital gain is $200. But if the price level had
doubled during the time since you bought the asset, the real gain would only be
$100. The current system taxes the nominal gain. This is not ideal, but
indexing capital gains for inflation, without indexing other forms of capital
income and capital expense, would create numerous distortions and
inconsistencies in the tax system and increase sheltering. Given how low
inflation has been in recent years and given the complexity of indexing all forms
of capital income and expense, this issue can be kept on hold for now.

What are the options for reform?

1. Eliminate step-up
in basis at death

The simplest change would be to end basis step-up at death,
eliminating the “Angel of Death” loophole. Eliminating basis step-up for heirs
would result in a regime called “carryover basis.” The basis of an asset would
not change when bequests are made. When the asset is later sold by an heir, the
taxable basis would be the same as when the decedent owned it. Under a
carryover basis system, capital gains tax would continue to be owed when the
gain is realized. An asset that was purchased at $100, bequeathed and inherited
at $300, and sold by the heir at $350 would have a capital gain of $250. Under
the current system with step-up in basis, the capital gain would only be $50.

Shifting to carryover basis discourages lock-in and tax
shelters. The Joint Committee on Taxation staff calculate
that a policy ending basis step-up implemented this year would raise $104.9
billion over the next 10 years. In addition, curtailing tax avoidance would
allow policymakers to raise the capital gains tax rate and generate increased
revenues, without generating as much tax avoidance as would occur with a higher
rate under the current system.

A carryover basis regime maintains the practice of taxing
capital gains at realization and thus retains the advantages related to
investor liquidity and ease of valuation.

One argument against carryover basis is that, in some cases,
the taxpayer may not be able to document the basis of a long-held asset. This
is easy enough to address. A carryover basis regime should stipulate a “default
basis” (say, 10 percent of the sale price). If taxpayers can prove the basis is
higher than the default basis, they would be entitled to do so. If taxpayers
cannot or choose not to provide such records, the 10 percent basis rule would
apply, and the capital gain would be deemed to be 90 percent of the sale price.

2. Tax capital gains
at death

A somewhat more aggressive reform would be to tax capital
gains at death. Under this regime, death would be treated as if the holder sold
the asset. The decedent would owe capital gains tax on unrealized capital gains
accrued during his or her lifetime. The heir would then inherit the asset at
its current value through basis step-up.

For example, if an investor with an asset basis of $100 were
to die when the asset’s marketable value was $300, his estate would pay capital
gains tax (as well as any estate tax owed) on the $200 gain. The heir to this
asset would have the basis stepped up to $300 – the value of the asset at the
time of inheritance.

Relative to basis carryover, taxing unrealized gains raises
more revenue, reduces sheltering opportunities, and reduces the lock-in effect.
Lily Batchelder and David Kamin (2019),
using JCT projections (2016),
estimate that taxing accrued gains at death and raising the capital gains tax
rate to 28 percent would bring in $290 billion between 2021 and 2030.

However, taxing gains at death creates challenges for
investors that eliminating basis step-up and moving to carryover basis does
not. After death, an investor’s estate owes tax without receiving a payment for
an asset and may find it difficult to pay the tax on time. This could be
addressed either by would-be decedents buying life insurance to cover the
liability and/or allowing estates to pay the tax over a period of time (e.g.,
five or ten years). Also, unlike the carryover basis system, a capital gains
tax at death requires valuation of some privately-held and non-marketable
assets, like family businesses or art, that may be difficult to value.

3. Tax capital gains
on an accrual basis

A more far-reaching reform would be to tax capital gains not
just at death, but every year as they accrue. Under an accrual tax, sometimes
called a “mark-to-market” system, investors would pay tax on their capital
gains every year, regardless of whether the gains were realized or not. The
term “mark-to-market” means that, for tax purposes, an asset’s reported value
can be marked, or tied, to its market value.

“Accrual taxation represents…a move away from the
realization principle… It would eliminate the lock-in effect, the use of
capital-gains-bearing assets as tax shelters, and most of the incentive to
shift labor income into capital gains.”

Accrual taxation represents a major break from the current
system as a move away from the realization principle, and it has several
advantages. It would eliminate the lock-in effect, the use of
capital-gains-bearing assets as tax shelters, and most of the incentive to
shift labor income into capital gains. Because it restricts avoidance, accrual
taxation would allow for a significantly higher tax rate on capital gains
without inducing significant avoidance. Accrual taxation brings the tax system
in line with the basic definition of income outlined above. It would increase
the tax base and thus raise revenues. Using Survey of Consumer Finance data,
Batchelder and Kamin calculate that accrual taxation (a) on marketable assets
only and (b) limited to the top 1 percent of households would raise $1.7
trillion over ten years, even after allowing for a 15 percent avoidance rate.

Accrual taxation, however, is not without problems. First,
like taxing capital gains at death, this reform option raises liquidity
concerns. To address this concern, asset holders could pay their capital gains
tax liability over 5 or 10 years (Toder
and Viard 2016).

The valuation problems for non-marketable assets are similar
to those that arise under taxation at death, but they are more difficult
because under accrual taxation the assets must be valued every year, which
would be quite difficult for taxpayers and the IRS. The solution would be to
couple accrual taxation of marketable assets with retrospective taxation (as
described below) of non-marketable assets. Kamin and Batchelder estimate this
coupling would increase tax revenue by $400 billion, even if retrospective
taxation only applied to the top 1 percent.

While mark-to-market is straightforward for gains in
marketable assets, it becomes more complex for economic downturns and losses.
For example, suppose Warren Buffett owns $50 billion in stock, and suppose that
a recession causes the stock market to fall by 10 percent (the classic
definition of a bear market), and that capital gains are taxed as ordinary
income with a top rate of about 40 percent. In that case, the $5 billion
decline works out to $2 billion in negative income for tax purposes (40 percent
of $5 billion is $2 billion). So, would the government owe Buffett $2 billion?
To avoid that obviously politically unappealing prospect, investors with losses
could be allowed to apply them against future capital gains. The value of the
loss allowed to be carried forward could be unlimited in value and duration or
limited in either. Presently, capital losses can offset $3,000 of other taxable
income in a year, and excess losses can be carried forward for deductions in
following years.

4. Retrospective
taxation

Retrospective taxation (Auerbach 1988) offers a
way to retain taxing capital gains at realization but eliminate the lock-in effect
and associated sheltering problems that deferral creates.

Under the current system, the statutory tax rate on
long-term capital gains is constant as the holding period lengthens. As a
result, the effective tax rate on accrued capital gains falls as the holding
period rises—this is the lock-in effect. To make the effective tax rate on
accrued capital gains constant as the holding period rises, eliminating the
lock-in effect, the statutory tax rate should rise as the holding period
lengthens.

The capital gains tax rate can be set as a function of the
final sale price, the risk-free interest rate, the investor’s marginal tax
rate, and the holding period. This system is applicable to both marketable and
non-marketable assets, but it is particularly valuable for non-marketable
assets, as it eliminates the valuation problems that arise there. It also
resolves the liquidity problem that plagues accrual taxation.

Where to from here?

The taxation of capital gains is a live issue in the Democratic primaries. Joe Biden, Cory Booker, Julián Castro, and Elizabeth Warren have called for taxing capital gains at death. Castro, Warren, and Booker want to tax capital gains on an accrual basis. Booker and Castro, before dropping out of the race, voiced support for retrospective taxation or related policies. Reforming the capital gains tax can address inequalities and inefficiencies of the current system, and it appears likely that the focus on the issue will continue into 2020.

For information purposes, this is the matrix we have been
working off of.