President Biden has proposed to tax capital gains earned by high-income households more like other income. This is a significant reform that would close loopholes that fuel inefficient tax sheltering, make the income tax more progressive, and help pay for some of Biden’s domestic policy wish list.
Under current law, long-term capital gains and stock dividends are taxed at lower rates than other income. The top tax rate on investment income is 20 percent plus a 3.8 percent net investment income tax (NIIT). The top income tax rate on wages and salaries is 37 percent. (Labor income is also subject to Medicare payroll taxes, which not coincidentally also add 3.8 percent for high-income taxpayers.)
The tax benefits for capital gains don’t stop at lower rates. Taxpayers can postpone paying capital gains taxes by holding onto assets since no tax is due until sale. And they can avoid the tax entirely by keeping assets until they die or donating them to charity.
A whole industry of tax planners devotes their considerable skills to converting high-taxed ordinary income into lightly taxed, or untaxed, capital gains. This saves high-income people billions of dollars in taxes and represents a giant waste of economic resources. Many of these schemes make no economic sense – but for the tax advantages.
Biden would substantially limit those loopholes. He’d restore the top individual income tax rate to 39.6 percent, the rate that applied before 2018, and apply it—and the 3.8 percent NIIT—to long-term capital gains and dividends for households with total annual incomes over $1 million.
Biden also would tax unrealized gains at death, subject to several exceptions. Married couples would owe no tax until the surviving spouse died. Family-owned businesses could postpone the tax until the business was sold. The tax on other illiquid assets such as real estate could be paid over 15 years, and gifts to charity would be exempt.
Critics of Biden’s proposal have several complaints. None hold water. Critics worry that raising capital gains taxes would lower the after-tax return for individual investors and drive down stock prices. However, taxable individuals hold less than one-third of corporate stock. The rest is owned by nonprofits, retirement plans, life insurance companies, and foreigners—none of whom pay individual income taxes on US capital gains and dividends.
If share prices fell because individuals dumped corporate stock, those other investors would jump at the opportunity to earn a higher return. The result: Any price decline would be short-lived.
Another complaint is that capital gains and dividends already are taxed as profits at the corporate level and should not be taxed twice. But many capital gains accrue to assets other than stock. And most corporate capital comes from sources unaffected by individual capital gains taxes, such as those retirement plans or foreign investors.
A more plausible critique is that the higher tax rates would not increase revenue because the capital gains tax is so easy to avoid by postponing sales. Indeed, anti-capital gains tax evangelist Larry Lindsey opined <paywall> that Biden’s plan to nearly double the top effective capital gains tax rate from 23.8 percent to 43.4 percent would lose revenue.
That could happen if Congress only increased tax rates. But Biden also would close the biggest of capital gains tax loopholes—the “angel of death loophole,” which allows people to avoid ever paying tax on the increased value of their assets by… dying.
If those unrealized gains were taxed at death, as Biden proposes for some high-income decedents, investors would sell more assets during their lives, and gains held until death would eventually be taxed unless donated to charity. The Tax Policy Center estimated the combination of a rate increase and taxing unrealized gains at death that Biden proposed during the campaign would generate more than $300 billion over 10 years. The current proposal would raise less because our estimates did not account for the $1 million exclusion announced today.
Some critics complain that the capital gains tax over-taxes savings. Since one dollar plus interest in the future is economically equivalent to one dollar in the present, taxing the normal rate of return amounts to double tax.
That could be a rationale for moving towards a consumption tax, which would exempt all savings from tax, but it is not a persuasive argument for preferential rates on capital gains alone. And many capital gains assets earn substantial above-normal returns, which would be taxable under a consumption tax.
Similarly, a significant share of capital gains represents inflation. But the share is even larger for interest income and interest expense than it is for capital gains. A theoretical solution would be to index the whole tax system for inflation, although that would be very complex. But it makes no sense to cut capital gains taxes to reflect inflation while allowing investors to fully deduct their unindexed interest expense.
Biden’s plan is a sensible way to raise revenue and tax investment profits that largely go untaxed today. It is far easier to administer than the wealth tax some Democrats support, it can do a small part to reduce income inequality, and it can help reduce unproductive financial gamesmanship.
PS, there’s a lot more detail about these arguments, which have not changed much in the past two decades, in my 1999 book, The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed.