Leaders in Congress and Democratic presidential candidates have released tax plans using different methods to raise federal revenue and combat wealth inequality. One area of potential reform is the treatment of capital gains. To accurately compare how capital gains treatment changes in each of their plans, the value of taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. deferral should be added to the nominal tax paid as a percentage of income. Accounting for deferral reduces effective tax rates for proposals retaining this tax advantage.
Under current law, assets yielding a capital gain through appreciation may have deferred tax liability until those gains are realized when sold. These gains benefit from lower statutory tax rates when held for longer than one year. This incentivizes taxpayers to keep their capital gains unrealized for tax purposes, reducing federal revenue in the short-run. Additionally, the tax code allows for a step-up in basisThe step-up in basis provision adjusts the value, or “cost basis,” of an inherited asset (stocks, bonds, real estate, etc.) when it is passed on, after death. This often reduces the capital gains tax owed by the recipient. The cost basis receives a “step-up” to its fair market value, or the price at which the good would be sold or purchased in a fair market. This eliminates the capital gain that occurred between the original purchase of the asset and the heir’s acquisition, reducing the heir’s tax liability. for inheritors of appreciated assets, which leaves the unrealized capital gains appreciation accrued during a decedent’s life untaxed.
Biden’s Capital Gains TaxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. Proposal
Former Vice President Joe Biden’s tax proposal retains the tax code’s deferral of capital gains until the gain is realized, but eliminates the provision permitting a step-up in basis for inheritors of the asset upon death. It is ambiguous whether Biden’s plan would treat death as a realization event, meaning capital gains within the property passed to an inheritor would be immediately taxable, or if the new owner would be allowed to carryover the decedent’s previous tax basis but continue to defer tax liability.
Additionally, Biden would raise the income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually, up from the current tax rate of 20 percent. This is in addition to the 3.8 percent net investment income tax (NIIT) for jointly married fillers making above $250,000 in modified adjusted gross income.
Wyden’s Mark-to-market Tax Proposal
The Biden tax plan keeps deferral of unrealized capital gains prior to death, which contrasts with the mark-to-market capital gains tax proposed by Sen. Ron Wyden (D-OR). Wyden’s mark-to-market proposal would impose ordinary income tax rates on unrealized capital gains each year for the top 0.3 percent of taxpayers. This does not retain a deferral advantage, as tax is paid in each year a capital gain is accrued.
The choice to eliminate deferral matters a great deal. This is because deferral allows a taxpayer to delay paying tax for years even while the asset appreciates and earns income.
Take, for example, an asset presently valued at $40 million earning a 5 percent rate of return for 25 years prior to the owner’s death, and the owner is at the top marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. under current law (see Table 1). Under both the Biden tax plan and the Wyden mark-to-market tax regime, the taxpayer earns $89 million and faces a statutory tax rate of 37 percent.
Note: Present value estimates use a discount rate of 5 percent. Uses current law top marginal income tax rate of 37 percent for comparison.
|Asset Income||$89 M||$89 M|
|Statutory Tax Rate||37%||37%|
|Tax Paid||32.93 M||32.93 M|
|Present Value Effective Tax Rate||22.3%||37%|
|Present Value Tax Paid||$10.21 M||$16.91 M|
Due to differences in the timing of the tax payments under each plan, the effective tax rate also differs. Under the Wyden plan, the taxpayer remits a tax liability of 37 percent of the asset’s appreciation each year. Under Biden’s tax proposal, taxpayers may continue to defer the unrealized capital gain of 5 percent per year until the taxpayer dies in year 25. This is because money is more valuable if it is held closer to the present, as there is an opportunity cost in the form of market returns to the asset. Thus, delaying tax payment under the Biden proposal is a real benefit to the taxpayer.
Policymakers should consider the advantage of tax deferral when evaluating tax plans on capital gains. This ensures that each proposal can be compared consistently when examining the tax policy trade-offs.
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