Unpacking Biden’s Tax Plan for Capital Gains

July 31, 2019

Scott Eastman

Scott Eastman

Democratic presidential candidate and former Vice President Joe Biden recently released a health-care plan that, according to his campaign, would cost $750 billion over a decade. To finance the health-care plan, he would 1) increase the top marginal income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually, and 2) eliminate a tax expenditure called “step-up in basis” that allows decedents to pass capital gains to heirs without tax.

Under current law, capital gains are taxed as income. A capital gain is a profit from the sale of a capital asset—such as a house, stock, bond, or jewelry— from the time that asset is acquired until the time it is sold. The price at which an asset is purchased is called the asset’s “basis,” and taxpayers pay tax on the difference between an asset’s basis and its sales price when they sell, or realize, that capital gain.

For capital gains realized on assets held for less than one year (short-term capital gains), taxpayers pay taxes according to their ordinary individual income tax rate, ranging from 10 percent to 37 percent. For assets held longer than one year (long-term capital gains), taxpayers pay a reduced tax rate, ranging from 0 percent to 20 percent, depending upon a taxpayer’s income. Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.

Currently, when a person dies and leaves property to an heir, the basis of that property is increased to its fair market value. This “step-up in basis” means that any capital gains that occurred during the decedent’s life go untaxed. When the heir sells that property, any capital gains taxation will be assessed based on the heir’s new basis. Step-up in basis reduces the tax burden on transferred property, as the total value of transferred property is already taxed by the estate tax.

Biden’s plan would first raise taxes on capital gains by treating them as ordinary income for those earning more than $1 million. On his website he said he would also raise the top rate on ordinary income back up to 39.6 percent from the 37 percent rate put in place by the Tax Cuts and Jobs Act. As such, the top rate on long-term gains would nearly double from 23.8 percent to 43.4 percent. Biden’s campaign cites a Joint Committee on Taxation report on tax expenditures which estimates that the special lower rate on capital gains and dividends reduces federal revenue by $127 billion each.

While the expenditure estimate implies that the government loses a lot of revenue from the lower rate on capital gains, it is highly unlikely that the federal government could get this much revenue from just raising the rate. Research from the Congressional Budget Office (CBO) and the Joint Committee on Taxation (JCT) shows that capital gains realizations are very sensitive to taxation. This is because taxpayers can time when they want to realize their capital gains in order to minimize their tax bills. Specifically, the CBO and JCT estimate that the elasticity of realizations to the tax rate is -1.2 in the short run and -0.79 in the long run. Specifically, a 1 percent increase in the capital gains tax rate would result in a 0.79 to 1.2 percent drop in capital gains realizations.

In practice, this means that proposals to significantly raise capital gains tax rates, with no other changes, can lose federal revenue. Using CBO data on capital gains realizations and these elasticities, we estimate that raising the top rate to 43.4 percent (39.6 percent statutory rate plus the 3.8 percent Net Investment Income Tax) could lose about $2 billion each year.[1]

However, Biden is not simply proposing to raise the top rate on capital gains. He also proposes eliminating step-up basis in capital gains. According to the JCT, not taxing gains at death results in a loss of about $40 billion each year.

Again, this is a tax expenditure estimate and not a revenue estimate, and the amount of revenue Biden’s proposal would ultimately raise would depend on how he structures the elimination of step-up in basis. He could require heirs to take on the decedent’s basis when they receive an asset, known as carryover basis, but still allow heirs to defer realization of that inherited asset’s capital gain. This would raise much less than making death a taxable event—and even then, proposals to tax capital gains at death can have many exemptions.

It is also worth noting that these two proposals interact in two important ways. Since Biden is raising the tax rate on capital gains, the value of the tax expenditure for step-up in basis will mechanically increase. This is because the rate at which these gains would otherwise be taxed at would be higher.

In addition, eliminating step-up in basis at death reduces a taxpayers’ incentive to defer realizing gains. Part of the reason why there is such a strong incentive to defer the tax on capital gains is that if an individual defers long enough, the tax on the asset will eventually be forgiven. Without step-up in basis, a taxpayer has a greater incentive to realize during their lifetime. As such, eliminating step-up in basis can indirectly boost revenue from capital gains.

While the plan will raise additional federal revenue in a progressive manner for his health-care plan, it isn’t costless. Raising taxes on capital gains would reduce the incentive to save by reducing the after-tax return to saving. Lower domestic saving leads to lower income for Americans in the future and can lead to lower output by reducing domestic investment. In addition, there are administrative, structural, and transition issues that Biden will need to consider if he ultimately eliminates step-up in basis.

[1]We estimate the plan would increase the average tax rate on capital gains from 19.1 percent to 27.7 percent, and the marginal tax rate on capital gains from 22.4 percent to 33.4 percent.

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A 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.

Tax expenditures are a departure from the “normal” tax code that lower the tax burden of individuals or businesses, through an exemption, deduction, credit, or preferential rate. Expenditures can result in significant revenue losses to the government and include provisions such as the earned income tax credit, child tax credit, deduction for employer health-care contributions, and tax-advantaged savings plans.

The 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.

An estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S.

A 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.

The average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes.

The 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.