Analysis of the Economic, Revenue, and Distributional Effects of Repealing Step-up in Basis

February 24, 2020

With Super Tuesday approaching, the six top Democratic presidential candidates continue to hone their tax proposals in order to address income inequality and raise additional federal tax revenue. Some candidates propose changing the tax treatment of deferred assets, specifically assets passed onto heirs after death.

For example, shortly after launching his campaign, President Biden proposed repealing step-up in basis for capital gains. While repealing step-up in basis would raise substantial revenue relative to current law, it would reduce national saving and total wealth and increase compliance costs for the government and taxpayers.

Basis and Realization

The purchase price of an asset is typically referred to as the asset’s basis. Capital gains, or losses, refer to the difference between an asset’s purchase price (basis) and its value at the time of sale. It is not until a person realizes a capital gain (sells an asset for a profit) that capital gains taxes are due.

Some assets are held for generations and passed from their original owners to heirs. In the event these investors never sell their assets, these assets are not subject to capital gains taxes.  

As investors acquire and retain assets over time, the value of these assets fluctuates. Under current law, the tax basis of property transferred to an heir at death is increased to its current market value. This process, called step-up in basis, means that any appreciation in the value of the property that occurred during the original owner’s life goes untaxed. If the heir chooses to sell the property, any tax would be assessed on the new basis, which means that only asset appreciation after the asset had been inherited would face capital gains tax.

Repealing Step-up in Basis

There are many trade-offs to repealing step-up in basis. Under the current system of capital gains taxation, step-up in basis discourages people from realizing their gains. Eliminating step-up in basis would encourage more realizations, increase federal revenue, and remove a tax expenditure that allows taxpayers to entirely exclude returns on saving from taxation.

While it is less than neutral for capital gains to entirely escape taxation, as can occur due to step-up in basis, the policy also mitigates what would otherwise be a significant effective tax rate on saving. This occurs due to the taxes that would apply in the absence of step-up in basis on property transferred to heirs: an estate tax on the total value of an estate’s property, as well as capital gains taxes on any appreciation within the property’s assets.

On the other hand, repealing step-up in basis would make the code more neutral with respect to assets relative to income and gifts. It would also make the code more progressive and increase auditing costs for the Internal Revenue Service (IRS). Unlike under prior law, where these assets were not subject to tax, the IRS would be responsible for accounting and auditing taxpayers on their assets at death, sometimes without all the necessary information to determine the price or basis of the assets.

Repeal would also likely increase compliance costs for taxpayers, as they would have to verify the original cost basis of every capital gain to ensure they are compliant. This is often difficult when a donor is living but could be next to impossible for an heir if a decedent did not leave proper documentation of an asset’s original cost basis.

Economic, Revenue, and Distributional Effects of Repealing Step-up in Basis

Using the Tax Foundation General Equilibrium Model, we find that repealing step-up in basis would reduce national earnings (GNP) by 0.11 percent and result in an 0.88 percent decrease in wealth. This is because removing step-up in basis for inherited assets subjects previously untaxed income to capital gains tax rates at death or transfer. Repealing step-up in basis would affect domestic investors subject to capital gains tax, reducing the amount of domestic saving and lowering domestic earnings (GNP). This decrease in domestic saving would be offset by greater investment from abroad and a larger claim on American assets by foreigners.

Table 1. Economic Effect of Repealing Step-up in Basis for Capital Gains

Source: Tax Foundation General Equilibrium Model, November 2019.

GDP GNP Capital Stock Change in Wealth
-0.00% -0.8% 0.00% -0.88%

Repealing step-up in basis would raise $116 billion over the 10-year window on a conventional basis.

Table 2. Conventional Revenue Effect of Repealing Step-up in Basis (Billions of Dollars)

Source: Tax Foundation General Equilibrium Model, November 2019. Values may not add due to rounding.

Year 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2020-2029
Conventional $11 $11 $11 $11 $12 $12 $11 $12 $12 $12 $116

Repealing step-up in basis almost exclusively affects taxpayers in the top 20 percent. Most notably, the distributional effect is almost four times larger for those in the top 1 percent relative to those in the top 20 percent. Since the top 1 percent own a greater percentage of assets subject to the deferral treatment provided by step-up in basis, a repeal affects those filers more significantly.

Table 3. Conventional Distributional Effect of Repealing Step-up in Basis (Percent Change in After-Tax Income)

Source: Tax Foundation General Equilibrium Model, November 2019.

Income Group Conventional
0% to 20% 0.00%
20% to 40% 0.00%
40% to 60% 0.00%
60% to 80% 0.00%
80% to 100% -0.13%
80% to 90% 0.00%
90% to 95% -0.01%
95% to 99% -0.01%
99% to 100% -0.49%
Total -0.07%

Repealing step-up in basis would directly affect those in the highest income brackets while leaving most taxpayers unaffected.

Conclusion

Removing step-up in basis comes with advantages and drawbacks, especially in isolation from reforms in other areas such as estate, capital gains, and gift taxes. For example, repealing step-up in basis would make the code more neutral by removing a tax expenditure that allows taxpayers to entirely exclude returns on saving from taxation. It makes the code more stable by broadening the tax base and increasing revenue.

Removing step-up in basis would make the code more progressive by removing a tax expenditure that primarily benefits wealthy taxpayers and taxing a previously untaxed base of accrued gains over a lifetime. As our model shows, revenues would increase and those in the top income groups would pay more relative to current law. Additionally, the repeal of step-up in basis makes the code more transparent for current investors and their future heirs since they are notified ahead of time that they will be required to pay tax on their assets at death.

However, pursuing this course of action would increase taxpayer and government compliance costs, requiring more hours spent complying with the tax rather than other productive activities and more money needed for IRS accounting and auditing. Absent a reduction in the capital gains tax rate, repealing step-up in basis would increase the tax burden on saving, lower the total share of income earned by Americans, and shrink the overall wealth stock by a sizable margin.

Presidential candidates and policymakers will need to weigh these trade-offs as they seek ways to address income inequality and tax code progressivity.

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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.

The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

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. An estate tax is paid by the estate itself before assets are distributed to heirs.

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.

After-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income.