To help pay for his $1.8 trillion American Families Plan to provide benefits such as paid family and medical leave, universal preschool and free community college education, President Joe Biden is looking to raise taxes on the sale of stocks and other assets owned by the nation's wealthiest investors.
Biden proposes nearly doubling the long-term capital gains tax rate for households with more than $1 million in income, from its current 20 percent to 39.6 percent, the same rate that they would pay under his plan on wages earned from working. Biden also would eliminate a critical inheritance-related tax loophole that allows a lot of capital gains to go untaxed (more on this later). Biden economic adviser Brian Deese explained in an April 26 White House press briefing that the tax hike will affect only the richest Americans, amounting to just 0.3 percent of all taxpayers.
While supporters of Biden's proposal see the increase as a way to make taxation fairer and get the richest Americans to pay their fair share, Biden's critics in the GOP claim raising the capital gains tax rate for the wealthy would discourage investment and lead to slower economic growth, as the Washington Examiner reports.
But if you're like most Americans, whose incomes primarily come from being paid for working at jobs, you may be wondering what all this brouhaha is about, since capital gains account for 1 percent of the total income of the bottom 80 percent of U.S. households, according to the Peter G. Peterson Foundation. So here's a quick primer.
What are Capital Gains and How Are They Taxed?
As the Tax Policy Center explains, capital gains are profits from the sale of an asset such as shares of stock, a business, real estate or a work of art.
If you buy something and sell it quickly — in a year or less — whatever profit you make is treated basically the same as your income from wages and taxed as such. This is called the short-term capital gains rate. If you are in the 37 percent tax bracket, your short-term capital gains will be taxed at 37 percent.
But if you hold on to something for more than one year and then sell it, you're taxed at the long-term capital gains rate, which is based upon one of three tax brackets. If you have taxable income of less than $40,000 a year for a single person, for example, you don't pay any capital gains tax. If you earn between $40,000-$441,450, you pay a 15 percent rate. If you're above that, you pay 20 percent.
There are a few nuances to that basic formula. For example, capital gains on collectibles such as artwork or rare coins are taxed at a maximum 28 percent rate, as are shares of qualified small business stock.
Also, there are exceptions in the law that keep most ordinary people from having to pay capital gains. If you have a qualified retirement plan such as a 401(k), for example, you can sell shares from your account and not pay capital gains. And if you sell your home for more than you paid for it many years ago, you'll be able to exclude the first $250,000 of your gain — $500,000 for couples – from capital gains taxes.
The starting point for calculating capital gains, known in tax lingo as the basis, is how much you paid for the asset, plus commissions, and in the case of something like real estate, the cost of improvements less depreciation.
Why Do We Have a Separate Tax Rate for Capital Gains?
After ratification of the 16th Amendment in 1913 established the federal government's authority to levy income taxes, capital gains were taxed at the same rate as ordinary tax rates. That changed after World War I, when Congress passed the Revenue Act of 1921, which for the first time put a lower tax rate on profits from investments as a way of stimulating economic growth, and differentiated between short-term and long-term assets, as this 2007 Congressional Research Service report details. After that, Congress started experimenting with different formulas for taxing capital gains.
"The main justification for taxing capital gains at a lower rate is to offset any double taxation because corporate income is already subject to the corporate income tax," Stephanie Leiser explains in an email. She's a lecturer at the University of Michigan's Gerald R. Ford School of Public Policy, and a tax policy expert who wrote a piece for The Conversation about capital gains.
"Other reasons include incentivizing investment and entrepreneurship and helping to offset the fact that part of capital gains is just inflation and doesn't reflect real growth in value," Leiser says.
Tax revenues from capital gains tend to go up or down, based upon how the stock market and the economy are doing. In 2019, they amounted to $193 billion, or about 11 percent of individual income tax revenues, according to the Peter G. Peterson Foundation.
How Much More Revenue Would Biden's Increase Generate?
That's a little complicated. According to the Penn Wharton Budget Model's analysis, just raising the capital gains tax rate for wealthy investors wouldn't necessarily generate more money for the federal government. That's because investors and their advisers are pretty good at coming up with strategies for avoiding taxes, such as timing capital gains to come in years when they have offsetting losses.
That's why, according to Leiser, the most important part of Biden's proposal is not the rate increase itself, but the elimination of a tax loophole called the basis-step up. Currently, if an investor buys $100,000 in stocks and they triple in value, he or she can pass that portfolio along to heirs, and the "basis"— the original value of the stocks – is reset to $300,000. If the heirs eventually sell the stock, they're only taxed on however much the stocks increased in value over that $300,000. Nobody ever has to pay taxes on the $200,000 in appreciation that occurred while the original investor held the stocks.
"Most of us earn almost all of our lifetime income from wages/salary, and that's taxed in the year you earn it, " Leiser explains. "But with capital gains, if you can hold on to assets until you die, those gains are never subject to income taxes."
That results in a huge amount of untaxed wealth. A 2015 analysis written for the Federal Reserve estimated that untaxed capital gains amounted to 55 percent of the value of estates worth $100 million or more.
"The basis step-up has allowed tax-free accumulation of intergenerational wealth — research shows that it's been one of the most important drivers of wealth inequality and the racial wealth gap in this country," Leiser explains.
Biden would change that, by requiring heirs with incomes of more than $1 million to pay taxes on the entire amount that a stock has grown in value since it originally was acquired by whoever left it to them.
According to Penn Wharton's analysis, by eliminating the stepped-up basis loophole, Biden's increase would raise $113 billion over 10 years.
How would increasing capital gains taxes affect the economy? An analysis by investment firm UBS notes that in recent financial history, increases in capital gains taxes haven't caused the stock market to slump. After the last increase in 2013, for example, the S&P index rose that year by nearly 30 percent. Other factors such as the overall economic outlook, monetary policy and interest rates have a much more powerful effect on stock prices and rates of return, the firm says.
Additionally, according to UBS, a rate increase's effect would be muted because about 75 percent of stocks are in accounts that aren't subject to capital gains, such as retirement accounts, endowments, and accounts held by foreign investors. UBS also notes that due to Congressional pushback in some quarters, it's more likely that the top capital gains tax rate will move to 28 percent, rather than 39 percent.