The combination of history, international competition, and the destructive nature of the capital gains tax suggests any attempts to raise revenue by raising rates are doomed to failure. The focus on June 28th should not be on raising the capital gains rate, but should instead be focused on how to keep the rate low. History shows that this is the most effective way to both raise revenue and promote economic growth.
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All of the practices described above are consequences of taxing realized capital gains instead of accrued gains. The other key features of the existing capital gains tax—preferred rates and basis step-up at death—interact with taxation on realization in problematic ways. The lower tax rates on capital gains than other forms of income encourage taxpayers to classify income as capital gains rather than as wages, and they make sheltering options more attractive. Together, deferral taxation and basis step-up give investors enough discretion over whether and when to cash in assets that policymakers need to keep the capital gains rate relatively low.
A variety of studies suggest that with deferral taxation and basis step-up, the revenue-maximizing tax rate is in the range of 28—35 percent Gleckman At higher rates, investors would choose to hold on to assets rather than realize them, causing capital gains tax revenues to fall. When the asset is later sold by an heir, the taxable basis would be the same as when the decedent owned it.
Under a carryover basis system, capital gains tax would continue to be owed when the gain is realized. Shifting to carryover basis discourages lock-in and tax shelters. In addition, curtailing tax avoidance would allow policymakers to raise the capital gains tax rate and generate increased revenues, without generating as much tax avoidance as would occur with a higher rate under the current system.
A carryover basis regime maintains the practice of taxing capital gains at realization and thus retains the advantages related to investor liquidity and ease of valuation.
One argument against carryover basis is that, in some cases, the taxpayer may not be able to document the basis of a long-held asset. This is easy enough to address. If taxpayers can prove the basis is higher than the default basis, they would be entitled to do so. If taxpayers cannot or choose not to provide such records, the 10 percent basis rule would apply, and the capital gain would be deemed to be 90 percent of the sale price.
A somewhat more aggressive reform would be to tax capital gains at death. Under this regime, death would be treated as if the holder sold the asset. The decedent would owe capital gains tax on unrealized capital gains accrued during his or her lifetime.
The heir would then inherit the asset at its current value through basis step-up. Relative to basis carryover, taxing unrealized gains raises more revenue, reduces sheltering opportunities, and reduces the lock-in effect. However, taxing gains at death creates challenges for investors that eliminating basis step-up and moving to carryover basis does not. Lower rates are not the only way the tax code gives preferential treatment to capital gains, however.
Unlike wages or salaries, which are taxed when earned, capital gains are not taxed as the asset grows in value—they are taxed only when the asset is sold. This gives owners of capital assets the ability to defer tax. And a giant loophole in the tax code allows a large share of these deferred capital gains to escape income taxes entirely. This loophole is known as stepped-up basis. The stepped-up basis rule also leads to inefficiency through a lock-in effect: For tax reasons, people hold onto assets for their entire lives that they would otherwise sell.
There are other loopholes and preferences that allow wealthy people to avoid entirely or at least defer capital gains taxes. Investors holding stocks can strategically select which ones to sell at what time to harvest losses while deferring taxes on gains.
They can also avoid capital gains tax if they donate assets that have grown in value to a charity, even while claiming the charitable deduction against their ordinary income. A special small-business tax exclusion allows investors in startups that hit it big to avoid taxes on their gains.
In sum, capital gains enjoy very favorable treatment under the tax code, as they are taxed at preferential rates and provide asset owners with opportunities to defer or avoid tax altogether. Despite the fact that inequality has only increased since the pandemic began, 9 some in the administration have said that next year they would seek to cut the top capital gains rate further. President Donald Trump has said that he wants to cut the top rate from 20 percent to 15 percent. Supreme Court.
Cutting the top rate on capital gains would overwhelmingly benefit the very wealthy. As Figure 3 shows, the top 1 percent enjoy 80 percent of the benefit of the now-existing preferential rates, 12 and they would benefit even more if those rates were cut further.
The Institute on Taxation and Economic Policy estimates that 99 percent of the tax cut from cutting the capital gains rate from 20 percent to 15 percent would go to the richest 1 percent of Americans. The uber-wealthy within the top 1 percent would get even larger tax cuts.
According to the most recent tax data, the highest-income 0. If the top capital gains rate had been cut to 15 percent and the 3. The wealthy would also benefit from a separate proposal to cut capital gains taxes floated by Trump administration officials, which would index capital gains for inflation.
First, the taxation of capital gains only when an asset is sold results in the "bunching" of income at those times. Under a progressive income tax system, if an asset is held for a number of years, taking all of the profit as income in one year could push a tax payer into a higher tax bracket than he would have been in had the gains been realized as they accrued. A more troubling aspect of this bunching is the effect of inflation on the return to stockholders and, thus, on their willingness to buy stock.
Because capital gains currently are not indexed for inflation, some of the perceived gain is illusory and represents no real increase in purchasing power. In extreme cases, the effective tax rate on the real capital gain may exceed percent.
Probably the most troubling feature of the capital gains tax is the "lock-in" effect. If individuals face a high tax rate, they are unlikely to sell their securities and pay taxes on the capital gain.
This lock-in effect is especially problematic for small, start-up companies because investors who are"locked" into previous investments have a reduced incentive to sell those stocks in favor of new offerings by young companies. The problem is made worse by the fact that when investors leave assets to their heirs, the heirs can usually avoid paying taxes on the assets' appreciation from the original purchase price.
This effect creates a strong disincentive for many people to sell assets, especially ones they have held for many years. Although there are many recognized drawbacks to a relatively high capital gains tax rate, the arguments against cutting the rate are also compelling. The opposition is based on several grounds. First, although there would be an initial rise in government tax revenue, most researchers agree that this rise would be transitory, based only on the increased asset sell-off immediately following the tax change.
In the long-run, the government would have to cut spending or raise taxes in other areas unless it chose to incur even greater deficits. Second, a reduction in the tax rate would further undermine the progressivity of the tax system because relatively wealthy individuals tend to receive capital income see Table 1.
The magnitude of this effect is difficult to pin down, however, since investors' behavior would inevitably change following any tax law modification.
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