Capital Gains and Estate Taxes

Contrary Evidence — Podcast also available

In this post, we are going continue our dive into taxation. Last week, I described four lenses for evaluating taxation methods: Fairness, Yield, Economic Impact and Complexity. This week we will apply those lenses to Capital Gains and Estate Taxes.

One of the hot debates today surrounds capital gains taxes. We tax long term capital gains at a lower rate than other income to encourage investment. Long Term Capital gains are the profits that investors recognize on assets they hold for one year or longer. Capital Gains tax revenue is dynamic from year to year but on average, this tax contribute only 7.5% of the total federal tax revenue collected.

The primary argument for increasing the tax rate on capital gains is fairness. It seems unfair that a family of four with family income of $200,000 has a higher marginal tax rate than a multibillionaire whose income is all capital gains. The other side of the fairness question is double taxation. The investor that paid tax when the income was earned and is now asked to pay tax on profits earned from investing the prior income, feels like she is getting taxed twice.

The primary argument against raising capital gains is that it can have a high economic impact. When an investor has capital available, he has lots of choices of what to do with the money but those choices fall into three primary categories. The investor can choose to spend the money which contributes to economic growth. For simplicity sake, I will consider the option of Donating to a charitable organization or political organization as a type of spending. The investor can bank the capital in a low risk, low return vehicle like a treasury bond. The investor can put the capital into an investment that offers the possibility of higher returns but also carries higher risk. This third category is the one that is impacted by changes to the capital gains rules.

When capital gains taxes are raised, three things happen. First, investors sell assets just prior to the increase in tax rates so that their capital gains are taxed at a lower rate. The maximum capital gains tax was raised from 20% in 1986 to 28% in 1987. The capital gains tax revenue jumped in 1986 as investors tried to lock in their profits with a lower tax rate. It took ten years before the same amount of capital gains tax was collected and that corresponded with a drop in the maximum capital gains tax down to 21.2%. This shows that the capital gains tax increase that went into effect in 1987, actually resulted in less tax revenue.

The second thing that investors can do when capital gains tax rise is to delay selling the assets that have appreciated. That also occurred during the period from 1987–1997. The third thing that investors can do is to make less long-term investment. A slowdown in this type of investment slows economic growth.

The last type of tax that we will inspect is estate tax. Today, there is no estate tax when one spouse dies and bequeaths their share of the estate to their spouse. When the second spouse dies, the estate is subject to a 40% tax on the amount above $11.7M. In reality, the actual tax paid on estates is well below 40% because of lots of loopholes. The other special rule with estate taxes is that the capital gains cost basis for assets is reset to the value on the day of death. This means that the profit generated on those assets up to that date is never taxed.

The double taxation complaint is often raised to oppose estate taxes. In reality, the person that has died does not pay any tax, that person’s heirs do. If someone buys a lottery ticket and wins $10M, most of those winnings are taxed at the maximum income tax rate. If someone inherits $10M, that person might pay no tax on their windfall.

Like virtually all taxes, the wealthy have the means to avoid or minimize estate taxes. The estate tax was only applied to .1% of estates in 2019. The effective tax rate for the .1% that were taxed was only 17%.

Estate taxes generate less than 1% of the total tax revenue. The passion around estate taxes is all about fairness and wealth disparity and not connected to a meaningful source of tax revenue.

Because of the small revenue generated from estate taxes, these tax rates and policies have minimal overall impact on economic growth. Heirs can be forced to sell assets to pay the tax liability but there are provisions for installment payments associated with family businesses that allow payments to be spread over 14 years.

With estate taxes, there is also a societal consideration. Does inherited wealth help the economy and society at large? The evidence seems to indicate that on average, the recipients of large inherited wealth are less productive and contribute less to society. There are many recipients that are productive but that is not the norm. Keep in mind that we know that about a third of all people that win a lottery bigger than $1M, declare bankruptcy within ten years. Sudden windfalls of cash can cause a number of issues including the destruction of ambition.

As I look at the facts it is easy to come to the conclusion that raising capital gains and estate tax rates will not generate significant revenue; The argument in favor of raising these rates has to do with the understandable backlash against income and wealth disparity. The debate on raising the effective tax rates on these two taxes boils down to a question of fairness versus effectiveness. Lower capital gains and inheritance taxes are perceived as unfair by low income and low wealth individuals. Raising tax rates on capital gains creates some drag on the economy and neither tax will make a meaningful impact on tax revenues.

Based on these facts, I come to the following conclusions. First, we should add a new higher capital gains tax for individuals with incomes greater than $10M. I suggest a maximum capital gains tax rate of 25% plus the Medicare surtax which would result in an overall tax rate of 28.8%. The primary reason for making this change is that it would help Americans feel that the system was more fair.

Following that same line of thinking, I would be in favor of lowering the exemption limit on estates to $5M while holding the tax rate. This will also help build confidence in the fairness of our tax policies.

Lastly, we should eliminate the step-up provision on inherited capital gains. As a reminder, when someone dies, the cost basis of their capital assets is adjusted to the current market value. This means that the capital gains on those assets up to this point in time, are never taxed.

None of these changes will make much difference in tax revenue generated and likewise, they will not slow economic growth; however they will help build trust and confidence. The erosion of trust in government and other institutions is very real and a negative drag on society. It is worth a little tax pain to restore some trust.