Reforming the capital gains tax is one way to simultaneously address both rising inequality and growing federal deficits, say William G. Gale and Grace Enda of the Brookings Institution. The current tax system allows some kinds of economic income – unrealized gains in a variety of guises – to go untaxed, and Gale and Enda provide some options for policymakers who want to capture some of that wealth, both to cover existing fiscal shortfalls and to reduce inequality:
1. Eliminate the “Angel of Death” loophole: Currently, wealth can be passed on to the next generation on a stepped-up basis, with capital gains and associated taxes wiped out for inheritors and values reset at current levels. Alternatively, estates could be passed down on a carryover basis that keeps original purchase prices in place, leaving the inheritor on the hook for the full capital gains tax at the time of sale. The Joint Committee on Taxation estimates that such a change would produce about $105 billion over 10 years.
2. Tax capital gains at death: Taxing all estates at death would raise billions more than a carryover system, but would likely be difficult to implement for illiquid or hard-to-value assets.
3. Tax capital gains every year: Paying taxes on a “mark-to-market” basis every year would raise more than $1 trillion over 10 years by some estimates, but would also likely create serious problems related to valuations and cash flow.
4. Vary the capital gains tax rate: “Retrospective taxation” would allow the tax rate to increase over time, eliminating the benefits of tax shelters while allowing tax payments to be postponed until an asset is sold.