President Biden is expected to propose two changes to the tax code affecting wealthy households that together could generate hundreds of billions of dollars in revenues over 10 years.
First, Biden wants to roughly double the capital gains tax rate for households earning more than $1 million per year, requiring them to pay the same rate as applied to ordinary income, which he also wants to raise to 39.6%, up from the current 37%. Combined with the existing surtax on investment income of 3.8%, used to help fund Obamacare, those provisions would produce a top capital gains tax rate of 43.4%.
According to an analysis by the Tax Policy Center, the capital gains tax increase is projected to raise $370 billion over 10 years.
Second, Biden wants to end the “step-up in basis” on estates, which allows many inheritances to go untaxed. The current rule allows heirs to value inherited property at the time of death, wiping out all capital gains up until that point for tax purposes. Instead, Biden is expected to propose that heirs pay taxes on all capital gains, measured from the time property was acquired – resulting in much higher tax bills on inheritances in wealthy families.
The combo could be the key: According to a widely-discussed analysis by researchers at the Penn Wharton Budget Model, rather than raising revenues, Biden’s proposed increase in the capital gains tax rate would be counterproductive, producing a loss in revenue of $33 billion over 10 years. That’s because capital gains taxes are relatively easy to avoid. Wealthy investors can simply not sell their assets, preferring instead to pass them along in their estates, a move that under current rules effectively eliminates capital gains taxes.
When combined with the elimination of the “step-up in basis” on estates, however, the increase in capital gains taxes is projected to increase revenues by $113 billion over a decade, Penn Wharton says.
“Revenue effects of the proposal depend on how unrealized capital gains are treated at death,” the analysis says. “Under the current-law regime where investors have numerous avenues to avoid capital gains taxes, we estimate that raising the top statutory rate on capital gains to 39.6 percent would decrease revenue by $33 billion over fiscal years 2022-2031. In contrast, under a regime without stepped-up basis at death—as proposed in President’s campaign plan—the proposed tax rate increase would raise $113 billion over 10 years.”
Looking for the optimal rate: Economists may argue about what tax rate produces the most revenue, but there is general agreement that capital gains taxes can be counterproductive if they are set too high. Former White House economic adviser Jason Furman said Tuesday that the optimizing rate is probably close to 30%, but that’s only if investors can avoid taxes on their estate. Without that loophole, the optimal tax rate could be much higher.
“If you are also ending step-up basis at death (as Biden proposes), the revenue-maximizing rate is much higher — plausibly above 43.4%,” Furman said.
A relatively small pool: Brian Deese, the director of the National Economic Council, said the tax would apply to a very small group, “not the top 1%, it’s not even the top one-half of 1%.” About 540,000 taxpayers reported incomes over $1 million in 2018, according to tax data reported by CNBC.
White House steps back from estate tax rate increase: Although Biden pledged during the presidential campaign to increase the estate tax rate, Bloomberg said Tuesday that the White House would not include that provision in the proposal released this week.