What’s Going on With Biden’s Capital Gains Tax?

What it is, why it matters, and what the future holds.

The last major piece of legislation presented by the Biden Administration at the end of its first 100 days is the the American Family Plan, a $1.8 trillion set of policies aimed at supporting families through tax cuts, direct payments, grants, etc.

These programs are projected to by funded by enhanced IRS enforcement and an increase on the capital gains tax. It is the second item that this article will be addressing.

What is the Capital Gains Tax?

To answer that question, we need to define capital gains.

From NerdWallet,

Capital gains are the profits from the sale of an asset — shares of stock, a piece of land, a business — and generally are considered taxable income.

There are actually two types of capital gains: short term and long term.

From the Tax Policy Center,

Capital gains and losses are classified as long term if the asset was held for more than one year, and short term if held for a year or less.

Short-term capital gains are taxed as ordinary income at rates up to 37 percent; long-term gains are taxed at lower rates, up to 20 percent.

Now that have our baseline definitions, let’s move on to the impact of capital gains on both individuals and the economy.

Why Is The Capital Gains Tax Such a Big Deal?

For the buy-and-hold crowd, the low rate of the long term capital gains tax is a godsend.

Capital gains are just money earned from money, icing on the investment cake, so to speak. Having that earned money taxed at a level less than standard income is the cherry on top.

The low tax rate has been viciously defended over the past several decades by those who can most afford to fund the fight: millionaires. The reason is that investments provide much of their income.

Half of [millionaires’] income comes from wages through business, and the other half comes from interest, dividends and capital gains. Those numbers have not changed much since 1989.

The richer you get, the higher proportion of your income is from capital gains.

For the 99 percent of taxpayers making less than $500,000, salaries and wages account for 75 percent of their adjusted gross income.

For taxpayers making $500,000 to $1 million, salaries and wages account for more than half of earnings.

But for those making $10 million or more, salaries and wages only account for around 15 percent of their income. Their real money comes from capital gains, with capital gains accounting for about half of their earnings.

Some will even argue against any tax on capital gains, as you are investing income that you have already earned and been taxed on. Why should you be taxed again for successfully investing that money?

What Does the Biden Plan Do?

The Biden administration has proposed almost doubling the maximum capital gains tax rate, from the current 20% to a much higher 39.6%. The idea is to have capital gains taxed at about the same rate as standard income, which has a top bracket of 37%.

(FYI, the 39.6% tax rate was the former top bracket, prior to the Tax Cuts and Jobs Act of 2017. Using this number is just political salt in the wound when refuting one of Trump’s signature policies.)

On the surface, it sounds like a lot of people are going take a hit to their retirement. But there are two pieces of good news to ease your fears.

This rate would only apply to those who have $1 million or more in annual income, which means only 540,000 investors need to actually worry about this tax.
This tax would not apply to many of the investment vehicles used by average people, such as the IRA, 401(k), and 403(b). In fact, 75% of investors hold their assets in one or more of these accounts, which would be shielded, regardless of income level.

The expected revenue would fund several economic policies, most notably those found in the American Families Plan.

There are a few issues though, as any tax increase will see a behavior shift of those affected.

Problems With the New Plan

There are three main issues with the increased capital gains tax.

The rich will just shift assets away from taxable accounts, reducing taxable income and tanking the stock market.
The rich will gift their assets when they die, effectively resetting the realized gains to zero and netting zero taxes.

Asset Shift

One problem with almost doubling the capital gains tax is that the rich will move their money away from stocks and into other assets that have lower taxes. For example, there are plenty of ways to lower taxes in real estate holdings if you are a landlord holding several rental properties.

Dumping stocks would create a glut of supply, distorting normal market forces (and prices).

The opposite effect might also happen, as the rich might be enticed to merely hold onto their equities and not trade as much as they would in the lower tax environment. Given that 56% of stocks are held by the upper one-tenth of 1%, not that many people need to buy into this idea for it to affect the market.

If half of the stock market isn’t available to sell, liquidity bottoms out, and the market get disrupted.

NBC summed it up nicely:

Tax experts say there are legitimate reasons for taxing capital gains at a lower rate, primarily having to do with inflation and market efficiency, but raising it too high could prove counterproductive by short-circuiting the market activity that would trigger the tax and yield revenue for federal coffers.

There is research that points to a level at which a higher capital gains tax yields diminishing returns, with around 28 or 29 percent the upper limit.

This might be one of the extremely few instances where there is an actual Laffer Curve that exists.

Inheritance

The other issue that might undermine the revenue projections from the capital gains tax increase is that the rich might just decided to follow the buy-and-hold method outlined above, then gift all of their assets to their children.

Sure, they’ll pay federal estate taxes, and some states have both estate and/or inheritance taxes. But those would have been applied to the inheritance upon death regardless.

If a person gifts unsold assets and not the money gained from selling those assets, they avoid the capital gains tax. Furthermore, the tax calculation resets the “original” price from which to measure gains at the price of inheritance, not the price of purchase by the now-deceased.

This change in base price is known as the “step up in basis”. If it is not changed as part of the tax increase, it will actually cost the government money. One analysis from the Penn Wharton Budget Model shows the following:

PWBM estimates that raising the top statutory rate on capital gains to 39.6 percent would decrease revenue by $33 billion over fiscal years 2022–2031.

If stepped-up basis were eliminated — as proposed in President Biden’s campaign plan — then raising the top rate to 39.6 percent would instead raise $113 billion over 2022–2031.

Will It Pass?

Probably, but probably not at the 39.6% rate. Congress is too divided, and Democrats aren’t going to have all 50 on board with this to unilaterally pass it in the Senate.

The richest populations in the United States live in the biggest cities, which are mostly represented by Democrats. They will be hard pressed to explain why they are doubling the taxes on their constituents’ most lucrative source of income.

I expect that there will be an increase in capital gains tax, but the step up in basis tactic will remain, albeit in a weakened version.

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This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.

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