This column contains a correction.
Wealth inequality in the United States has reached unprecedented levels, and the tax code’s favorable treatment of income from wealth is a contributing factor. A bombshell report from ProPublica on June 8 dramatically illustrates why: The country’s wealthiest people pay virtually no federal income tax on their massive accumulation of wealth.
Congress has a golden opportunity this year to fix the tax code. In the budget that President Joe Biden sent to Congress on May 28, he proposes several critical tax reforms aimed at “rebalanc[ing] the tax system away from special preferences for wealth and toward fair treatment regardless of the type of income.” These reforms, which are also included in his American Families Plan, would work to equalize the treatment of capital gains so that income from wealth is taxed more like income from work. Congress now has the chance to make important progress in fulfilling the principle that the tax code should not favor wealth over work by enacting President Biden’s capital gains proposals.
Most significantly, President Biden’s plan would make millionaires pay ordinary tax rates on their capital gains and repeal the stepped-up basis loophole, which allows millionaires and billionaires to avoid paying any income tax—ever—on their accumulation of wealth. The changes in President Biden’s proposal would only affect the wealthiest taxpayers, creating a fairer and more efficient tax code that substantially reduces inequality.
Capital gains receive special treatment in the tax code, and lower rates are only part of the problem
Capital gain is the profit received from selling an asset—such as corporate stock, an interest in a business, or real estate. If the asset has been held for more than one year, it is considered a long-term gain and is subject to special low tax rates. Long-term capital gains face a top tax rate of just 20 percent—compared with the top rate of 37 percent on wage and salary income. (When including Medicare taxes on earnings and the parallel tax on investment income, the top rates are 23.8 percent and 40.8 percent, respectively.)
“[Biden’s plan addresses] perhaps the most glaring loophole in the income tax—the complete exemption of the bulk of the wealth accumulation of the super-rich from income tax.”
– Tax lawyer Hank Gutman to Congress, May 12, 2021
The richest individuals receive the vast majority of the benefit from these special rates. According to the Tax Policy Center, fully 80 percent of the benefit of the special rates accrues to the highest-income 1 percent of Americans—those with incomes of more than $819,000. Fifty-eight percent of the benefit accrues to the highest-income 0.1 percent of Americans—those with incomes over $3.45 million. Those households in the top 0.1 percent receive an average annual benefit of more than $825,000 from the lower tax rates alone. (see Figure 1)
The wealthiest Americans reap the most benefit largely because they own such an outsize share of capital assets. The richest 1 percent by wealth owns more than half of all corporate stock held by Americans, more than half of private business wealth, and a disproportionately large share of real estate (14 percent), according to Federal Reserve Board data. In fact, most of the income that people making more than $10 million per year report on their tax returns is in the form of capital gains and dividends that enjoy preferential rates. The wealthy also benefit most from the special low rates because the vast majority of the wealth held by middle-class Americans is in their homes, which are largely shielded from capital gains taxes, and in qualified retirement plans, which are also not subject to capital gains taxes.
Figure 1
Capital gains enjoy another even more fundamental tax advantage under the current tax code. Capital gains are not included in a person’s income for tax purposes unless and until the asset is sold. By contrast, taxes on wages and salaries must be paid as they are earned; in effect, they are paid in real time through paycheck withholding.
The ability to defer taxes on capital gains is a large benefit. A worker who earns $50,000 per year will pay income taxes on her earnings every year—in fact, they will be deducted automatically from each paycheck. An investor whose stock appreciates by millions each year will not pay income taxes on that gain until the asset is sold, allowing the year-to-year tax savings to compound.
As ProPublica discovered, the very wealthiest Americans, whose gains are in the tens of billions, are paying only a small pittance of taxes in relation to how much their wealth has grown. (see Table 1)
Table 1
The ability to choose when to recognize income from capital gains also opens up a variety of pathways to avoid or further delay taxes. For example, people holding assets that have appreciated in value can strategically sell them at times when they can be offset with losses—a strategy known as “tax-loss harvesting.” Special rules known as “like-kind exchanges” allow real estate investors to continue deferring taxes on gains even when sold, as long as they replace the holding they sold with a similar one. Very wealthy people can avoid incurring capital gains taxes but still turn their investments into cash by borrowing against their assets and continuing to hold those assets. And the biggest potential benefit from deferring capital gains taxes is that the wealthiest Americans can go their entire lives without paying taxes on their capital gains.
The stepped-up basis loophole lets wealthy people avoid ever paying tax on their gains
Under the provision known as stepped-up basis, if an individual holds an asset for his entire life, when he passes it on to an heir, the gain is completely wiped out and capital gains taxes will never need to be paid on it. Under the provision, when a wealthy person leaves their asset to an heir, the basis of that asset—which, for an asset such as corporate stock, would be the price at which it was acquired—is “stepped up” to its value at the time that the person dies. For the heir, this means that any gain on that asset would be calculated from its price at the time they received it, rather than its price at the time that the original owner had purchased it. Because no capital gains taxes were paid by the original owner—as the asset was never sold—this effectively wipes out the entire gain that accrued over the course of their lifetime. As tax lawyer Hank Gutman recently told Congress, repealing step-up in basis addresses “perhaps the most glaring loophole in the income tax—the complete exemption of the bulk of the wealth accumulation of the super-rich from income tax.”
Economists Gabriel Zucman and Emanuel Saez estimate that among U.S. billionaires, $2.7 trillion of their total $4.3 trillion of wealth (64 percent) consists of unrealized capital gains—in other words, gains that have never been taxed. (see Figure 2) For the biggest estates—those worth over $100 million—more than half their assets are unrealized capital gains. Altogether, stepped-up basis costs the United States more than $40 billion each year in foregone revenues, with the benefits flowing overwhelmingly to the wealthiest 1 percent. Moreover, it creates economic inefficiencies through a “lock-in” effect—encouraging wealthy people to hold assets indefinitely even if they would otherwise sell them.
Figure 2
Biden’s plan closes the stepped-up basis loophole and makes millionaires pay the top ordinary tax rates on their gains
President Biden’s American Families Plan includes a group of proposals that fundamentally reforms capital gains taxation. Together, these reforms bring the taxation of income from wealth much closer to the taxation of income from work.
President Biden’s proposals would:
- Equalize the tax rates for ordinary income and capital gains on income exceeding $1 million so that millionaires would no longer enjoy preferential tax rates on capital gains and dividends. Biden’s plan also proposes to raise the top rate from 37 percent to 39.6 percent.
- End stepped-up basis by ensuring that capital gains are taxed at the time a person gifts or bequeaths an asset to an heir, if they have not been taxed already. To ensure that only the wealthy are affected, the proposal would allow a $1 million lifetime exemption per person and other special provisions, discussed further below.
- Ends the ability of high-income real estate investors to defer capital gains taxes through like-kind exchanges on gains of more than $500,000 per year. Large profits on real estate investments would be taxed when the property is sold, similar to how other capital assets are taxed now.
- Ends the notorious carried interest loophole that allows investment fund managers to pay preferential tax rates on the interests that they receive in their funds as compensation for managing them. President Biden’s proposal to equalize the rates on ordinary income and capital gains greater than $1 million would effectively eliminate most of the loophole; his plan goes a step further, however, and taxes carried interest as ordinary income for taxpayers with incomes greater than $400,000.
Biden’s proposals to reform capital gains taxes raise $344 billion in revenue
- Reform the taxation of capital income (raising the top rate for millionaires and ending stepped-up basis): $322.5 billion
- Close carried interest loophole: $1.5 billion*
- Repeal deferral of gain from like-kind exchanges: $19.6 billion*
- Total, capital gains reforms: $344 billion
* Note: The estimates for these two proposals assume the first proposal—Biden’s broader capital gains reforms—is in effect.
President Biden’s plan protects middle-class families and family farms and businesses in several ways
Some members of Congress have raised concerns that repealing stepped-up basis would increase taxes on average taxpayers. But President Biden’s plan only affects the wealthiest taxpayers because it includes a $1 million exemption and special protections that would come on top of several that already exist in the tax code.
Under current law, investment gains in qualified retirement plans and 401(k) plans are not subject to capital gains taxes. Current law also exempts up to $250,000 of gain ($500,000 for couples) on the sale of one’s home. In addition, the capital gains rate is zero for taxpayers with income less than $40,400 ($80,800 for married couples), and 15 percent, lower than the ordinary rate, on incomes less than $445,850 ($501,600 for couples). These provisions shield the vast majority of Americans from capital gains taxes on their main sources of wealth; none of it would change under Biden’s plan.
No family would have to sell their farm or business to pay capital gains tax upon the death of the original owner because of Biden’s proposal—capital gains tax is delayed as long as the farm or business stays in the family.
Biden’s stepped-up basis proposal further exempts all but the wealthiest Americans by allowing a general exemption of up to $1 million of gain per person, effectively $2 million per couple. The general exemption would come on top of the exemption for homes. As the Tax Policy Center’s Robert McClelland finds, the Federal Reserve Board’s Survey of Consumer Finances (SCF) indicates that only 3 percent of households have more than $1 million of unrealized gains, but an even slimmer share would be affected by Biden’s proposal because in the normal course many households will sell assets to retire upon, thereby realizing their gains. The exemption in Biden’s plan is 10 times larger than the one contained in President Barack Obama’s 2015 proposal to close the stepped-up basis loophole.
Some members of Congress have raised concerns about the effect of repealing stepped-up basis on family farms and businesses. Their concern is that family farms and businesses that are handed down to the next generation would be forced to sell if the original owner must pay capital gains tax. Biden’s plan addresses this concern by providing that no tax is due on the appreciation of family-owned and -operated farms or businesses as long as the business continues to be family-owned and -operated. That means that no family would have to sell their farm or business to pay capital gains tax upon the death of the original owner because of Biden’s proposal—capital gains tax is delayed as long as the farm or business stays in the family. The proposal also includes a special provision for illiquid assets generally—not only privately held businesses—that allows any tax on gains on assets transferred upon the owner’s death to be paid over 15 years.
Congress should also repeal the passthrough deduction
As Congress considers raising revenue from wealthy individuals and leveling the treatment of income from wealth and income from work, it should also repeal the special deduction for passthrough business income. That deduction, which was enacted in the 2017 tax law, allows owners of business entities such as partnerships, S-corporations, limited liability companies, and sole proprietorships to claim a 20 percent deduction on their business income, subject to certain limitations. Because passthrough income is extremely concentrated among the rich, meaning they benefit the most from deductions, 61 percent of the benefit of that provision goes to the richest 1 percent of Americans. Similar to the special treatment for capital gains, the passthrough deduction results in unfair differentials in tax rates and invites people to structure business arrangements for tax avoidance purposes. President Biden’s budget does not include a proposal on the passthrough deduction, but Congress should repeal it.
Conclusion
The preferential treatment of capital gains income has helped fuel the dramatic increase in dynastic wealth over the past few decades and allows the richest people in the United States to avoid ever paying capital gains taxes on the growth of that wealth during their lifetimes. By eliminating stepped-up basis and raising capital gains tax rates, Congress now has the chance to reverse course and repeal one of the biggest tax loopholes, creating a fairer tax code as well as a more efficient and productive economy.
Seth Hanlon is a senior fellow at the Center for American Progress. Galen Hendricks is a research associate for Economic Policy at the Center.