The first of the 12 guidelines for a tax policy framework established by the Association of International Certified Professional Accountants calls for equity and fairness. Many tax proposals include changing the preferential treatment of capital gains taxes as a means of achieving greater equity in distributing the tax burden among taxpayers.
Capital gains are the profit realized from the sale of capital assets. Many policy experts believe the current tax policy places an unfair burden on wage-earning income-tax payers compared to households whose income favors capital gains. These experts see capital gains tax reform as a way to effect social policy. Recent years have seen swings in tax policy relating to capital gains and income, and the changes are expected to continue during the administration of President Joseph R. Biden.
A crucial skill for tax professionals is the ability to anticipate and adapt quickly to changes in tax laws to ensure their clients are able to meet their financial goals. Degrees such as a Master of Laws in Taxation and a Master of Taxation prepare tax professionals with the skills and knowledge to meet their clients’ tax-planning requirements, especially during times of changeable tax policy.
What Are Capital Gains?
Capital gains represent a capital asset’s increase in value over time. Assets subject to capital gains taxes generally include stocks, bonds, precious metals, jewelry and real estate. Profit from capital assets held for less than one year are considered short-term capital gains. These are taxed as ordinary income at rates that range from 10% to 37%. However, capital assets held for more than one year are considered long-term capital gains and are taxed at rates of 0%, 15% or 20%, depending on the filing individual’s tax bracket.
The Tax Policy Center estimates that in 2019, taxpayers whose annual income exceeded $1 million realized 76.8% of the benefits of capital gains tax rates being set lower than income tax rates.
Here are some other considerations regarding current and proposed capital gains tax rates.
- Low long-term capital gains tax rates make possible the many tax shelters that hinder economic growth and efficiency. These shelters may be used to convert salaries, wages and other income into capital gains.
- The lower tax rates on capital gains also complicate the tax system.
- Higher tax rates for ordinary income vs. long-term capital gains relieves people who earn capital gains from paying tax on all their income for the year (based on a definition of economic income as the sum of consumption and the change in the household’s income in the tax period).
- The tax policy proposed by the Biden administration would tax capital gains as ordinary income for taxpayers who earn more than $1 million. It would also increase the top ordinary tax rate to 39.6% for incomes greater than $400,000. As a result, filers whose income is greater than $1 million would pay capital gains taxes at a rate of 43.4% as opposed to the current top rate of 20%.
How Capital Gains Taxes Impact Social Policy
Reforms to capital gains tax law would affect social policy in the United States in many ways.
- At present, capital gains are taxed only in the year the asset is sold, no matter how long the asset is held and the gains accrue. Therefore, not all of a household’s annual economic income—the sum of the household’s consumption and change in wealth—is taxed annually.
- The current approach to capital gains taxation may encourage a taxpayer to defer selling assets in order to defer the payment of tax. It also may encourage a taxpayer to hold onto the asset until the holder dies and the transferee gets a “step up” in the basis of the asset (sometimes referred to as the “angel of death” provision –– although it should be noted that any unrealized loss on an asset held at death is “lost” and never able to be used by the transferee). The provisions discourage people from realizing profits and thereby being liable for taxes.
The current federal policy on income tax capital gains applies the tax in the year in which the asset is sold, which is called “taxation upon realization.” By contrast, the “mark-to-market” approach would tax capital gains in the year in which the gain on the assets accrued. Query, however, whether the concomitant “loss upon realization” would be enacted.
The current tax rate on realized capital gains is lower than the tax rate on wages if the asset is held for longer than one year before it is sold. The top marginal tax rate on long-term capital gains is currently 20%, although it is expected to increase under the Biden administration. On the other hand, the top marginal tax rate on wage income is presently 37% and may rise to 39.6% under the Biden tax plan.
Varying levels of wealth are held in the form of capital assets across income levels. The Tax Foundation notes that about half of all unrealized capital gains are held by the wealthiest 1% of households. However, by reducing income-generating assets, a tax on unrealized capital gains could reduce the amount of money available to invest in new businesses.
The current U.S. capital gains tax policy may be viewed as contributing to income inequality in several ways.
- It exacerbates the uneven distribution of wealth by reducing the capital gains tax burden on wealthier households while not reducing the ordinary income tax rates of low-income households. Bloomberg cites a study by the Federal Reserve Bank of Atlanta that concluded approximately 25% of lower-income workers in the U.S. face marginal tax rates of greater than 70% when adjusted for the loss of government benefits.
- According to the U.S. Federal Reserve System, the median income of white U.S. families in 2019 was $188,200, while the median income of Black families was $24,100, less than 15% of that of white families. The median income of Hispanic families in 2019 was $36,100.
Potential Capital Gains Tax Reform Effect on Social Policy
One result of the current capital gains tax approach is an increase in the effective tax rate for people in the low- and middle-income tax categories. The current system benefits higher-income earners at the expense of households with annual incomes of $50,000 or less. Proponents of capital gains tax reform state that ending the preferential treatment capital gains receive compared to earned income would raise government revenue more equitably than raising taxes on earned income.
The current policy of taxation upon asset realization affects social policy in many ways.
- The “lock-in effect”: The current approach to capital gains taxation encourages asset holders to retain an asset for as long as possible. This approach may cause the subsidization of under-performing assets and discourage investment in new business ventures.
- Tax sheltering: Existing assets may be used as collateral for loans that are then used to purchase new assets. The loans are repaid with tax-deductible interest. However, reform of these types of tax sheltering provisions could also lead to a collateral reduction in charitable contributions.
The potential impact of capital gains tax reform involves many aspects of both taxation and social policy.
- The “mark to market” or accrual approach: Under this approach, capital gains would be taxed when accrued rather than when realized. Assets are “marked-to-market” so that any increase in value a taxpayer realizes in the year is treated the same as interest, rents and profits from pass-through businesses.
- Indexing capital gains to inflation: This controversial approach to capital gains taxation would reduce the tax burden for older taxpayers who have held their capital assets for many years. For example, a person who paid $722 per acre for farmland in 1987 that increased in value to $2,815 per acre in 2019 would owe $482 per acre in capital gains tax if the gain were realized in 2019. However, indexing for inflation would reduce the capital gains tax bill by 50%.
- Removing the “step-up” in basis of assets at death: The tax on property transferred after the owner’s death is increased to its current market value, or stepped-up basis. When the heir sells the property, they pay taxes only on the difference between the sale price and the stepped-up market value, not the original price paid by the decedent. As a result, any appreciation of the property’s value during the previous owner’s lifetime remains untaxed. If this rule were removed, the tax code would increase the taxes paid by the wealthiest 20% of households without impacting most other taxpayers. It should also be noted, however, that current law also requires the basis of an asset that has lost value to be “stepped down” in which case the value of that unrealized loss is “lost” forever.
The Biden administration’s proposed changes to the tax code are designed to generate revenue that would reduce the tax burden on low- and middle-income taxpayers. The increased revenue from capital gains taxes would also fund infrastructure improvements, energy development, manufacturing and other programs.
The new administration is expected to continue the 2017 Tax Cuts and Jobs Act’s Opportunity Zone program, which creates tax-deferred capital gains and other benefits for investments in economically disadvantaged communities.
Tax-loss harvesting techniques take advantage of slight dips in the value of investments. For example, selling an asset that has lost value and replacing it with a similar investment allows taxpayers to offset the loss with any gains realized from the new investment, with some limitations. The Biden plan’s proposal to increase ordinary income tax rates would make it more difficult to reap the benefits of tax-loss harvesting.
Staying One Step Ahead of Impending Changes to Tax Law
The tax code is in a constant state of flux as markets, industries, technologies and political administrations rise and fall. Tax professionals are challenged with anticipating the effects of capital gains tax reform and other policy changes to ensure their clients benefit from the most favorable tax treatment possible. The Master of Laws in Taxation and Master of Taxation online degree programs at Villanova University prepare professional accountants and attorneys to meet this challenge by offering an advanced curriculum and graduate certificates geared to current and future tax systems and changes.
Learn more about how these Villanova University online programs help tax professionals achieve their professional goals.