Or, Why California Governor Gavin Newsom Should Hope that the Federal Capital Gains Tax Rate is Not Increased
One thing that economists are fairly sure of is that a cut in the tax rate on capital gains increases the amount of gains subject to the tax and that, conversely, an increase in the tax rate on capital gains decreases the amount of gains subject to the tax. This is especially true in the short run.
This is so because capital gains taxes are levied in the United States only when the capital gains are realized, i.e., when the asset is sold, and the decision about whether to sell the asset is up to the owner.
Here’s how George Washington University economist Joseph J. Cordes put it in, “Capital Gains Taxes,” in the first edition of my Concise Encyclopedia of Economics:
Because capital gains are not taxed unless an asset is sold, investors choose when to pay the tax by deciding when to sell assets. Payment of the tax can be delayed by holding on to an asset with a capital gain, which is financially worthwhile because the amount owed in taxes remains invested in the asset and continues to earn an investment return. Payment of capital gains can be avoided altogether if an asset is held until death. After weighing the advantages of not selling, a rational investor may conclude it is better to keep an asset rather than sell it. When this happens, the capital gain becomes “locked in.” No tax is collected because no capital gain is realized through sale. The gain from staying locked in is greater at higher tax rates, so that the volume of capital gains that are realized falls as the tax rate rises, and vice versa.
Cordes notes that this point is made by proponents of the view that decreasing capital gains tax rates increases capital gains tax revenue, but the point holds whether or not the net effect is to increase tax revenue.
Cordes points out that the net effect on capital gains tax revenues from cutting the capital gains tax rate will depend on how sensitive capital gains realizations are to the capital gains tax rate. If they rise by a higher percent than the percentage drop in the tax rate, that is, if realizations are highly elastic with respect to the tax rate, then capital gains tax revenues will rise. And if they aren’t very sensitive, capital gains taxes will fall. It’s an empirical issue and Cordes deals nicely with the state of knowledge at the time he wrote, namely in the early 1990s.
Stephen Moore makes the same point about capital gains realizations in “Capital Gains Taxes” in the second edition of the Concise Encyclopedia of Economics. He writes:
The capital gains tax is different from almost all other forms of federal taxation in that it is relatively easy to avoid. Because people pay the tax only when they sell an asset, they can legally avoid payment by holding on to their assets—a phenomenon known as the “lock-in effect.”
The effect is symmetric: If the federal government increases the tax rate on capital gains, as Democratic candidate Joe Biden proposes, the effect will be to make capital gains realizations lower than otherwise. Biden proposes to increase the top marginal income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually. The 39.6 percent is the same rate Biden would have on the ordinary income of the highest-income taxpayers. The top federal tax rate on ordinary income is now 37 percent and the top federal tax rate on long-term capital gains is now 20 percent. (Although, as Scott Eastman of the Tax Foundation points out, “Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.)
In short, Biden’s proposed tax rate increase on capital gains is huge, especially for the highest-income taxpayers, who, by the way, have a large percent of overall capital gains.
Here’s what’s not ambiguous: the result of an increase in the federal tax rate on capital gains would be less capital gains tax revenue for California’s state government.
California’s government taxes capital gains at the same rate it taxes ordinary income. With lower capital realizations by California residents, the state government will get less tax revenue from capital gains taxes than otherwise.
And California’s government relies more on capital gains tax revenues than many other states do. In 2019, the latest year for which we have the data, capital gains tax revenues, at $13.8 billion, were 9.5 percent of general fund tax revenues.
Which is why Gavin Newsom, who is facing a large state government budget deficit (although he has substantially overstated it) should hope that whoever is elected in November will not raise the federal tax rate on capital gains.
READER COMMENTS
Thomas Hutcheson
Aug 22 2020 at 7:26pm
Your argument suggests that capital gains (deflated by inflation) should be levied annually as accrued (or at least that should be allowed as an option) and at death. I suspect that the forgiveness of tax on gains to heirs is what does the damage in terms of gaming when gains are “taken.”
Vivian Darkbloom
Aug 23 2020 at 4:06am
Your analysis is incomplete in at least one important respect: Biden’s plan also proposes to eliminate the step-up in basis at death. Without the step-up there is a much lower incentive to defer realizations than currently is the case. It is not clear how in practice these changes would interact; however, it is not at all clear to me that in the long run the changes would result in lower tax revenue to California particularly if, which is nearly inevitable, California would follow the same tax basis rule.
Eastman discusses this countervailing effect elsewhere (see footnote 2 at your link).
Alan Goldhammer
Aug 23 2020 at 9:24am
This was also my feeling when reading the post. It’s also a fools errand to conjecture what the tax landscape will look like post election. Perhaps Congress come to their senses and eliminate all tax preferences including the carried interest loophole that effects both federal and state tax collections.
David Henderson
Aug 23 2020 at 10:39am
Vivian, Good point.
Thomas Sewell
Aug 31 2020 at 11:13pm
Realistically, people with long-term capital gains don’t always wait for death, they tend to also either wait for a temporary lowering of the capital gains tax rate, or else for an opportunity to transfer the gains to another entity (charity, living trust, etc…) in order to avoid the taxes long term.
Raising the rate is simply raising the incentives to do so.
Fazal Majid
Aug 23 2020 at 7:11am
As a net-contributor state, any increase in Federal taxes means more money is taken out of California to subsidize rural states with disproportionate voting power. Thus the argument holds for any federal tax increase.
robc
Aug 23 2020 at 9:21am
Isnt every state a net-contributor? Once you consider money wasted or spent in Afghanistan or wherever, I think even MS gets back less than they send in.
Maybe DC, due to number of federal jobs?
BC
Aug 23 2020 at 8:44am
Many people advocate eliminating capital gains taxes, without much success, because they penalize savers over spendthrifts. Have people tried promoting *temporary* capital gains tax cuts as an alternative? I don’t know how CBO scoring works with respect to capital gains taxes. Is it static enough such that a 1-yr suspension of capital gains taxes with a doubling of the original rate the following year would score as (roughly) revenue neutral? If so, then one could politically claim the measure as revenue neutral even though the effect would be that many savers could sell during the tax suspension year to reset their basis in whatever they purchased as a replacement, thereby mostly effectively eliminating the capital gains tax. The temporary cuts could be proposed at politically opportunistic times as ways to stimulate investment and the economy without increasing the (scored) budget deficit.
BC
Aug 23 2020 at 8:52am
Also, are distributional analyses static? Presumably, a static distributional analysis would also score a temporary capital gains tax cut as distribution neutral if it was followed by an offsetting hike the following year.
Stephen
Aug 23 2020 at 11:38am
As others have pointed out, the interaction between capital gains taxes and estate taxes influences behavior dramatically. Progressives are not only attacking the step-up basis rule but are trying to lower the estate tax exemption from its current $11+ million per individual to $3.5 million, a change that will force many Californians with homes to do something more sophisticated than create a living trust and ignore further estate planning.
Two more points: 1) the lock-in effect applies to more than just stocks that one should probably diversify out of–it can lock people in to their appreciated homes in places like the Bay Area (the gain-on-sale-of-personal-residence exemption of $250,000 single/$500,000 married has receded in importance because it was enacted in 1997 and has not been indexed for inflation); 2) the SALT $10,000 limitation already imposes a high effective State+Federal tax rate on capital gains in a high-tax State like California.
Many tax strategies that are being employed now will have to be drastically overhauled if the November elections go a certain way. For me a divided government where nothing extreme is done on taxes for 2-4 years would be a satisfactory outcome.
Scott Sumner
Aug 23 2020 at 11:52am
Very good post. You said:
“Although, as Scott Eastman of the Tax Foundation points out, “Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.”
The extra 3.8% tax actually applies to all income, making the top federal tax rate 40.8% (37% plus 3.8%)
Thomas Hutcheson
Aug 23 2020 at 5:14pm
There are numerous problems with capital gains taxation: 1) Gains are not indexed for inflation. 2) Gains are not taxed on death. 3) Gains are not taxed at rates as if taxed on accrual. 4) Gains are taxed at rates less than rates of ordinary income.
All these could be corrected with taxation based on consumption at progressive rates.
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