Reforming Federal Capital Gains Taxes Would Benefit States, Too

Congress’s action or inaction on federal tax changes under consideration in the Build Back Better plan could have important implications for states on many fronts. One critical area of note is at the foundation of income tax law: setting the definition of income that most states will use in administering their own income taxes.

Lawmakers are still debating whether to reform taxes on capital gains, or the income that investors—especially wealthy investors—see when their assets grow in value over time. There is reasonably widespread agreement both in Congress and the Biden administration that the preferential, low tax rates applied to capital gains income need to be increased. But real reform will require looking beyond the headline tax rate and toward the more fundamental issue of ensuring that the capital gains income of extremely wealthy families is ever taxed at all. For states, which largely depend on the federal government to define what counts as income for tax purposes, this issue is far more important than the federal government’s choice of tax rate.

Under the current federal tax code, capital gains are taxable only if the asset generating those gains is sold during the taxpayer’s lifetime. That is, if the gain is “realized” while the owner is alive. Unlike workers, who regularly pay income taxes through automatic withholding from their paychecks, investors can watch their assets churn out huge gains for decades without ever having to set aside a dime for taxes. If those investors hold onto their assets until death—which typically only very wealthy people can afford to do on a significant scale—all the income generated by their investments is sheltered from income tax forever. Neither the original owner nor the heir to that property will pay income tax on the gain and, more importantly for state governments, the gain will never appear on federal income tax forms.

Because nearly all states with income taxes piggyback on the federal government’s definition of income, this means that capital gains the federal government chooses to overlook end up being invisible to state governments. In other words, deep flaws in the federal definition of taxable capital gains are being mimicked in state income tax codes all around the country.

Prior to the advent of the digital age, taxing gains only at the moment of realization could be defended as an administrative convenience. And for ordinary families today, who see much of their gains through gradual increases in their home’s value, taxing at realization arguably still works well enough. But the super-wealthy, who have come to own an outsized share of our nation’s wealth, are a different story. The vast majority of their earnings accrue through unrealized capital gains. To avoid taxes, they routinely tap these gains through low-interest loans against their portfolios instead of selling the asset.

Shockingly, the current federal definition of taxable capital gains omits more than half of the gains flowing to extremely wealthy families. One result of this was revealed in a recent Pro Publica analysis showing that Warren Buffet, Jeff Bezos, and Michael Bloomberg each faced federal income tax rates of less than 1.5 percent when measured relative to how much their financial resources increased between 2014 and 2018—all because the way in which they got richer was invisible to federal and state tax authorities. Looking at a somewhat broader group of households—the nation’s 400 wealthiest families—economists at the White House estimate an average income tax rate of just 8.2 percent by this measure.

This gaping hole in the federal tax code damages both economic and racial equity not only by allowing the richest households to accumulate wealth tax free but also by shrinking state tax bases, constraining state revenue growth, and exacerbating the regressive nature of state tax systems in general. The problem is so profound that it impedes the efforts of analysts, including those of us at ITEP, to fully measure its scope. As long as the IRS continues to collect and report incomplete income data—that is, data excluding unrealized capital gains—most tax models will understate the financial resources of the nation’s wealthiest families and overstate the progressivity of federal and state income taxes.

There are at least two options for correcting the federal tax code’s deeply flawed definition of capital gains income. The first is known as anti-deferral accounting (or mark-to-market taxation), under which very wealthy people would pay tax on their asset growth each year rather than being allowed to defer those tax bills until they sell their assets. This kind of system already exists in some narrow areas of the tax code related to futures contracts and securities dealers and expanding it to include America’s wealthiest families in a broader way would represent an important step toward equalizing the tax treatment of wealth and work. Sen. Ron Wyden, Chair of the U.S. Senate Finance Committee has long been a proponent of this reform and President Biden supports it as well.

The second approach would be to end, or restrict, a provision known as stepped-up basis, which is the feature of law that permanently exempts capital gains from tax when a wealthy person dies and passes an asset to an heir. Under this approach, investors would continue to receive the benefit of deferral throughout their lifetimes (unlike workers, who will continue to pay withholding on every paycheck), but at least a tax bill will eventually come due when the investor passes away. President Joe Biden has championed this reform.

Unfortunately, both these reforms were left out of the revenue package soon to be voted on by the U.S. House of Representatives, but leaders in the Senate have shown more interest in these ideas. Historically, states have looked to the federal government to take the lead in creating a reasonable definition of income for tax purposes and the states have tended to follow that lead for the most part. This allows for some degree of harmony between state and federal law, which simplifies tax administration and enforcement. But if Congress misses this opportunity to correct the fact that a staggering amount of capital gains income will never be taxed by any level of government, states will need to be ready to strike out on their own and enact more reasonable systems that do not suffer from this blind spot.

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