September 28, 2021
Director of Federal Tax Policy
September 28, 2021
Last week, a new report from the White House examining the wealthiest 400 Americans reaffirmed what the public recently learned from a ProPublica expose: The very wealthy do not pay income taxes on all of their true income each year the way the rest of us do.
For high-net worth individuals and families, asset appreciation is a huge part of their income, but the tax code does not consider such financial gain income unless they sell their assets. Sen. Ron Wyden, the chairman of the Senate Finance Committee, has proposed a Billionaires’ Income Tax, which would expand the tax code’s definition of income for very wealthy people to include asset appreciation, also called unrealized capital gains.
This proposal could be included as a revenue-raising provision in the Build Back Better legislation that is working its way through Congress. The Build Back Better plan has already taken a couple of different forms, including a set of proposals published by the White House and a bill loosely based on those proposals that was recently approved by the House Ways and Means Committee. All versions of this plan discussed by White House officials and Democratic lawmakers include, among several revenue-raisers, some reforms that would limit existing income tax breaks for capital gains.
Sen. Wyden’s Billionaires’ Income Tax is the latest tax proposal related to capital gains to be discussed publicly. ITEP wrote about Wyden’s idea when he first proposed it as “anti-deferral accounting” (also called mark-to-market taxation) in 2019, and we provided comments to Wyden’s staff about how to make the proposal as strong as possible. To understand it better, it helps to situate Wyden’s idea in the context of the bigger debate over how we should tax capital gains.
The Problems with Capital Gains and the Income Tax
When an asset’s value increases over time, that increase is a capital gain. Capital gains are a type of income, but the tax code taxes it far less than other types of income. This is deeply unfair because most (although not all) capital gains go to very well-off people. (Warren Buffett has famously stated that he pays a lower effective income tax rate than his secretary as a result and has condemned this as unfair.)
There are generally three major problems with the way we tax capital gains today.
Problem: Deferral of Tax on Unrealized Capital Gains
Solution: Sen. Wyden’s Billionaires’ Income Tax
The first problem is that, under the current rules, capital gains are only included in income for tax purposes when an asset is sold and the gains are “realized,” which means the seller profits from an asset sale. Unrealized capital gains are not taxed, meaning a person who owns an asset that is worth more and more each year can defer paying income taxes on the appreciation until they sell the asset.
Unrealized capital gains are the main type of income for some very wealthy people, who can defer paying income taxes on it for years, allowing their wealth to grow much more rapidly than the wealth a middle-class person might put in a savings account where the income it generates (the interest paid on the account) is taxed each year. Wyden’s Billionaires’ Income Tax would shut down deferral of income tax on unrealized capital gains for the very wealthy.
Problem: Realized Capital Gains Are Taxed at Lower Rates than Earned Income
Solution: Eliminate or Reduce Gap Between Tax Rates for Capital Gains and Other Income
The second problem is that, even when capital gains are realized, they are taxed at lower rates than other types of income. The result is that even when wealthy investors are paying taxes on their income, they pay at lower rates than people who earn their income from work.
Under current law, the top income tax rate for capital gains is 20 percent while the top income tax rate for other types of income is 37 percent. (High-income people also pay an additional 3.8 percent tax to fund health care on both earned income and investment income like capital gains, so, including that, the top rates are 23.8 percent for capital gains and 40.8 percent for other types of income.)
There is general agreement among most Democrats in Congress and White House officials that the current top income tax rate for capital gains is too low but less agreement on exactly what the rate should be. The President’s plan would effectively remove the lower rate for capital gains entirely for millionaires. (Taxable income beyond $1 million would be taxed at 39.6 percent regardless of the type of income).
The bill recently approved by the House Ways and Means Committee would effectively set the top rate for capital gains at 28 percent (including top income tax rate of 25 percent for capital gains plus a 3 percent surcharge on all income beyond $5 million). This means that the gap in tax rates would be narrowed, but not closed, under the Ways and Means bill.
Problem: Unrealized Gains Are Exempt When Asset Owners Die and Pass Assets to Heirs
Solution: Biden’s Proposal to Tax Unrealized Gains Upon Death of Asset Owner
The third problem is the exemption for unrealized gains on assets that taxpayers leave to their heirs when they die. When the owner of an appreciated asset dies, under the current rules the tax code simply forgets about the unrealized capital gains forever. This means that the effective income tax rate on a great deal of unrealized capital gains is zero percent. This exemption for unrealized gains on assets passed to heirs is often called the “stepped-up basis rule.”
If you buy an asset for $5 million, your basis in the asset is $5 million. If one year later you sell it for $8 million, you realize a gain equal to the $8 million you receive minus your basis of $5 million, which comes to $3 million. (Non-tax people would simply say you made a $3 million profit from selling the asset.) But if you die and leave the asset to your heirs, the current rules “step up” their basis to the $8 million that the asset is worth when they inherit it. That means they could sell it right away for $8 million and, under the current rules, they would realize no gains and therefore have no income from the sale of the asset to report on their tax return.
President Biden proposed to sharply restrict this tax break by taxing unrealized capital gains at death, with some generous exemptions to ensure that only the well-off would be affected. Only gains in excess of $1 million ($2 million for married couples) would be taxed and gains on assets that are part of a family business or family farm would not be taxed so long as the enterprise continues to be owned and operated by the family. An intense disinformation campaign that included former Democratic members of Congress claimed that the proposal would hurt family farms despite the fact that they were explicitly exempt. The Ways and Means Committee succumbed to the lobbying campaign and left the President’s proposal to tax unrealized gains at death out of the bill that the committee approved.
Why Do We Need to Tax Unrealized Capital Gains of Wealthy People?
When people first hear about proposals to tax unrealized capital gains, they often ask, “Is this income, and if so, should we tax it?”
The answers to those questions are “yes” and “yes, when we are talking about the very rich.”
Most of us think of “income” as money because that is most of our income. But an economist would say that unrealized capital gains are also income, and for some wealthy people they are the main type of income. If you had a net worth of $5 million last year and your net worth is $8 million this year because the value of your assets has increased, an economist would say you must have had income of least $3 million because you have the ability to spend another $3 million on whatever you want.
In theory this is true for people at any income level, but there are sound reasons why every proposal to change the rules exempts people who are not rich. For an ordinary person with a typical income and typical net worth, it makes sense that the rules allow deferral of any income tax on capital gains until an asset is sold.
For example, if you make $70,000 a year and you purchased a rental property a decade ago for $150,000 and now it is worth $200,000, no one expects you to pay income taxes on the $50,000 of unrealized capital gains until you sell the property, mainly because you may not have cash to pay that tax until you sell the property. No one is suggesting that we change that.
But the situation for the wealthy is very, very different. Much of the wealth owned by high net-worth people is stock that they can easily sell whenever they need cash, but they can avoid selling and instead borrow against their assets in order to finance their lifestyles without realizing any gains that would be subject to income taxes. CEOs and founders of successful companies sometimes choose to receive most of their income in the form of unrealized gains and they decide how much income to realize each year (by selling stock). They naturally realize relatively little of it, so most of it goes untaxed.
For example, the ProPublica article mentioned earlier revealed that Jeff Bezos’s assets appreciated by $99 billion over five years. During that period, he reported income of just $4.2 billion to the IRS and paid nearly a billion in federal income taxes. Of course, $1 billion in income tax payments over five years seems like a lot on the surface. But an economist would say that Bezos’s real income exceeded $100 billion over that five-year period ($99 billion plus $4.2 billion), and the income tax he paid during those years came to about 1 percent of that total income.
Biden’s proposal would ensure that this income is taxed – eventually, when a wealthy person dies.
Wyden’s proposal could be even better in that it would have the effect of taxing this income each year. The ability of wealthy people to defer income tax on their unrealized gains allows them to build up their wealth to astronomical levels much more quickly. For example, in 2015 David S. Miller explained that Buffett, whose net worth was nearly $70 billion at that time, would have been worth $9.5 billion if his capital gains had been taxed each year regardless of whether he sold assets.
Most of us earn our income from work and pay income taxes on it annually. The rules allowing wealthy people to defer paying taxes on a huge part of their income for years provide them with a massive subsidy to accumulate even greater wealth.
Another reason to tax unrealized gains of the wealthy as income is that it makes other tax reforms more effective. For example, raising the top rate on capital gains would not be as effective of a reform (or revenue-raiser) if the other two problems are not addressed because wealthy people could avoid the rate-increase by holding onto their assets for a long time and by leaving more assets to their heirs to escape paying income tax on the gains.
Biden’s proposal would block the latter maneuver by taxing unrealized gains at death. Wyden’s in many ways would go farther because it would prevent wealthy people from reducing their taxes by deferring the income tax on their gains each year. His proposal would tax unrealized gains annually, or, when that is not feasible, would allow wealthy people to defer paying income tax on gains until they sell an asset but would then increase the tax owed in a way that negates the benefit of deferral. As a result, a taxpayer would not save any money by holding onto an asset longer and would find it much more difficult to avoid the rate increase.
A previous post from ITEP explains the details of Wyden’s “anti-deferral accounting” proposal, which he now calls a Billionaire Income Tax.
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