Let’s Reform Capital Gains Taxes,
Not Just Tinker with the Rate
Capital gains taxation has been a perennial political football, from Carter to Reagan to Bush to Clinton to Bush II. And now it’s Obama’s turn. His meandering path over the campaign trail and post-election has included: raise the rate to “no higher than Reagan’s 28%” … hike it to “no more than Clinton’s 20%” … and leave the rate at Bush’s 15% until that sunsets at the end of 2010 and returns to 20%.
Debates over capital gains tax have always focused on “the rate,” but that feature plays only a limited role in the tax’s inequities, complexity, and distortions. It would be unfortunate if policy failed to consider more sweeping reforms to remove the most damaging aspects of the tax for investor decision making, efficient capital allocation, and economic growth.
A five-point reform agenda for capital gains taxation should be pursued by the incoming administration, and the current economic setting is uniquely propitious for these reforms. These five points are not mere theoretical, untested provisions; they reflect the tax treatment of capital gains in Canada since 1971, when that country instituted capital gains taxes in exchange for abolition of estate taxes.
As will be shown, these reforms offer significant advantages of improved equity, simplicity, and incentives relative to current US federal tax provisions.
1. Holding period Unlike in some other countries, the US tax system distinguishes between short-term and long-term holdings. Only assets held for over one year receive the lower, preferential tax rate on capital gains. This has several adverse effects. It complicates record keeping and tax reporting; it distorts investment and portfolio decisions; and it encourages various “gaming” maneuvers such as hedging an accrued gain until it becomes long-term(albeit using an imperfect hedge to avoid the prohibition on “selling short against the box”).
Abolition of the minimum holding period would treat all realized gains and losses identically. This approach eliminates all the cited complications and distortions, and it permits individual investors to concentrate on their primary role: allocating capital to yield the greatest economic returns. Abolishing the holding period is the most vital reform for taxing capital gains, but its benefits are compounded with other reforms.
2. Cost basis Taxable gains on partial sales of stock or mutual fund holdings are computed using a complex cost basis. Stock investors can choose to earmark particular shares for sale or otherwise must use a first-in, first-out method. Mutual fund investors have the same options and additionally can elect to use an average-cost method. These choices complicate record-keeping, tax-reporting, and enforcement; they further permit gaming the tax system.
Alternatively, investors could be required to use the average-cost method for all shares or units held of each equity or fund, regardless of when they were bought and when they are sold. That would simplify matters for both the investor and the tax authority; it would also eliminate gaming for purely tax deferral purposes. If all the investor’s securities are held with a single brokerage, its reporting of average-cost bases suffices. Simplified rules along with information reporting on cost bases would also reduce the scope for non-compliance, estimated to cost the Treasury more than $250 billion over ten years.
3. Death taxes When an individual dies while holding appreciated assets, their cost basis to the heir is raised to market value; all the previously accrued gains are fully freed of capital gains tax. This provision poses inefficient incentives for older and ailing individuals to hold onto assets with low expected future returns. It is also a major reason for imposing high estate tax rates—a salient issue for the wealthiest decedents, whose estates are laden with accrued gains on long-held assets. Unrealized gains represent about 56 percent of the value of estates worth at least $10 million.
An appropriate reform would impose “deemed realization” of accrued capital gains on assets held at death. If the assets pass to a surviving spouse, they retain their original cost base and bear tax on all the gains when eventually sold. This approach avoids perverse, inefficient incentives for holding onto poorly performing assets purely for tax purposes. Importantly, it also opens the way for reforming the estate tax with lower, less distorting rates.
4. Capital losses Capital losses exceeding capital gains in any year can offset other income up to $3,000, and any remaining capital losses must be carried forward to offset future years’ capital gains. This provision encourages year-end tax-loss selling, which distorts capital markets with “turn-of-the-year” effects, and it disadvantages investors with large current capital losses relative to their capital gains realized in recent years.
A simple reform is to permit individual investors to carry back any net capital losses to offset capital gains realized in the previous three years and thus to obtain tax refunds (capital loss carry-backs are already allowed for corporate taxpayers). This change would reduce the incentive for year-end tax-loss selling and other investor timing contortions. It would also be fairer to small and midsize investors who have uncertain prospects for future capital gains sufficient to offset current capital losses.
5. Tax rates Long-term capital gains are taxed at preferential rates relative to short-term gains and other income, as they have been for most of US history. However, since the Bush tax cuts of 2003, long term gains are taxed at a flat 15 percent rate for all taxpayers in the 25 percent bracket and higher—the great majority of those with capital gains. So a single tax filer with $33,950 or a couple with $67,900 of taxable income pays capital gains tax at the same flat rate as a multi-millionaire.
Taxing capital gains using a fixed inclusion rate, a method the US utilized over most of its history, would restore a sense of fairness to the tax system. With 50 percent of capital gains included in taxable income, most middle earners would pay at 12.5 or 14 percent—less than the current 15 percent rate—and earners in the top two brackets would pay at 16.5 and 17.5 percent—not far above the current rate. (Those preferring higher or lower taxation of capital gains could opt for either a 60 percent or a 40 percent inclusion rate, respectively.)
Even if the Obama administration simply waits for the top bracket rate to revert to 39.6 percent in 2011, a 50 percent inclusion rate would limit the top effective rate for capital gains to 19.8 percent—meeting the “no higher than 20 percent” commitment. Capital gains are highly concentrated among top earners; in 2006 more than 80 percent of the $340 billion of net long-term capital gains went to the 4 percent of households with taxable incomes above $200,000.
But the reform of capital gains taxation should be much more about improving the simplicity, efficiency, and incentives of tax policy than just extracting more revenues from the “rich.” With the proposed reforms, high wealth investors would be able to make much simpler, more profitable choices—and ones more conducive to economic growth—even while paying a bit more in taxes.
Comprehensive reform of capital gains taxation would also save scores of millions of hours each year for taxpayers at all income levels as well as for tax advisors and administrators; over 15 million taxpayers had to deal with computing gains and losses on asset sales in 2006. Tinkering with the tax rate alone would not reduce time and effort for anyone.
Settling capital gains tax policy early in the new administration would give investors greater clarity—invaluable in the current volatile financial and economic setting. A sensible reform package for capital gains taxation goes well beyond the single-minded issue of “the rate” to address matters of equity, efficiency, and simplicity as well as facilitating estate tax reform.
References and Further Reading
- Auerbach, Alan J., Leonard Burman, and Jonathan Siegel (2002) “Capital Gains Taxation
and Tax Avoidance: New Evidence from Panel Data,” in Joel B. Slemrod, ed., Does Atlas Shrug? The Economic Consequences of Taxing the Rich (Harvard University Press), 355-88.
- Dodge, Joseph M. and Jay A. Soled (2005) “Inflated Tax Basis and the Quarter-Trillion-
Dollar Revenue Question,” Tax Notes, January 24, 453-62.
- Internal Revenue Service (2008) Statistics of Income—2006: Individual Income Tax Returns (Washington, DC). (Figures on distribution of capital gains and filers with capital gains or losses were derived from this source.)
- Ivkovic, Zoran, James Poterba, and Scott Weisbenner (2005) “Tax Loss Trading by
Individual Investors,” American Economic Review, 95, 1605-30.
- Kesselman, Jonathan R., (2005) “Capital Gains Taxation: Augmenting the Advisory Panel’s Report,” Tax Notes, December 26, 1687-90.
- Kesselman, Jonathan R. (2005) “Reform U.S. Capital Gains Taxation à la Canada,” The
Economists’ Voice, August 15, http://www.bepress.com/ev/vol2/iss3/art1
- Poterba, James M. and Scott J. Weisbenner (2001) “Capital Gains Tax Rules, Tax-Loss
Trading, and Turn-of-the-Year Returns,” Journal of Finance, 56, 353-68.
- Steuerle, Gene (2005) “Improved Information Reporting for Capital Gains,” Tax Notes,
August 8, 697-98.
- Stiglitz, Joseph E. (1983) “Some Aspects of the Taxation of Capital Gains,” Journal of
Public Economics, 21, 257-94.
- Weisbenner, Scott and James Poterba (2001) “The Distributional Burden of Taxing Estates and Unrealized Capital Gains at Death,” in James R. Hines, Jr., Joel Slemrod, and
William G. Gale, eds., Rethinking Estate and Gift Taxation (Brookings Institution Press),