Towards Sensible Capital Gains Tax Reform

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Capital gains taxation: boring but very likely relevant in the near future given massive deficits in the United States

No matter who is elected (Trump or Biden), the United States faces massive budget deficits that the nation will face. It is likely that even a Trump administration would have to raise taxes.

If Joe Biden is elected president and Democrats take control of the Senate, there’s a good chance Trump’s 2017 tax laws will be significantly changed. As part of the Biden plan, taxes on long-term capital gains would be significantly increased for many people earning less than $ 1 million per year; and for those earning over $ 1 million, their capital gains would now be taxed as ordinary income.

In addition, under his regime, capital gains would be taxed on death. Under current law, an estate can pass assets to heirs without incurring capital gains taxes because no capital gains are recognized. Any capital gains are passed on to the heirs and would only be realized on the sale of the asset concerned by the heirs.

It is of course not clear what a final bill would look like after all the political maneuvering that would most likely take place before a final bill is passed.

The purpose of this article is to examine why we have a capital gains tax and to examine what fair tax treatment of capital gains might look like. The ideas expressed in this article are not my own. I give credit to my mentor and professor at Lehigh University, the late Professor Eli Schwartz. He taught a Public Finance course when I was in school and I also had the honor of being his student assistant for two years.

Professor Schwartz eventually became the Dean of the Economics Department at Lehigh University. He was an expert in various facets of corporate finance and economics and an original thinker. He has written books and taught courses on related financial and economic topics.

Justification of a capital gains tax

What was the rationale for introducing a capital gains tax (which is taxed at a lower rate than ordinary income)? An example will make this more understandable. Suppose you buy a property for $ 100,000 and in five years you sell it for $ 150,000. If there had been no capital gains tax, you would have had to pay ordinary income tax on the $ 50,000 gain. This does not seem fair because part of this gain is due to inflation and is not a “real” gain in the lexicon of economists. Just to give a very simplified example: suppose that during this five-year period the general price level increases by, say, 25%. This means that $ 25,000 of the price increase is due to inflation and that only $ 25,000 is “real”. In other words, you haven’t earned $ 50,000 in purchasing power over the five-year period. You have in fact earned “only” $ 25,000 in purchasing power. Given this state of affairs, it is unfair to tax all those $ 50,000 monetary gains on ordinary income tax.

Clearly, capital gains over a period of time are not the same as ordinary income. It is for this reason that the Capital Gains Tax was put in place to ensure that capital gains taxes are lower than ordinary income.

I have asked many people in the business and financial world why there should be a capital gains tax and the answer in too many cases is that it is good for the stock market. This may be the effect of the capital gains tax, but it is not a convincing answer as to the need for such a tax.

Capital gains taxes are paid on gains (when realized) from assets such as real estate, stocks, and other investment assets such as works of art. Capital gains taxes are generally exempt from certain profits made on the sale of one’s principal residence. Under current law, the first $ 250,000 of capital gains is exempt for single taxpayers and $ 500,000 for those filing joint tax returns. Since most people’s wealth is tied up in their homes, this isn’t much of a tax break in an age when homes are worth a lot more than they used to be. The Biden plan would hurt even middle-income people if they decided to sell their primary residence.

A fair way to tax capital gains

The fair way to treat capital gains according to Professor Schwartz is as follows: when a gain is realized (in our example, the $ 50,000 when the building is sold), we should only tax the “actual” gain. and that should be at the regular rate of income. That is, the increase of $ 25,000 due to inflation should not be taxed while the remainder of $ 25,000 should be taxed at regular tax rates.

How to tax capital gains on main residences

As mentioned earlier, capital gains on the sale of a principal residence should not tax the first $ 250,000 ($ 500,000 for married filers). A doubling of the capital tax rate proposed by Biden would hurt many middle-income citizens and not be acceptable to many people when (and if) the Biden proposal comes under scrutiny. Suppose a married couple bought their house 40 years ago for $ 200,000 and now sells it for $ 1,200,000. This is a capital gain of $ 1,000,000, of which $ 500,000 is subject to capital gains tax. According to Biden’s proposal, the capital gains tax on that $ 500,000 would increase in most cases. I doubt that such a result is politically acceptable. The amount of the exemption should probably be increased.

Reaction of the rich to Biden’s proposed capital gains tax increases

Biden’s proposal would not be easily accepted by high net worth investors who today enjoy favorable treatment with historically low rates of appreciation. There would be a huge increase in capital gains tax for many people earning less than a million dollars a year; and the elimination of all capital gains treatment for those earning more than $ 1 million per year.

The “deferred interest” loophole

There is also the famous “deferred interest” loophole which allows fund managers to claim what is really salary income as capital gains. The result is that they pay taxes on their earnings at about half the rate that ordinary taxpayers pay on income. This is why Warren Buffett pointed out that his secretary has a higher tax rate than him. This loophole allows Steve Schwartzman, the director of Blackstone (one of the world’s leading fund managers) to be taxed at lower rates than most people in the country. This flaw must be eliminated.

Conclusion

Before we can discuss the taxation of capital gains, we need to understand the underlying rationale for a capital gains tax. The proposal to eliminate the capital gains tax and replace it by adjusting capital gains for inflation, then taxing “real gains” at ordinary income tax rates, makes sense. from the point of view of equity. Nevertheless, in my opinion, there is no way that such a proposal will ever be considered. There are too many powerful interests that benefit from the taxation of capital gains that would block such a proposal.

But I think we would all be better served if we understood why there is a capital gains tax in the first place, then we could have a better discussion of how best to deal with capital gains in code. tax. We need to make sure that the middle class is not subjected to tax increases simply because their one precious asset (their primary residence) has appreciated in value over the years.

Neither should we allow fund managers who do not invest their own money to obtain what is ordinary income taxed at lower capital gains rates. Fair is fair.

Jacques Kyprios


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