How might the taxation of capital gains be improved?
Taxing capital gains at the same rates as ordinary income would simplify the tax system by removing major incentives for tax sheltering and other attempts to manipulate the system.
The Tax Reform Act of 1986, signed by President Ronald Reagan, raised tax rates on capital gains and lowered rates on ordinary income, but set the same 28 percent top rate for both. The goal: reducing tax planning devoted to converting ordinary income to capital gains. The policy worked—briefly. Successive congresses raised the top rate on ordinary income (now 43.4 percent) and reduced the top rate on capital gains (now 23.8 percent). As the gap between the two rates widened, so did the incentives to manipulate the system. Now might be a good time to once again tax capital gains and ordinary income at the same rate, which would be higher than today’s rate on capital gains but lower than the rate on ordinary income.
In the 1980s, taxpayers exploited the ordinary income/capital gain gap by making investments that generated ordinary deductions—such as interest, lease payments and depreciation—to reduce their current income tax liability. These taxpayers got their money back (and presumably more) in the form of long-term capital gains. The ’86 act targeted these arrangements by limiting the use of passive loss, interest, and accelerated depreciation deductions. But, most importantly, the ’86 act also eliminated the ordinary income/capital gain gap, which removed much of the juice.
With the return of the ordinary income/capital gap, various schemes to convert ordinary income into capital gains have followed. Last year, the Senate investigated basket options, which used the tax alchemy of derivatives to convert short-term into long-term capital gains. Over the last several years, private equity and other investment managers have been compensated with “carried interest,” which allow them to claim long-term gains rather than salaries.
These planning opportunities are available only to the well off. More generally, capital assets are held predominantly by the well-off, who derive the most benefit from the capital gains preferences (figure 1).
Some may object that reducing the tax rate on capital gains is necessary to prevent “lock in”—holding property to defer tax liability (perhaps until death, when the tax basis of the asset is stepped up to permit heirs to sell without realizing any taxable gains). But if Congress is concerned about the lock-in effect, it could either tax capital gains at death or reinstate the carryover basis so that heirs retain the lower basis. Either step would reduce the tax incentive to keep assets until death—and could raise substantial revenue that would make it possible to reduce tax rates or the deficit.
Finally, if Congress is concerned about the potential double taxation of corporate earnings, it might integrate the two levels of taxes on corporate income. That is, Congress could tax corporate earnings only once, taxing the corporation or its shareholders but not both. The US Treasury (1992) has laid out several options for such integration.
IRS, Statistics of Income Division. SOI Tax Stats—Individual Income Tax Returns Publication 1304 (Complete Report). Table 1.4. “All Returns: Sources of Income, Adjustments, and Tax Items.”
Burman, Leonard E. 1999. The Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed. Washington, DC: Brookings Institution Press.
———. 2012. “Tax Reform and the Tax Treatment of Capital Gains.” Testimony of Leonard E. Burman before the House Committee on Ways and Means and the Senate Committee on Finance, Washington, DC, Sept. 20.
Rosenthal, Steven M. 2014. “Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits.” Testimony before the US Senate Permanent Subcommittee on Investigations of the Committee on Homeland Security and Governmental Affairs, July 22.
US Department of the Treasury. 1992. “Integration of the Individual and Corporate Tax Systems.” Washington, DC: US Department of the Treasury.