The voices of Tax Policy Center's researchers and staff
Republican leaders have several challenges to overcome before they can pass a big tax bill. Here are two: (1) They need revenue to pay for at least some of the tax cuts they proposed in the Unified Framework released in late September; and (2) the Trump Administration promised it would not cut taxes for high-income households. One way to address both problems is to raise effective tax rates on long-term capital gains.
But the solution may not be to raise the top long-term capital gains rate applicable to the highest-income taxpayers, which now can be as high as 25 percent. A better fix may be to boost the lower 15 percent rate (applying to taxpayers with incomes below the top tax bracket) to 20 percent. While it may seem counterintuitive, that step could generate much more revenue than raising the top rate, while still imposing most of the tax increase on high-income households.
To understand how a proposal like this might work, first look at how we tax long-term capital gains today.
Profits on the sale of assets held for a year or less are considered short-term gains and are taxed like ordinary income at regular income tax rates. Capital gains on assets held for more than a year (long term gains) enjoy a lower tax rate, but one that is linked to ordinary income tax rates. Thus, income from long-term capital gains that would otherwise fall in the 10 percent or 15 percent income tax bracket is taxed at a zero rate; long-term gains that otherwise would fall in the 25 to 35 percent brackets are taxed at 15 percent; and long-term gains that otherwise would fall in the 39.6 percent bracket are taxed at 20 percent.
In addition, single taxpayers with modified adjusted gross income above $200,000 ($250,000 for married couples filing jointly) pay an additional 3.8 percent tax on net investment income, including long-term capital gains. And the limitation on itemized deductions for high-income taxpayers effectively adds another 1.2 percentage points to the long-term capital gains tax rate. This creates a top long-term capital gains rate of 25 percent. But to keep things relatively simple, let’s focus on the top 20 percent rate.
TPC estimates that in 2017 individuals will realize $660 billion in short-term and long-term gains, making a tax increase on such investment income a potentially large source of revenue. Eighty-five percent of those gains will be realized by those with incomes in the top 10 percent, and almost 70 percent by those in the top one percent. A higher capital gains rate could be very progressive and help achieve Trump’s promise.
However, taxpayers can always avoid paying capital gains tax by simply not selling their assets. For that reason, a higher long-term maximum capital gains tax rate may not generate much additional revenue. TPC estimates that raising the 20 percent tax rate on long-term capital gains to 25 percent would generate less than $25 billion from 2018 through 2027.
Yet Congress can raise more revenue and target most of the tax increase to high-income taxpayers by reducing the incentive to defer gains. This can be done by raising the 15 percent rate on long-term capital gains to 20 percent. TPC estimates that this change would generate $50 billion over a ten-year period, more than twice as much as raising to 20 percent rate by a similar 5 percentage points. Why? Because most gains are realized by taxpayers in the 39.6 percent bracket who already face the 20 percent tax rate on their long-term capital gains. This proposal raises their average tax rate on capital gains but leaves their marginal tax rate unchanged. It’s the marginal tax rate that determines whether taxpayers sell assets with accumulated gains or hold them instead.
Consider a hypothetical single taxpayer with $600,000 in taxable income, all from long-term capital gains. The table shows how raising the 15 percent rate to 20 percent would work. Because her gains in excess of $418,400 still would be taxed at 20 percent, she’d have no incentive to cut back on additional gains beyond that point. She’d pay an additional $19,022.50 whether she realizes $600,000 in gains or $500,000 in gains.
This approach isn’t perfect. For example, taxpayers who only realize gains at the current 15 percent tax rate still would have an incentive to defer gains in response to the increased rate. Some likely would do so. Also, those taxpayers whose other (non-gains) income puts them in the top individual income tax bracket already pay a 20 percent rate on all of their long-term gains and thus would pay no additional tax under the proposal. (TPC estimates take account of these factors.)
As a result, by 2027 only about 70 percent of the increased tax revenue from raising the 15 percent rate to 20 percent would come from taxpayers in the top 10 percent of the income distribution and about 15 percent would come from the top one percent. That’s somewhat less than the fraction of the tax increase that would be paid by taxpayers in these income groups from increasing the 20 percent rate to 25 percent but it would raise more revenue and still shift most of the extra burden to high-income taxpayers.
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