Why State-for-Local Tax Swaps Are So Hard to Do

Why State-for-Local Tax Swaps Are So Hard to Do

Tax Policy – Why State-for-Local Tax Swaps Are So Hard to Do

Tax reform is hard. But sometimes local tax reform makes it look easy, particularly when those reforms involve a state-for-local tax swap. Currently, both Texas and Nebraska are considering state-for-local tax swaps, but they’re running into an old problem: frequently, only a net tax cut can ensure that most taxpayers are not worse off, while only a tax increase can hold local governments harmless.

Local revenue systems are often a hodgepodge of taxes, old and new. Mainstays like the property tax or often a local option sales tax coexist uneasily with head taxes, inventory taxes, occupation taxes, and license taxes, some of them evolved from peddler’s taxes or other archaic forms of taxation. Tangible personal property taxes, though widely regarded as economically inefficient, hang on in many states, and sometimes so do gross receipts taxes, for all their acknowledged flaws. In some states, a constellation of small, inefficient local revenue sources can be so widely acknowledged as flawed to earn the appellation “nuisance taxes”—in official state publications!

Policymakers are often interested in eliminating certain taxes, because they’re inefficient, unpopular, volatile, or for any number of other reasons. If, however, the taxing authority cannot afford to forgo the lost revenue from repeal, a replacement revenue is needed—hence the tax swap.

The term “tax swap” often carries negative connotations, but it need not. Most tax reforms involve shifting liability among taxes to some degree, and sometimes one or more taxes outright replace another. Almost all states’ current tax codes are the result of an epochal shift in state taxation beginning about a century ago, when states scrapped their statewide property taxes and began to replace the collections with income and sales taxes. Proposals to modernize sales taxes often involve tax swaps (broadening the sales tax base and using some of the revenue to pay down rate reductions elsewhere), and can promote equity, stability, and economic efficiency. Lesser rebalancing of revenue sources happens with regularity, designed to increase efficiency, equity, simplicity, or some other policy aim.

Each swap must be considered on its own merits: some would improve state tax codes, while others may increase their complexity or undermine a state’s competitiveness. But the concept of the tax swap is itself neutral. When, however, a state revenue source is swapped for a local one, the complexity of the swap increases markedly. This does not mean that no state-for-local swaps are worth doing, but it does require careful deliberations, as the mechanics of a state-for-local tax swap are considerably more intricate than those of replacing one state revenue stream with another.

Four Kinds of Tax Swaps

In theory, four kinds of tax swaps are possible within state and local taxation: state-for-state, state-for-local, local-for-state, and local-for-local. A state increasing its gas tax, tied to a reduction in the sales tax rate, is a state-for-state tax swap. A state wiping out a locally-levied gross receipts tax in exchange for aid to localities funded by state income taxes is a state-for-local tax swap. Although rarely done explicitly, a reduction in state tax rates tied to new local spending mandates might be seen as a local-for-state tax swap, particularly if accompanied by new local revenue authority. And a locality paying down the repeal of some of its nuisance taxes with a slight property tax increase would be engaging in a local-for-local tax swap. Notably, local-for-local swaps might be initiated by a given locality or could be mandated by state government.

Distributional impacts must be grappled with where any tax change is concerned; they are not limited to tax swaps. For a tax swap involving a single level of government (state-for-state or local-for-local), the impact of distributional changes takes place at the taxpayer level (that is, changes in individual taxpayers’ overall liability). Where two levels of government are involved, however, they also take place at the governmental level. The same can also be true when states mandate a local-for-local tax swap, depending on the swap’s design.

The Challenge of Tax Distribution

Texas is currently considering an increase in the state sales tax to pay down reductions in local property tax millages, while Nebraska is contemplating using the sales tax to engineer property tax relief in the form of modified assessment ratios and tax credits. Other states have gone down this path, and they’ve learned just how complex it can be.

The new revenue stream will, necessarily, have a different economic incidence than the one it replaces. It is likely to have a different geographic footprint as well. However the state chooses to disburse the resulting revenue to localities, there are bound to be difficulties.

For the sake of narrative simplicity, let us use a generic version of the Texas and Nebraska proposals—a state sales for local property tax swap—though the basic analysis would apply to other state-for-local tax swaps as well. Obviously, as a starting point, taxable property and taxable sales are not proportional to each other. Some jurisdictions may have high property values but relatively little retail, hence low sales tax collections. Others may have large retail corridors, but struggle with the rest of the property tax base. How much tax is collected from each geographic region, and from each income class, will change under the swap. Thus far, this is not unique; the same would happen with a tax swap on a single level of government.

Here, however, the second-order effect takes place: not only do collections change, but local distributions do as well. Having collected the revenue, the state must decide now to allocate it to localities.

Policymakers might opt to distribute it proportionally to the revenue being replaced, such that a locality collecting 5 percent of the state’s overall property tax revenue would receive 5 percent of the replacement revenue. This approach rewards the jurisdictions with the highest property tax collections, which could be a combination not only of the properties with the highest assessed values but also those with the highest rates. Jurisdictions which exercised greater frugality might reasonably object to their tax dollars being siphoned off to provide additional aid to jurisdictions which have historically imposed higher taxes.

If, as in Texas and Nebraska, only a partial replacement of the property tax is intended, local policymakers (and the voting public, to the extent that they have to approve rate increases) have an incentive to raise property tax rates and cut other taxes—which runs directly counter to legislative intent—because higher property taxes yield a higher state revenue match. In a scenario where the property tax was repealed outright (which is not part of the proposal in either state), tax collections at a particular point in time could serve as the basis for a redistribution formula indefinitely, with increasingly indefensible results as time passes.

Alternatively, revenue could be distributed based on population, which—in a sales tax for property tax cut swap—would redistribute revenue to higher-density areas, particularly if property tax relief is limited to owner-occupied housing. This could be an explicit policy goal, or it might not, particularly if the intention was property tax relief. Property taxes might be lower, but those who faced the highest overall property tax burdens might—lower property taxes notwithstanding—shoulder an even greater tax burden.

Relief only targeted to owner-occupied housing, meanwhile, can be perversely regressive, since rental properties are generally classed as commercial property. Renters—many of them lower-income—would thus pay the higher sales tax without getting the benefit of any property tax relief.

It might be allocated based on where the additional sales tax is collected (destination sourcing), which makes it functionally like a mandatory local-for-local swap. Or revenues could be distributed by some other formula.

If the goal is to offset educational costs, for instance, it might be allocated according to a school funding formula that reflects educational needs. Such an approach might have merit—but as a school finance measure, not purely or primarily as a tax swap. In both Indiana and Michigan, for instance, state government assumed greater responsibility for education funding, with revenue earmarked from the state sales tax. To avoid (or at least limit) increased levels of overall taxation, mechanisms were put in place to reduce local property taxes in line with the reduced local responsibility for school funding. These policies should be understood, primarily, as school funding equalization measures, not property tax relief. The distributional changes—for individuals and taxing jurisdictions—were the goal, not an unintended consequence of a tax swap.

This is the quandary of a state-for-local tax swap: the only way to ensure that most taxpayers are not worse off is often to design the swap as a substantial net tax cut, while the only way to hold local governments harmless may be to engineer a substantial tax increase.

The Risk of an Overall Tax Increase

Even if, overall, the tax swap does not immediately increase tax burdens within a given jurisdiction, moreover, it might well end up that way. This is one of the biggest objections to state-for-local tax swaps, and while there are mechanisms to mitigate the risk, it is difficult to avoid it altogether.

Typically, proposals for a tax swap impose some sort of rollback or repeal requirement for the targeted local tax. So, for instance, property tax millages might have to decline by 20 percent, or capped below current levels, or be subject to reduction by the amount necessary to ensure a dollar-for-dollar reduction against the new local aid. Each approach has its own implications for local budgets. Equally importantly, however, is that it is difficult to ensure that the rates remain lower because of the tax swap.

Local governments tend to enjoy some autonomy in rate-setting, though they are subject to property tax limitations of varying levels of efficacy. Once rates are rolled back due to a tax swap, state officials can impose limits on the growth of tax collections (often called levy limits) to prevent local tax jurisdictions from reverting to their old rates while pocketing the new state aid, but most limits permit some growth factor and often authorize voter overrides. If property taxes are suddenly lower—even if other taxes have, with little transparency, risen to offset them—localities could easily max out their annual growth, or even secure voter approval to raise rates outside the cap, resulting in net tax increases while failing in the ostensible rationale for the swap: lowering property taxes.

Conclusion

In sum, state-for-local tax swaps are difficult to get right, both as a matter of policy design and practical politics. There are cases in which a state-for-local tax swap is still worth doing, because the targeted tax is so inefficient, or in service of other (non-tax) policy aims. There may, moreover, be options for other kinds of tax swaps, or for granting local governments greater authority to engineer their own local-for-local tax swaps tailored to their aims. At times, it may be appropriate for state government to mandate local participation, repealing authority for a given tax and perhaps replacing it with different tax authority.

Any such proposals require thoughtful deliberation, but some remain well worth doing. The potential moral hazards of a state-for-local tax swap, however, require a particularly cautious approach. Policymakers should want to know the details and contemplate the ramifications, avoiding the temptation to view a swap as an easy solution to goals like property tax relief.


Source: Tax Policy – Why State-for-Local Tax Swaps Are So Hard to Do

Tax Treaty Network of European Countries

Tax Treaty Network of European Countries

Tax Policy – Tax Treaty Network of European Countries

In an increasingly globalized world, many individuals and corporations work and do business abroad. As a result, jurisdictions need to define how income earned in foreign countries is taxed. Otherwise, income could be taxed in more than one country, resulting in double taxation. To avoid this, countries have negotiated double tax agreements (DTAs).

These tax treaties align many tax laws between two countries. They usually provide mechanisms to eliminate double taxation of business and wage income earned by individuals who live or have their main income in one country but (temporarily) work in another country. Additionally, they often include the mutual reduction or elimination of withholding taxes on interest, dividends, and royalties earned by foreign individuals and corporations.

Tax treaties can provide certainty and stability for taxpayers, reduce tax evasion, and encourage foreign investment and trade. A broad network of tax treaties thus contributes to the competitiveness of an economy.

European tax treaty 2019 tax treaty network of european countries 2019

The United Kingdom has the broadest network of tax treaties in Europe (131 countries), reflecting its long economic and political history of global trade and investment. The UK is followed by France (107 countries) and Italy (102 countries).

The countries with the smallest network of tax treaties are Iceland (43 countries), Greece (57 countries), and Estonia (57 countries). On average, the European countries covered hold 82 double tax agreements.


Source: Tax Policy – Tax Treaty Network of European Countries

An Analysis of Senator Warren’s ‘Real Corporate Profits Tax’

An Analysis of Senator Warren’s ‘Real Corporate Profits Tax’

Tax Policy – An Analysis of Senator Warren’s ‘Real Corporate Profits Tax’

Key Findings

  • Senator Elizabeth Warren (D-MA) released a proposal for a surtax on corporate profits called the “Real Corporate Profits Tax.”
  • The Real Corporate Profits Tax would be equal to 7 percent of a corporation’s profits as reported on its financial statement with an exemption for the first $100 million in profits.
  • According to the Tax Foundation Model, the Real Corporate Profits Tax would reduce long-run output by 1.9 percent, shrink the capital stock by 3.3 percent, and reduce wages by 1.5 percent.
  • The Real Corporate Profits Tax would raise approximately $872 billion between 2020 and 2029 on a conventional basis.
  • The smaller projected economy over the next decade would result in lower individual income, payroll, and excise tax revenue collections. As a result, we estimate that this tax would increase federal revenue by $476 billion between 2020 and 2029 on a dynamic basis.
  • The Real Corporate Profits Tax would reduce after-tax income for taxpayers at all income levels. However, it would raise taxes more for high-income taxpayers, increasing the progressivity of the U.S. tax code.

Introduction

Senator Elizabeth Warren released a proposal to enact a surtax on U.S. corporations. According to the Warren campaign, the “Real Corporate Profits Tax” would be equal to 7 percent of the worldwide profits reported on a corporation’s financial statement. The first $100 million in profits of a corporation would be exempt from the tax.

According to Senator Warren, the goal of this policy is to prevent companies that report profits to their shareholders in a given year from paying little to no federal income tax. The senator’s aim is to close the “book-tax” gap in profits. Under current law, companies have an incentive to report high profits to their shareholders while reporting low profits to the IRS. This tax would be based entirely on book profits to reduce this incentive.

Economic Effects

According to the Tax Foundation General Equilibrium Model, this proposal would reduce economic output (GDP) by 1.9 percent in the long run. We also estimate that the capital stock would be 3.3 percent smaller and wages 1.5 percent lower, with about 454,000 fewer full-time equivalent jobs.

Table 1. Economic Impact of the “Real Corporate Profits Tax”
Source: Tax Foundation General Equilibrium Model, March 2019

Gross Domestic Product (GDP)

-1.9%

Capital Stock

-3.3%

Wages

-1.5%

Service Price of Capital

2.6%

Full-time Equivalent Jobs

-454,000

The Real Corporate Profits surtax would reduce output primarily through an increase in the service price of capital, or the required return necessary for investment to break even, after tax and depreciation, in the United States. We estimate that the service price would rise by 2.6 percent under this proposal. A higher service price means that capital investment would become less attractive, leading to reduced investment and, eventually, a smaller capital stock. The smaller capital stock would lead to lower output, lower worker productivity, and lower wages.

Notably, the surtax would have a larger negative impact on the incentive to invest in the United States than a 7 percentage-point increase in the corporate income tax rate. This is chiefly because companies would not be able to use  expensing or accelerated depreciation for their capital investments.

The extent to which the corporate income tax distorts investment decisions depends largely on how much of a given investment can be deducted against taxable income in present value. Under current law, companies can expense, or deduct immediately, short-life assets against their taxable income. Long-life assets qualify for accelerated depreciation. The result is that many investments are exempt or partially exempt from taxation. Under the surtax, however, companies would not have access to expensing. The result is that all investment would be fully subject to the surtax.

Other aspects of the surtax would also distort corporate investment behavior. It appears that companies would not be able to carry forward losses into future years. As a result, investments that might lose money for several years before turning a profit could face high effective tax rates. Based on descriptions of the plan, the surtax also would include foreign income in its tax base with no deduction or credit for foreign taxes. This would make it less likely for U.S. companies to own foreign investments and would ultimately reduce national income.[1]

Revenue Effects

We estimate that the Real Corporate Profits Tax would raise $872 billion between 2020 and 2029 on a conventional basis. Corporate tax collections would be $79 billion higher in 2020. Over the next decade, collections would grow as corporate profits increase with the U.S. and world economy. By 2029, the surtax would raise $102 billion.

Table 2: Revenue Impact of the “Real Corporate Profits Tax” (billions of dollars)
Source: Tax Foundation General Equilibrium Model, March 2019. Values may not add to total due to rounding.
Year 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2020-2029

Conventional Estimate

$79 $79 $79 $81 $84 $87 $90 $94 $98 $102 $872

Dynamic Estimate

$72 $66 $59 $53 $49 $45 $39 $34 $31 $28 $476

On a dynamic basis, the proposal would raise $476 billion over the same period. The smaller revenue collections on a dynamic basis are due to lower output over the next decade. Wages and profits would be lower, reducing revenue collections from the individual income tax, payroll tax, and excise taxes. Revenue from these taxes would be $396 billion lower over the next decade as a result of the proposal.

Distributional Effects

According to the Tax Foundation General Equilibrium Model, the Real Corporate Profits Tax would make the tax code more progressive. However, taxpayers at all income levels, on both a conventional and dynamic basis, would see a reduction in after-tax income.

On a conventional basis, the bottom 80 percent of income earners would see a reduction in after-tax income of between 0.49 percent and 0.59 percent. Taxpayers in the 80th to 99th percentile would see a slightly larger reduction in after-tax income of between 0.64 and 0.89 percent. The top 1 percent of taxpayers would see a much larger reduction in after-tax income of 2.35 percent. Overall, after-tax income would fall by 0.93 percent.

On a dynamic basis, the smaller economy would result in an even larger drop in after-tax income. Taxpayers in the bottom four income quintiles (0% to 20%, 20% to 40%, 40% to 60%, and 60% to 80%) would see a reduction in after-tax income of between 1.64 percent and 1.95 percent. Taxpayers in the 80th to 99th percentile would see a slightly larger reduction in after-tax income of between 1.67 and 2.16 percent. Taxpayers in the top 1 percent would see a 4.16 percent drop in after-tax income.

Table 3. The Distributional Impact of the “Real Corporate Profits Tax.”
Percent-change in After-tax Income
Income Group Conventional Dynamic
Source: Tax Foundation General Equilibrium Model, March 2019.

0% to 20%

-0.49% -1.95%

20% to 40%

-0.50% -1.69%

40% to 60%

-0.55% -1.70%

60% to 80%

-0.59% -1.64%

80% to 90%

-0.64% -1.67%

90% to 95%

-0.70% -1.81%

95% to 99%

-0.89% -2.16%

99% to 100%

-2.35% -4.16%

TOTAL

-0.93% -2.16%

In general, the corporate income tax falls on the owners of capital (shareholders) and workers. Shareholders bear the burden of the corporate tax directly through reduced after-tax returns on their investments. Workers bear the burden of the corporate tax indirectly through reduced compensation. The share of the corporate tax borne by workers depends on how the corporate income tax impacts the incentive to invest. As mentioned previously, the Real Corporate Profits Tax would distort investment decisions by subjecting corporate investment to additional taxation. As such, this tax would fall on U.S. workers in the form of lower wages. We should also expect that this surtax would fall more heavily on workers, through lower wages, than the current corporate tax because it would fall more heavily on investment than the current corporate tax.

It is also worth nothing that the exemption for the first $100 million doesn’t necessarily contribute to the progressivity of the surtax. The annual profitability of a company doesn’t correspond to the well-being of those who ultimately bear the burden of the tax. A large corporation with more than $500 million in profits may be owned by a broad pool of shareholders with modest incomes. In contrast, a small, closely-held corporation that earns $50 million in profits, and falls under the threshold, might only have two high-income owners.

Conclusion

Senator Elizabeth Warren (D-MA) introduced a 7 percent surtax on corporate profits called the “Real Corporate Profits Tax.” We estimate that this tax would reduce the incentive to invest in the United States, and result in a 1.9 percent smaller economy, a 3.3 percent smaller capital stock, and 1.5 percent lower wages. The surtax would raise $872 billion between 2020 and 2029 on a conventional basis and $476 billion on a dynamic basis. The tax would make the tax code more progressive, but it would fall on taxpayers in every income group.


Methodology and Policy Assumptions

We use the Tax Foundation General Equilibrium Tax Model to estimate the impact of tax policies.[2] The model can produce both conventional and dynamic revenue estimates of tax policy. Conventional estimates hold the size of the economy constant and attempts to estimate potential behavioral effects of tax policy. Dynamic revenue estimates consider both behavioral and macroeconomic effects of tax policy on revenue. The model can also produce estimates of how policies impact measures of economic performance such as GDP, wages, employment, the capital stock, investment, consumption, saving, and the trade deficit. Lastly, it can produce estimates of how different tax policy impacts the distribution of the federal tax burden.

This analysis is based on details released by Senator Warren and her advisors. Ultimately, the impact of the proposal depends on its final details.

In estimating the impact of the surtax, we assumed that the 7 percent tax would apply only to C corporations (excluding S corporations, Partnerships, LLC, and Sole Proprietorships). We also assumed that the tax base would be equal to book profits minus an exclusion of $100 million.[3] There would be no deductions or credits for taxes paid, nor would companies be able to carry forward losses to future years.

To calculate the revenue effect of the surtax, we started with the current corporate income tax base and then adjusted taxable income to bring it closer to book profits. For example, companies would no longer benefit from expensing and accelerated depreciation, deductions for local, state, and foreign taxes, credits for specific activities, or the foreign tax credit. Foreign profits would be fully taxed each year. We also assume that companies would not receive deductions for losses. Companies would also not be subject to any special taxes or limitations such as BEAT, GILTI, FDII, or the limitation on net interest expense deductions.

In distributing the corporate income tax on a conventional basis, we assume that 50 percent of the corporate tax is borne by labor and 50 percent by capital.[4] On a dynamic basis, we assume that 50 percent of the corporate tax is borne by shareholders as a change in after-tax income, then changes in economic output are distributed to labor and capital in proportion to their share of total output.[5]


[1] We do not explicitly model this effect.

[2] Stephen J. Entin, Huaqun Li, and Kyle Pomerleau, “Overview of the Tax Foundation’s General Equilibrium Model,” Tax Foundation, April 2018 Update,” https://files.taxfoundation.org/20180419195810/TaxFoundaton_General-Equilibrium-Model-Overview1.pdf.

[3] These assumptions are similar to those made by University of California, Berkeley economics professors Emmanuel Saez and Gabriel Zucman in a letter to Senator Warren, https://elizabethwarren.com/wp-content/uploads/2019/04/Saez-and-Zucman-Letter-on-Real-Corporate-Profits-Tax-4.10.19-2.pdf.

[4] Stephen J. Entin, Tax Foundation, Oct. 24, 2017, “Labor Bears Much of the Cost of the Corporate Tax,” Tax Foundation,  https://taxfoundation.org/labor-bears-corporate-tax/.

[5] Huaqun Li and Kyle Pomerleau, “The Distributional Impact of the Tax Cuts and Jobs Act over the Next Decade,” Tax Foundation, June 28, 2018, https://taxfoundation.org/the-distributional-impact-of-the-tax-cuts-and-jobs-act-over-the-next-decade/.


Source: Tax Policy – An Analysis of Senator Warren’s ‘Real Corporate Profits Tax’

An Overview of Capital Gains Taxes

An Overview of Capital Gains Taxes

Tax Policy – An Overview of Capital Gains Taxes

Key Findings

  • Comparisons of capital gains tax rates and tax rates on labor income should factor in all the layers of taxes that apply to capital gains.

  • The tax treatment of capital income, such as capital gains, is often viewed as tax-advantaged. However, capital gains taxes place a double-tax on corporate income, and taxpayers have often paid income taxes on the money that they invest.

  • Capital gains taxes create a bias against saving, which encourages present consumption over saving and leads to a lower level of national income.

  • The tax code is currently biased against saving and investment; increasing the capital gains tax rate would add to the bias against saving and reduce national income.

Introduction

The tax treatment of capital income, such as capital gains, is often viewed as tax-advantaged. However, viewed in the context of the entire tax system, there is a tax bias against income like capital gains. This is because taxes on saving and investment, like the capital gains tax, represent an additional layer of tax on capital income after the corporate income tax and the individual income tax.

Under a neutral tax system, each dollar of income would only be taxed once. Currently, the tax code provides neutral treatment to some forms of saving, such as 401(k)s and Individual Retirement Accounts, but saving and investment activities outside of these arrangements do not receive neutral tax treatment.[1]

Capital gains face multiple layers of tax, and in addition, gains are not adjusted for inflation. This means that investors can be taxed on capital gains that accrue due to price-level increases rather than real gains.

Capital gains taxes affect more than just shareholders; there are repercussions across the entire economy. Capital gains taxes can be especially harmful for entrepreneurs, and because they reduce the return to saving, they encourage immediate consumption over saving.

Lawmakers should consider all layers of taxes that apply to capital gains, and other types of saving and investment income, when evaluating their tax treatment. Given the importance of national savings to the economy, raising taxes on saving would be misguided.

This paper will review the tax treatment of capital gains under current law and then discuss reasons for the lower rates as well as economic and revenue considerations for changing capital gains tax rates.

The Structure of Capital Gains Taxes

Capital gains, or losses, refer to the increase, or decrease, in the value of a capital asset between the time it’s purchased and the time it’s sold. Capital assets generally include everything a person owns and uses for personal purposes, pleasure, or investment, including stocks, bonds, homes, cars, jewelry, and art.[2] The purchase price of a capital asset is typically referred to as the asset’s basis. When the asset is sold at a price higher than its basis, it results in a capital gain; when the asset is sold for less than its basis, it results in a capital loss.

In the United States, when a person realizes a capital gain—that is, sells a capital asset for a profit—they face a tax on the gain. Capital gains tax rates vary with respect to two factors: how long the asset was held and the amount of income the taxpayer earns.

If an asset was held for less than one year and then sold for a profit, it is classified as a short-term capital gain and taxed as ordinary income. If an asset was held for more than one year and then sold for a profit, it is classified as a long-term capital gain. Table 1 illustrates the tax rates applicable to long-term capital gains for tax year 2019.[3] The income thresholds for long-term capital gains tax rates are indexed to inflation. However, the thresholds for the 3.8 percent net investment income tax (NIIT), an additional tax that applies to long-term capital gains, are not. Additionally, the NIIT also applies to short-term capital gains.

Table 1. 2019 Tax Rates on Long Term Capital Gains

Source: “2019 Tax Brackets,” Tax Foundation and IRS Topic Number 559

  For Unmarried Individuals For Married Individuals Filing Joint Returns For Heads of Households
    Taxable Income Over
0% $0 $0 $0
15% $39,375 $78,750 $52,750
20% $434,550 $488,850 $461,700
  Additional Net Investment Income Tax
3.8% MAGI above $200,000 MAGI above $250,000 MAGI above $200,000

In addition to federal taxes on capital gains, most states levy income taxes that apply to capital gains. At the state level, income taxes on capital gains vary from 0 percent to 13.3 percent.[4] This means long-term capital gains in the United States can face up to a top marginal rate of 37.1 percent.

If an asset is sold for less than its basis, resulting in a capital loss, taxpayers may use that loss to offset capital gains. If capital losses are more than capital gains, taxpayers can deduct the difference on their tax return to offset up to $3,000 of taxable income per year, or $1,500 if married filing separately.[5] If the total amount of the net capital loss is greater than the limit, it can be carried over to the next year’s tax return.[6]

Owner-occupied Housing Exclusion

Currently, the tax code provides an exemption for capital gains associated with the sale of owner-occupied homes.[7] Single filers may exclude up to $250,000 and married filers up to $500,000 if the filers had lived in the home for at least two of the previous five years. The exemption may be taken only once every two years.

This exclusion extends neutral tax treatment to a portion of capital gains but does not do so equally for all taxpayers. As a previous Tax Foundation report explained:

A fixed exempt amount protects a fixed amount of gains, regardless of the amount of the sale price that is due to inflation. The exemption might overcompensate or under-compensate for the inflation portion of the gain, and is therefore an imperfect offset to inflation, if that is the intent. However, it does extend saving-consumption neutral tax treatment to the investment in the home. In effect, the house is bought with after-tax income, and the annual shelter service provided by the home and the sales price are untaxed returns, as in a Roth IRA. For people who move often enough, the current policy shelters more of the gains in a home than would be covered by indexing. People who remain in one home for many decades or who bought high-priced homes on which subsequent price gains are large in dollar terms may find that they have gains greater than the exempt amounts. These homeowners would benefit from additional indexing of the initial cost basis and any improvements made over the years.[8]

Capital Gains in Estates

A policy called step-up in basis reduces capital gains tax liability on property that is passed to an heir. When a person leaves property to an heir, the cost basis of the asset receives a “step-up” in basis to reflect its fair market value at the time of the original owner’s death, which excludes any increase in value that occurred during the original owner’s lifetime from the capital gains tax.[9]

This policy discourages taxpayers from realizing capital gains, instead incentivizing them to hold capital gains until death. This policy, considered a tax expenditure, allows taxpayers to entirely exclude returns on saving from the capital gains tax. However, step-up in basis also prevents the double taxation that would occur if heirs owed both capital gains taxes and estate taxes on the same asset. Ending step-up in basis without also making reforms to the capital gains tax would increase the cost of capital and subject these returns to saving to multiple layers of tax.[10]

Should Capital Gains be Taxed Differently?

Comparisons are often made between the long-term capital gains tax rates and the tax rates that apply to ordinary income, with the call to equalize the two rates. However, several factors, discussed below, lead to a different conclusion.

A Double Tax on Corporate Income

Currently, the top marginal tax rate on ordinary income is 37 percent, while the top marginal rate on long-term capital gains is 23.8 percent. However, the capital gains tax should be thought of as a double tax; thus, one justification for the lower rate is that capital gains income is earned in an environment where other taxes have already been applied.[11]

The taxation of capital gains places a double tax on corporate income. Before shareholders face taxes, the business first faces the corporate income tax. A business pays the 21 percent corporate income tax on its profits; thus, when the shareholder pays their layer of tax they are doing so on dividends or capital gains distributed from after-tax profits.

Suppose that a taxpayer in the top tax bracket receives $100 of investment income. Such taxpayer would owe $23.80 in taxes on that investment income. But it can be easy to miss that the $100 in investment income had already been taxed at the corporate level—that $100 started out as $126.58 for the corporation, subject to the 21 percent corporate tax rate.

The capital gains tax is a double tax on corporate income

The corporation paid $26.58 in federal taxes on behalf of the investor, and the remaining $100 was passed on to the shareholder and taxed again. This results in a total of $50.38 of taxes on $126.58 of income, or an actual tax rate of 39.8 percent. 

In addition to corporate income taxes, it is typical that before an individual invests her money, she has already paid ordinary income taxes on it. This reduces the amount of money a taxpayer has to invest, thus implicitly subjecting the investment to federal taxes. Taxing capital gains creates an additional tax to the taxes on wages and business income.[12] But because individuals can delay realization of capital gains, this does lower the effective tax rate they face because delaying reduces the present value of the tax burden.[13]

Inflated Value of Capital Assets

As mentioned previously, capital gains taxes are owed when a capital asset is sold for a price higher than its basis. Under the current tax system, capital gains are not adjusted for inflation, meaning individuals pay tax on income plus any capital gain that results from price-level increases.[14] Inflationary gains do not represent a real increase in wealth, thus taxes on inflationary gains are taxes on “fictitious” income, which increases the effective tax rate on saving and investment.

In a previous Tax Foundation report, “Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains,” the following example is used to illustrate the problem caused by not adjusting capital gains for inflation:

When an individual buys a stock and later sells it for a capital gain, they must pay tax on this income. For instance, suppose an individual purchased an average stock valued at $7.51 in 1980 and sells this stock in 2013 for $100.[15] As a result, he realized a capital gain of $92.49 and must pay the 23.8 percent tax[16] of $22.01 on this nominal gain. However, since there was inflation during this period, the real gain was actually only $78.79. This implies that the taxpayer paid an effective rate of 27.9 percent on the real gain.[17]

In other cases, inflation can account for 100 percent of the capital gains tax owed; further, inflation can cause a nominal gain to be realized despite suffering a capital loss in real terms.[18] Ultimately, the lower rate on capital gains does not mitigate the inflation issue, as taxpayers still face tax liability whether they made a real gain or real loss.

Economic and Revenue Considerations

The capital gains tax creates a bias against saving. When multiple layers of tax apply to the same dollar, as is the case with capital gains, it distorts the choice between immediate consumption and saving, skewing it towards immediate consumption because the multiple layers reduce after-tax return to saving.

Suppose a person makes $1,000 and pays individual income taxes on that income. The person now faces a choice: should I save my after-tax money or should I spend it? Spending it today on a good or service would likely result in paying some state or local sales tax. However, saving it would mean paying an additional layer of tax, such as the capital gains tax, plus the sales tax when the money is eventually used to purchase a good or service. This second layer of tax reduces the potential return that a saver can earn on their savings, thus skewing the decision toward immediate consumption rather than saving. By immediately spending the money, the second layer of tax can be avoided.

As a whole, America does not save enough to fund its domestic investments; foreign saving makes up the difference.[19] In the United States, investment outpaces saving because foreign savers fund the investments that American savers cannot afford. If the return to saving for U.S. savers decreased, U.S. saving would fall and foreign savers would provide additional funds, all else equal. This would result in less ownership of U.S. assets by U.S. savers and a decrease in national income. Conversely, an increase in saving by U.S. savers would boost national income.

Consequences for Entrepreneurial Activity

An analysis of Federal Reserve data done by William M. Gentry indicates that entrepreneurial assets comprise a larger share of aggregate household portfolios than the taxable holdings of corporate equities.[20] In other words, there is a relatively large stock of unrealized capital gains associated with entrepreneurial ventures compared to corporate equities—entrepreneurial assets comprise nearly 17 percent of overall household portfolios.[21]

Entrepreneurship involves taking risk; but many of these risky investments are not successful, and those that are often begin by running losses for a period before becoming profitable.[22] Because the capital gains tax is a tax in addition to those on wage and business income, the capital gains tax is an asymmetric tax on successful entrepreneurial ventures.[23] Further, the capital gains tax is asymmetric in that it immediately taxes gains, while capital losses do not immediately result in a tax benefit.[24]

The capital gains tax is not neutral. Research shows that capital gains taxes can affect the decision to start a business, how and when entrepreneurs exit their business, and the ability to raise funds from outside investors.[25]

Realization Effect

Capital gains, and dividend income, comprise a relatively small share of individual income, meaning rate changes have a relatively small effect on total revenue raised by the individual income tax. For example, in 2016, capital gains accounted for just 8.4 percent of income reported on tax returns, meaning capital gains are a small portion of the individual income tax base.[26] Additionally, because of the realization effect, increases in the capital gains rate can lead to immediate reductions in revenue.[27]

Because capital gains are only taxed when realized, taxpayers get to choose when they pay their capital gains taxes, which makes them significantly more responsive to tax changes than other types of income.[28] Higher tax rates on capital gains cause investors to sell their assets less frequently, which leads to less taxes being assessed, known as the realization or lock-in effect.[29] This relationship between capital gains tax rates and realized capital gains is demonstrated in the chart below.

Capital gains realization rise when maximum tax rate on long-term gains falls

However, proposals such as mark-to-market would make the realization effect a non-issue. This is because under mark-to-market, yearly gains associated with assets would be taxed regardless of whether owners realize the gains. Senate Finance Committee Ranking Member Ron Wyden (D-OR) announced that he is developing a mark-to-market proposal to tax annual gains on assets owned by millionaires and billionaires.[30]

Conclusion

A neutral tax code would tax each dollar of income only once. Capital gains taxes create a burden on saving because they are an additional layer of taxes on a given dollar of income. The capital gains tax rate cannot be directly compared to individual income tax rates, because the additional layers of tax that apply to capital gains income must also be part of the discussion.

Increasing taxes on capital income would further the tax bias against saving, discouraging Americans from saving and leading to a decrease in national income.

Notes


[1] Erica York, “The Complicated Taxation of America’s Retirement Accounts,” Tax Foundation, May 22, 2018, https://taxfoundation.org/retirement-accounts-taxation/.

[2] Internal Revenue Service, Publication 550.

[3] There are other rules for certain types of capital gains. For example, net capital gains that result from selling collectibles such as coins or art are taxed at a maximum rate of 28 percent. See Internal Revenue Service, “Topic Number 409 – Capital Gains and Losses,” https://www.irs.gov/taxtopics/tc409.

[4] Jared Walczak, Scott Drenkard, and Joseph Bishop-Henchman, 2019 State Business Tax Climate Index, Tax Foundation, Sept. 26, 2018, https://taxfoundation.org/publications/state-business-tax-climate-index/.

[5] Internal Revenue Service, “Helpful Facts to Know About Capital Gains and Losses,” https://www.irs.gov/newsroom/helpful-facts-to-know-about-capital-gains-and-losses.

[6] Ibid.

[7] See Stephen J. Entin, “Getting ‘Real’ by Indexing Capital Gains for Inflation,” Tax Foundation, March 6, 2018, https://taxfoundation.org/inflation-adjusting-capital-gains/.

[8] Ibid.

[9] Scott Eastman, “The Trade-offs of Repealing Step-Up in Basis,” Tax Foundation, March 13, 2019, https://taxfoundation.org/step-up-in-basis/.

[10] Ibid.

[11] Tax Foundation, Options for Reforming America’s Tax Code, June 6, 2016, 26, https://files.taxfoundation.org/20170130145208/TF_Options_for_Reforming_Americas_Tax_Code.pdf.

[12] William M. Gentry, “Capital Gains Taxation and Entrepreneurship,” American Council for Capital Formation Center for Policy Research, March 2016, 23, https://www.law.upenn.edu/live/files/5474-capital-gains-taxation-and-entrepreneurship-march.

[13] See Kyle Pomerleau, “Economic and Budgetary Impact of Indexing Capital Gains to Inflation,” Tax Foundation, Sept. 4, 2018, https://taxfoundation.org/economic-budget-impact-indexing-capital-gains-inflation/.

[14] Kyle Pomerleau, “How One Can Face an Infinite Effective Tax Rate on Capital Gains,” Tax Foundation, Jan. 7, 2015, https://taxfoundation.org/how-one-can-face-infinite-effective-tax-rate-capital-gains/.

[15] This assumes the stock grew at the same rate as the S&P 500 during that 10-year period.

[16] As of January 1, 2013, the top tax rate on capital gains was 23.8 percent. This hypothetical assumes that the taxpayer’s AGI exceeds $200,000.

[17] The effective rate is found by dividing the tax of $22.01 by the real gain of $78.79.

[18] Kyle Pomerleau, “Inflation Can Cause an Infinite Effective Tax Rate on Capital Gains.”

[19] Alan Cole, “Losing the Future: The Decline of U.S. Saving and Investment,” Tax Foundation, Oct. 1, 2014, https://taxfoundation.org/losing-future-decline-us-saving-and-investment.

[20] Kyle Pomerleau, “Economic and Budgetary Impact of Indexing Capital Gains to Inflation, 4.

[21] Ibid, 9.

[22] Bureau of Labor Statistics, “Entrepreneurship and the U.S. Economy,” https://www.bls.gov/bdm/entrepreneurship/bdm_chart3.htm.

[23] William M. Gentry, “Capital Gains Taxation and Entrepreneurship,” 25.

[24] Kyle Pomerleau, “Testimony: The Tax Code as a Barrier to Entrepreneurship,” Tax Foundation, Feb. 15, 2017, https://taxfoundation.org/tax-code-barrier-entrepreneurship/.

[25] Ibid, 26.

[26] Robert Bellafiore, “Sources of Personal Income 2016 Update,” Sept. 11, 2018, Tax Foundation, https://taxfoundation.org/sources-of-personal-income-2016/.

[27] See Proposal 2 in Kyle Pomerleau and Huaqun Li, “How Much Revenue Would a 70% Top Tax Rate Raise? An Initial Analysis,” Tax Foundation, Jan. 14, 2019, https://taxfoundation.org/70-tax/.

[28] Ibid.

[29] Michael Schuyler, “The Effects of Terminating Tax Expenditures and Cutting Individual Income Tax Rates,” Tax Foundation, Sept. 30, 2013, https://taxfoundation.org/effects-terminating-tax-expenditures-and-cutting-individual-income-tax-rates/.

[30] United States Senate Committee of Finance, “Wyden to Unveil Plan to Ensure Wealthy Pay Their Fair Share,” April 2, 2019, https://www.finance.senate.gov/ranking-members-news/wyden-to-unveil-plan-to-ensure-wealthy-pay-their-fair-share-.


Source: Tax Policy – An Overview of Capital Gains Taxes