At a time when the economy is still recovering from a COVID-induced recession, one would think that the last thing policymakers would want to do is discourage investment. Yet that’s precisely what congressional Democrats might end up doing with a raft of proposed tax hikes on capital gains.
High-profile Democrats such as President Biden and Senate Ways and Means Committee Chairman Ron Wyden have supported a laundry list of tax hikes on investment income, including taxing capital gains and carried interest as ordinary income, ending the step-up in basis, and establishing mark-to-market systems. Any one of these proposals would prove economically harmful — taken together, they are potentially devastating.
Taxing capital gains as ordinary income has long been a popular idea on the left, driven by claims that capital gains benefit from a “preferential” tax rate. And it’s true that capital gains taxes are lower than traditional income taxes, facing a top tax bracket of 23.8 percent rather than 37 percent for ordinary income. Nevertheless, it’s myopic to conclude from this that the tax code favors capital gains income.
That’s because most capital gains are taxed already through the corporate income tax code. In reality, capital gains taxes are a form of double taxation — income a taxpayer receives from the growth in value of a stock holding or a dividend is lower than it would be absent the existence of the corporate tax. Capital gains’ “preferential rate” therefore is little more than an allowance for the impact of other parts of the tax code.
Democrats may yet overlook this fact. Taxing capital gains as ordinary income, which President Biden has pushed for, would result in the top capital gains tax bracket being raised from 23.8 percent to 43.4 percent after accounting for proposed changes to ordinary income tax brackets and the 3.8 percent Net Investment Income Tax. Accounting for the impact of the corporate income tax means those dollars face rates well north of 50 percent. It’s foolish to imagine that this would not have an impact on investment and savings, economic indicators which drive productivity and wage growth.
But that’s not where the proposed tax hikes end. Democrats are also targeting the step-up in basis, a provision that “resets” the cost basis of an asset when it is inherited. In other words, rather than taxing someone on gains all the way back from when Grandma bought an asset in 1959, it would tax them on gains they accrued since inheriting it from Grandma.
Progressives claim this provision entrenches generational wealth, but really it offsets some of the impact of inflation and the death tax. Much of the capital gains tax burden on long-held assets that taxpayers inherit comes not from real value gains, but from inflation, something the tax code does not account for. Meanwhile, heirs with few liquid assets subject to the death tax could be put in a position where they have to sell off parts of their inherited estate to pay their death tax bill — and then have to pay capital gains tax on the assets they sell to do so.
Also on the menu is a mark-to-market tax system. I warned back in late 2019 that mark-to-market was a dangerous idea which could be on the horizon, and it brings me no pleasure to be correct. Senator Wyden is now floating trial balloon mark-to-market systems for derivatives and carried interest.
A mark-to-market system would tax unrealized capital gains on an annual basis. The obvious problems with this — the difficulty of taxing on-paper gains that don’t necessarily translate to cash in someone’s pocket, and the need to offer loss allowances that could lead to huge tax refunds in bad economic times — have failed to phase a Democratic caucus desperate for pay-fors.
Though this list is more than sufficient to kneecap the economy just as it rises to its feet, it’s not even comprehensive. It’s a sign of just how radical and far-reaching Democratic tax plans are that a single op-ed on proposed tax hikes on capital gains income is not nearly enough space to describe everything Democrats are considering.
But the proposals covered in this space would, taken together, nearly double capital gains tax rates, eliminate provisions that protect heirs from hefty tax bills, and establish an administratively nightmarish system of taxation of unrealized gains. That’s a worrisome sign for taxpayers counting on their legislators to be responsible custodians of the economy and their tax dollars.
