November 23 - 100th Anniversary of a Capital Gains Preference

Our federal income tax law did not have special treatment for capital gains until a much lower rate (12.5% rather than a top rate of 73%) was added by the Revenue Act of 1921 (P.L. 67-87; 11/23/1921).

So, November 23 marks 100 years of complexity, lots of discussion on why and how there should be any preference for capital gains, and fairly constant changes to these rules.

The Revenue Act of 1921 defined capital asset as “property acquired and held by the taxpayer for profit or investment for more than two years (whether or not connected with his trade or business), but does not include property held for the personal use or consumption of the taxpayer or his family, or stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year.”

The 1921 Act also

•        Repealed the excess profits tax on corporations.

•        Increased the corporate income tax rate.

•        Rejected a proposal for national retail sales tax.

Treasury Secretary Andrew Mellon supported taxing earned income “more lightly” than capital gains. He noted: “The fairness of taxing more lightly income from wages, salaries or from investments is beyond question.” At the time, middle and lower income earners were not subject to income tax. See background from Tax Analysts and CRS, Capital Gains Taxes: An Overview, 3/16/18.

The rationale for the lowered rate in the Revenue Act of 1921 is similar to today: To “stimulate sales of appreciated property.” [Treasury study, Federal Income Tax Treatment of Capital Gains and Losses, June 1951, page 2]

There were three key reasons offered for preferential treatment: [page 21]

•        Equity – to avoid treating gains generated over more than one year to the progressive rate structure that exists for ordinary income.

•        Solutions:

•        Lower rate – viewed as simple

•        Annual mark-to-market – constitutional issue regarding definition of income; complexity of measurement and verification

•        Assign the gain to the year actually accrued but don’t tax until sold – viewed as complex

•        Income averaging

•        Consider effect of inflation on the asset’s value

•        Incentive  - not explained in the 1951 report, but likely the incentive was to discourage holding of assets (lock-in effect).

•        Revenue yield  - not explained in the 1951 report; but likely this meant to encourage sales to generate tax revenues.

Note: The capital loss limitation was added in 1924 but tightened after large losses of 1929.

A preferential rate or deduction existed until the Tax Reform Act of 1986 which taxed all income under a two-rate system: 14% and 28%. The logic for no lower rate for capital gains was that the rate had been lowered so much already. The Joint Committee on Taxation's Bluebook on the TRA86 observed that using the same rates for all income would "result in a tremendous amount of simplification for many taxpayers since their tax will no longer depend upon the characterization of income as ordinary or capital gain. In addition, this will eliminate any requirement that capital assets be held by the taxpayer for any extended period of time in order to obtain favorable treatment." [page 178]

Discussions on the best way to tax capital gains continue.  I think the question I get most often from students is why capital gains are taxed at a lower rate than wage and business income. That is a good question. I think part of the issue is we hear more about the reasons why we have to have a lower rate without hearing much about weaknesses in such positions (there are strengths and weaknesses to the issues for taxing capital gains more lightly than ordinary income). 

For example, a common argument for the lower rate is to address inflationary gains. But that is a weak argument today when tax prep software can easily be designed to adjust basis for inflation based on how long the asset was held. 

Another argument for the lower rate is the bunching effect in that the entire gain is reported in one year rather than over the time the asset was held. The solution is to mark to market each year. While this adds complexity, it would address the issue. And to reduce complexity, it could only be required for individuals with AGI above a certain level such as the magic $400,000. Again, technology we have today that we did not have in 1921 simplifies the recordkeeping and calculations for mark-to-market.

Another argument for lower rates on capital gains is to stimulate investment.  This is also weak because not all capital assets generate investment such as a start-up company might produce. In fact, this is why a more targeted approach was used in 1993 with enactment of Section 1202 for qualified small business stock.  

The bulk of the benefit from the lower capital gains rate structure does go to very high income individuals who tend to have a lot more capital gain income than ordinary income. This is why Warren Buffet noted years ago that his secretary had a higher marginal rate then he did. An October 2021 report by the CBO on the distribution of tax expenditures indicates that the preferential rate on capital gain and dividends provides 95% of the benefit to individuals in the top quintile and 75% to the top 1% [page 14]. 

With Build Back Better, President Biden proposed to tax capital gains at the top regular rate for individuals with income above $1 million [Greenbook, page 61]. The House Ways and Means Committee suggested replacing the 20% top capital gain rate with 25%. The bill that passed the House on November 19 has a surcharge of 5% for individuals with income above $10 million and another 3% when income passes $25 million [Sec. 138206, page 2237]. This affects a very small percentage of the top 1%, but for capital gains is still below the top rate of 37%.

Regardless of what capital gains change ends up in the final Build Back Better Act, one thing is certain - it won't be the last time we'll see congressional discussions on what the rate should be or changes made.

What do you think? Are you doing to celebrate or at least acknowledge the 100th anniversary of the capital gains preference on November 23?

Cheers!

And - Happy Thanksgiving!

Clearing a path to a lower corporate tax rate

What will comprehensive tax reform look like?

We hear a lot of talk from elected officials of both parties about the need to lower the corporate tax rate. There is also talk that it be done in a revenue neutral manner. That might mean different things to both parties. It might mean that there would be some revenue boost from lower rates (Republicans) versus more of a number crunching exercise (Democrats).

In 2011, the Joint Committee on Taxation estimated that it would cost $717 billion over ten years to lower the corporate rate to 28%.  Much of the revenue to make this revenue neutral comes from timing changes, such as slower depreciation. I think there will need to be an increase in the capital gains rate and cut back on some generous individual tax preferences (such as the exclusion for employer-provided health coverage and the home mortgage deduction) to help lower both teh corporate and individual rates.

I've got a short article in the 10/31 AICPA Corporate Taxation Insider on this topic - here.  I hope you'll take a look.

What do you think it will take to lower the corporate tax rate?

SJSU MST's Contemporary Tax Journal publishes Spring/Summer 2013 issue

I'm proud to announce the publication of the 4th issue of the student-run, online journal of the San Jose State University MST Program. You can find the journal here (current and past issues):

http://www.sjsumstjournal.com/

Here are the topics covered in the Spring/Summer 2013 issue:

TAX ENLIGHTENMENTS

• 100th Anniversary of the 16th Amendment 
• Research Credit: A Journey of Uncertainty
• Nonqualified Use of Principal Residence 
• A Tax Haven in the Friendly Sky?

ARTICLES

• Apple's Big Win Highlights Uncertainty in Valuing Tech Investments
• Seeking articles - see our submissions policy

FEATURE

• Summaries from the 28th Annual TEI-SJSU High Tech Tax Institute
• Summaries from the TEI-SJSU Tax Policy Conference - Tax Reform: Status, Needs and Realities

FOCUS ON TAX POLICY

• Transferability of the Research Tax Credit
• Return of the 20% Capital Gains Rate for Certain High Income Individuals 
• Surtax on Millionaires 
• Excessive Compensation - How Much is Too Much? 
• Increase and Make Permanent the Research Tax Credit 
• Preferential Treatment of Capital Gains
• Repeal of the Inclusion of Social Security Benefits in Gross Income 

TAX MAVENS

• Dan Kostenbauder, VP Tax Policy, Hewlett Packard Company 
• Fred Silva, Senior Fiscal Policy Advisor, California Forward  

There are wonderful pieces here - I hope you'll take a look!  Thank you!! 

A Canadian's proposal to avoiding the ‘fiscal cliff’

Professor Jonathan Rhys Kesselman of Simon Fraser University in Vancouver has an article in The Globe and Mail today (12/6/12) on suggestions for the U.S. in addressing the "fiscal cliff" and expiring tax cuts.  Professor Kesselman had a guest post in this blog in 2009 (1/1/09 post).

He suggests a different scheme for taxing both short-term and long-term capital gains via the tax base rather than a separate rate structure.  The U.S. has had various approaches to taxing capital gains back to the start of any different treatment in 1921.  Perhaps you remember the 60% exclusion for long-term capital gains in the 1980s? (I do)

President Obama has proposed only keeping the lower capital gain rate for the 98% of individuals who are not "upper-income."  That seems unnecessary given that the 98% don't have much in the way of capital gains.  The treatment should be the same, I think, which makes it more simple.  Also, there is a lot of dollars at stake in what the rate is - people in that 2% group have a lot of capital gains and dividends.

Take a look at Professor Kesselman's proposal - here.

What do you think?

Capital gains - what should the rate be?

Last week (9/20/12), the House and Senate tax-writing committees held a joint hearing - Tax Reform and the Tax Treatment of Capital Gains.  There was testimony on reasons to tax capital gains at lower rates and reasons not to. I will leave that reading to you (it is interesting).  There was also an editorial in the Wall Street Journal on 9/21 - "A Capital Gains Primer - Why a tax rate differential is fair and helps the economy."  Not surprisingly, it suggests that any call to raise the current, temporary 15% rate on capital gains "ignores the vital link between tax rates and capital investment. The lower the tax, the greater the incentive to take risks."

I think there is a lot more to this debate than the traditional views for lower rates such as to adjust for inflationary gains, to stimulate the economy, etc.  I'd like to raise a few items to consider in the discussion of what the rate should be on capital gains.  And, just a reminder of the reason for the focus on this topic now.  First, for 2013, the top rate on capital gains returns to 20% (18% if the asset is held over 5 years). And, high income individuals (income over $200,000 or $250,000 if married fling jointly) will have an extra 3.8% Medicare tax on all or a portion of their investment income starting in 2013 (per IRC Section 1411).

1. The Tax Reform Act of 1986 lowered the individual rates on all income to a top rate of 28%. That included the rate for capital gains.  Everyone seemed fine with that.  So, why the concern now that the rate has to stay at 15%? 
2. In 1997, President Clinton and Congress lowered the capital gains rate to 20% (18% if held over 5 years).  So, what is wrong with 20%?   
   
3. Any effort to lower the corporate tax rate, perhaps from 35% to 25%, needs to find a revenue neutral path.  It will be difficult if not impossible to cut enough special tax rules for corporations to get to a 25% revenue neutral rate.  Some of the revenue likely will have to come from the rate on capital gains. (See Nellen, The Rough Road to a 28% Corporate Tax Rate (11/10/11)). The discussions of corporate tax reform and capital gains taxation needs to merge and also include corporate integration (taxing corporate income once).
4. I always find it hard to believe that all capital gains help the economy.  Does someone selling Disney stock and buying Intel stock, for example, stimulate the economy and create jobs?
5. There is a good amount of revenue in the rate on capital gain question.  Of course, it is difficult to determine behavioral effects. Certainly if the rate were increased to 35% or higher, there would likely be fewer capital gain sales. But, it doesn't seem that anyone is talking about that.  President Obama's FY 2013 budget proposal includes having the capital gains rate return to 20% for higher income taxpayers and for that group to also have dividends taxed as ordinary income.  The revenue estimates from OMB on these two items are roughly $36 billion and $206 billion over 10 years, respectively.  (I'd recommend returning the capital gains rate to 20% for all taxpayers, not just higher income. I would like to see the issue of the rate on qualified dividends tied to the discussion on corporate tax reform).
6. Capital gains are mostly earned by higher income taxpayers.  For example, for 2009, per IRS data, 9% of returns with "Taxable net gain" had AGI of $250,000 or more. But looking at the percentage of the total "taxable net gain" dollar amount, 74% of such gains were on the returns of those with AGI of $250,000 or higher.
7. If there is to be any differential on capital gains, should it be through a lower rate or a deduction or exemption (such as a 60% deduction like we had years ago)?  I think states prefer a differential rate because it makes not conforming to it easier. But what is simpler for federal income tax purposes?

What do you think? What should be included in the capital gains debate? How should such gains be taxed? What about taxation of capital losses?

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Growing income inequality and the federal tax system

Laura Tyson of the Haas School of Business at UC Berkeley has a post on the Economix blog of the NY Times for 11/18/11 - "Tackling Income Inequality." She summarizes and analyzes data on changes in income and its elements (such as wages and capital gains) and how the income of the top 1% has "soared." She notes that there is reason for the Occupy Wall Street folks to focus on this topic.

The data is from a recent Congressional Budget Office report - Trends in the Distribution of Household Income Between 1979 and 2007 (10/11).

Tyson focuses on taxation of capital gains. She notes that when she was President Clinton's economic adviser, she led a study on the effects of reducing the capital gains rate. Per Tyson: "We concluded that a cut would decrease future tax revenue, would contribute to rising inequality and would not increase saving and investment as its advocates asserted." She also reminds readers that to reach a compromise on the budget, President Clinton signed legislation that dropped the top capital gains rate from 28% to 20% in 1997. That rate was dropped to 15% and also for qualified dividends, a few years later by President Bush and today, many believe it should stay at that rate.

Tyson also notes what is an income inequality issue and what becomes a federal revenue issue: "Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income."

I have blogged on this before to offer another perspective to consider with respect to the concern some raise that many individuals with income under $50,000 don't pay federal income tax (for example, 5/8/11 post). (For more on data from Tax Policy Center that for 2011 46% won't owe federal income tax - see their blog post of 7/27/11.) A 15% capital gains rate versus a 20% capital gains rate provides a $3,000 tax savings to someone with $60,000 of capital gains. So why a focus on someone with $50,000 of income perhaps not owing $3,000 of tax rather than the higher income person (with capital gain income) saving - and it is an even greater savings if the capital gains rate had stayed at 28%.

Back to the Tyson article - she suggests to address budget problems and reduce growing income inequality, to return ordinary and capital gains tax rates to what they were when Clinton left office, taxing some carried interests as ordinary income, adding a progressive consumption tax (no details of what it might be), and lowering the corporate tax rate (paying for it with the increased capital gains rate).

I encourage reading of both Dr. Tyson's article and the CBO report - interesting data and ideas.

What do you think?