By Ian Salisbury
January 20, 2015
When investments are inherited, how big a cut should government get?
Phil Ashley—Getty Images

In Tuesday night’s State of the Union address, President Obama will be calling for a number of new tax credits for the middle class, along with a plan to make community college tuition free. And to help pay for all that, he’s proposing raising the taxes on some investors’ capital gains.

Most debate about taxes tends to focus on the income tax. But that’s not Uncle Sam’s only source of receipts. Another big item is capital gains—essentially, the profit you earn when you buy something and then sell it at a higher price. You may have to pay capital gains taxes if you trade stocks or bonds or when you sell real estate. The tax code provides lots of ways for middle-income taxpayers to avoid capital gains levies, such as Individual Retirement Accounts, 401(k)s, and an exclusion on profits when you sell a primary residence. So the new taxes Obama is talking about are aimed at the affluent.

The president is arguing for two changes to the capital gains tax:

1. Raise the top rate from 23.8% to 28%. The highest possible rate on investment profits today is far lower than the top rate on wage income, which is 42.4%. Obama’s plan would narrow the gap.

2. Make more capital gains subject to taxes. When you sell an asset, you don’t owe capital gains tax on the whole sale price, only on the amount above what you paid—that is, your profit. But there is an important exception. If you sell an asset you inherited, the gain isn’t based on what your benefactor originally paid. It’s based on the value the day you inherited it. This “step-up in basis,” to use the tax jargon, can be very valuable.

For instance, imagine inheriting a $2 million stock portfolio for which your uncle had originally paid $1 million. If you sold it a year later for $2.5 million, you would owe capital gains on the $500,000 in appreciation since it came into your hands, but not the $1 million in value it gained before your uncle passed it down to you.

Simply get rid of the step-up, and you’d be on the hook for taxes on $1.5 million in profits. But Obama’s proposal includes some provisions to protect middle-class heirs. The first $100,000 in profits is off the table. Other exemptions target homes and “small, family-owned and operated businesses.”

And even Obama, who is arguing that the wealthy are getting too a sweet deal, isn’t proposing taxing capital gains exactly the same as wage income. Which raises a question: Why not?

This has actually been the case for the most of the roughly 100 years that the country has levied an income tax. One exception: Top rates for both income and capital gains were briefly both set at 28% after Ronald Reagan’s 1986 tax overhaul. Reagan agreed to hike the capital gains rate from 20%, in exchange for the Democrats slashing the top income tax bracket from 50%.

Inflation is one reason for capital gains’ special tax status. Partly because of record-keeping difficulties, the tax code doesn’t let taxpayers factor in inflation when calculating profits. So lower tax rates are a kind of rough compromise for investors who otherwise might owe tax bills on nominal gains simply because today’s dollar doesn’t have the same value it did in, say, 1970 or 1980.

The other big argument has to do with economic growth. Many economists argue that lower capital-gains tax rates are justified because they encourage people to save, invest, or start businesses. Ultimately, they argue, giving capital gains a break will spur growth that ripples through the economy.

Does it work? The evidence is mixed. Both Clinton and Bush cut capital gains tax rates. Under Clinton the economy boomed, while under Bush it tanked. But given everything else that happened in between—from the Internet revolution to the financial crisis—it’s difficult to tell what effect, if any, these policy changes had.

Low capital gains taxes also raise questions of fairness. They are a big reason some the wealthiest Americans pay a surprisingly light tax bill, at least in terms of percentage of earnings. The U.S.’s 400 top earners, all making more than $99 million, paid average tax rates of just 18% in 2010, according to recently released data. That compares with 11.8% for all taxpayers, but that broader figure also includes the 40% of households that pay no income taxes.

In any case, don’t hold your breath for a radical change to capital gains taxes in the next two years. With Republicans in control of Congress, “it’s a non-starter,” says Roberton Williams, a fellow at the Tax Policy Center.

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