President Joe Biden’s American Families Plan includes some ambitious spending proposals. Those pare offset, at least in part, by major changes in the way the capital gains of wealthy households are taxed. The proposal has rekindled a long-running debate over the taxation of investment income in general and capital gains in particular. This commentary reprises arguments that I have made earlier against the preferential tax treatment of capital gains as they apply to Biden’s plan.

The distributional logic

The administration’s search for sources of revenue is constrained by the president’s promise not to raise taxes on anyone earning less than $400,000 a year. Leonard Burman has a great piece for the Tax Policy Center explaining why that is a bad idea (in every sense except the political). Among other things, the pledge would seem to preclude targeted levies such as carbon taxes or higher gasoline taxes. It could also be construed as hampering revenue-neutral reforms aimed at simplifying the system, which would inevitably raise rates on some individuals even if they were neutral for every broad class of individuals. 

Politically speaking, however, the $400,000 limit is a given. That being the case, the logic for raising taxes on capital gains is strong, since the benefits of the existing preferential treatment flow predominantly to the rich. According to the Tax Policy Center, 75 percent of all capital gains accrue to the top 1 percent of all taxpayers, and 75 percent to just the top 1 percent. In contrast, the bottom two-fifths of all taxpayers account for less than 1 percent of all capital gains. And, in contrast to gasoline or carbon taxes, capital-gains taxes would be relatively easy to raise in a way that exempted people with incomes below the threshold.

But as is the case with other proposals to tax the rich, eliminating the capital-gains preference runs up against a variety of trickle-down objections, all of which allege that in one way or another, such proposals end up harming everyone, not just the people who pay the taxes. As Richard Rubin and Rachel Louise Ensign put it, writing for the Wall Street Journal, “Congress created the lower rate as an incentive to invest and a way to prevent the tax code from discouraging asset sales. It is also a rough adjustment for inflation and a way to limit taxes on income already taxed at the corporate level.” Let’s take a look at some of these supposed advantages of special tax treatment for capital gains.

Incentive effects

The idea that lenient tax treatment for capital gains affects incentives is the first line of defense for those who favor the status quo. However, it does not follow that the investments incentivized by low capital-gains taxes are necessarily more productive than those that would be made if capital gains were taxed as ordinary income. 

On the face of it, in fact, the strongest incentive effect is not to invest more, but to change business practices in ways that convert ordinary income into something that qualifies as capital gains for tax purposes. The means to that end are many. For example, this law firm advertises several strategies to “convert ordinary income into capital gains or tax-exempt income.” Those strategies include eliminating depreciation recapture when selling equipment, redemption of partnership interests, and the strategic use of options. 

One of the most controversial ploys is the carried interest rule, which allows hedge fund and private-equity managers to structure the income they receive for their services in a form that qualifies for taxation as capital gains. The 2017 Tax Cuts and Jobs Act, which slashed the corporate tax rate, was supposed to close the carried interest loophole, but it ended up making only minor modifications. For the most part, say tax analysts, the rule lives on. 

Tax avoidance strategies that convert ordinary income to capital gains would be a problem even if they did nothing but generate inequities and reduce federal revenues, but their effects are worse than that. Such strategies typically require more than just waving an accountant’s wand over something a firm would do anyway. Instead, structuring transactions to take advantage of specific tax rules often requires changing actual business practices, such as the choice of financing methods, the timing of investments, even the choice of one’s whole line of business. Often, the changes would be unprofitable except for their tax advantages. Although proponents of the capital gains preference claim it supercharges growth and efficiency, tax-induced changes in business practices are a significant drag on the real economy.

Inflation protection

A second argument used by supporters of the status quo is that low tax rates on capital gains are needed to avoid taxing “phantom” gains produced by inflation. The argument has a certain superficial logic, but it does not stand up to scrutiny. 

For example, suppose you buy some shares of stock at $100 and sell them for $120 a couple years later. Inflation has meanwhile pushed up the cost of living by 10 percent. That leaves you with an inflation-adjusted pretax gain of just $10. If you pay an ordinary-income tax rate of 40 percent on the $20 nominal gain (a total of $8), your tax rate on the $10 real gain is 80 percent. Cutting the rate on nominal capital gains to 20 percent in this scenario reduces the real rate to 40 percent – a move in the right direction, it would seem.

But there is a big flaw in that argument. Any arbitrary rule, such as a fixed lower tax rate or an exclusion of a portion of capital gains, can only crudely approximate the necessary adjustment for inflation. The 20 percent rate that is right in the example given above becomes too low if inflation slows (as it has in recent years). If inflation instead accelerated, it would become too high. Furthermore, the rate that just levels the playing field for a person in one tax bracket could be too high or too low for those in other brackets.

A more nuanced approach would be to index the basis on which capital gains are calculated to reflect actual inflation between purchase and sale. That would avoid the taxation of phantom capital gains, but not a second, equally serious problem: Other forms of investment income, too, are subject to phantom taxation when there is inflation. For example, the well-known tendency of nominal interest rates to rise when inflation accelerates causes an increase in the real rate of taxation on bonds and other fixed-income assets. 

Suppose, for example, that in a zero-inflation world, borrowers would offer a 5 percent interest rate on top-rated corporate bonds. If the rate of inflation rises to 5 percent, borrowers would be willing to offer a 10 percent nominal rate on the bond, since they know they will be able to pay future interest and principal in less valuable dollars. The 10 percent nominal rate leaves the bondholder’s real return and their real interest cost at 5 percent. So far so good. But suppose now that the bondholder is subject to a 20 percent tax on interest income. In the zero-inflation case, the interest income after tax is 4 percent. In the inflationary case, the holder has to pay tax on the whole 10 percent nominal rate, leaving an 8 percent nominal return after taxes. Subtracting 5 percent inflation, that 8 percent nominal return becomes just 3 percent in real terms. In short, even if borrowers adjust nominal interest rates to fully reflect inflation, inflation increases the effective tax rate on bondholders.

A helpful paper from the Congressional Budget Office explores the problem in detail. The paper confirms that faster inflation raises the effective tax rate on investment income, but it points out that the effect is inherently smaller for capital gains than for dividend or interest income. Attacking the problem of phantom capital gains in isolation by whatever means — a preferential capital-gains rate, an exclusion, or indexation – only widens the gap between the way inflation affects capital gains and the way it affects interest and dividends. Doing so increases the attractiveness of tax avoidance strategies that involve inefficient business practices.

Theoretically, the way to eliminate distortions caused by inflation would be to index the entire tax system. But trying to remove the effect of inflation on capital-gains taxes separately is likely to make things worse, not better. 

The logic of “double taxation”

“Double taxation” of corporate profits is a third common argument in defense of lenient tax treatment of capital gains. The idea is that corporate profits are taxed once at the business level and then again at the individual level when they are paid out as management bonuses, dividends, or capital gains. 

It is true that a preferential rate on capital gains would be one way to attack the distortion — one way, but a bad one. Economists have long argued that corporate taxes should, logically, be understood not as taxes on corporations per se, but rather as taxes on corporate stakeholders. Those include not just the rich whom the administration wants to target, but also workers, customers, and members of the middle class who own shares through pension funds and other retirement vehicles. 

For that reason, I am not enthusiastic about the administration’s proposal to raise the corporate tax rate from 21 to 28 percent, although I do favor the elements that are aimed at discouraging corporate tax avoidance to spread the tax burden more equitably among all corporations.

Cracking the lock-in effect

The strongest point made by critics of the existing capital-gains tax regime concerns the “lock-in” effect. That effect arises because capital-gains taxes do not have be paid on an asset until it is sold, creating an incentive for investors to hold assets longer than they would without the tax. As Martin Sandbu put in recently in the Financial Times, “taxing wealth only during transactions rewards hoarding rather than the deployment or reallocation of capital to whatever capitalists may think is the most productive use.” 

Under existing law, the lock-in effect is exacerbated by the so-called “Angel of Death” loophole, which allows heirs to escape, or at least defer, capital-gains taxes. Suppose, for example, that you buy assets for $10 million in 2020 and die in 2030, when they are worth $20 million. Your children inherit the assets and finally sell them in 2040 for $30 million. Under the current regime, your heirs pay no capital-gains tax until 2040, and then only on the $10 million gain that has occurred since the time of inheritance. 

The current practice of taxing capital gains at a lower rate than other forms of capital income weakens the lock-in effect. Conversely, removing the tax preference would, by itself, strengthen it. That, in turn, would cut into any increase in revenue. In fact, the Tax Policy Center estimates that removing the capital-gains preference for taxpayers earning $1 million or more without making any other changes would actually reduce federal revenues.

Wisely, Biden’s plan includes a measure that would mitigate lock-in by treating bequests of assets as if they were sales. Heirs would have to pay taxes on past capital gains at the time they took ownership of them. The value at that moment would then become the basis on which further capital gains would be assessed it they were held for a period and then sold later. However, it should be noted that certain provisions of the Biden plan would somewhat soften the tax impact, including a $1 million exemption, an exclusion for charitable bequests, and special treatment for family-owned businesses.

As Grace Enda and William G. Gale explain in a study for Brookings, there are other potential reforms, not included in the administration’s current proposals, that could further mitigate the lock-in effect. One would be to tax capital gains annually whether they were sold or not on an accrual or mark-to-market basis. Mark-to-market taxation would be easy to implement for assets like stocks and bonds that were actively traded, but not so easy for hard-to-value assets like real estate or private business interests. For those, an approach called retrospective taxation could be used. Under that system, capital gains would be taxed at the time of sale, but the tax rate would be higher the longer the asset had been held. The rate of increase in the tax rate would depend on market interest rates. If it were done right, the cost of the rising tax rate would exactly balance out the benefit of deferring taxes until sale. 


On the whole, given the administration’s self-imposed constraints on raising taxes on any but the highest incomes, I see the its proposals for taxing capital gains as ordinary income and treating bequests of appreciated assets as sales as well conceived. The revenue effect of those reforms would be further strengthened by the administration’s plan to increase enforcement funding for the IRS. Janet Holtzblatt of the Tax Policy Center thinks the administration is realistic to expect each dollar invested in enforcement to yield $4 or more in new revenue, although she warns it will take time for any new funding to produce its full effects.

There are critics on both the left and right who would prefer a wealth tax rather than higher taxes on capital income. Wealth taxes certainly have a certain theoretical appeal, but the Biden team is probably prudent to avoid them. Valuation and other technical issues have limited their use abroad and possible constitutional problems cast further doubt on their workability in the United States.Those who defend the preferential rate on capital gains are right when they argue that all taxes affect business decisions. But it is a non sequitur to say that because they affect business decisions, capital-gains taxes should be as low as possible. Viewed in the context of the tax system as a whole, the capital gains provisions of the American Families Plan have logic on their side. If fully implemented, they could yield substantial revenues while reducing some of the distortions that result from existing tax law.

Addendum: Not long after this commentary was posted, a trove of data on the super-low taxes paid by America’s super-wealthy provided dramatic new evidence of how easy it is to live off capital gains without paying taxes by using an entirely legal buy-borrow-die strategy. See here and here for details.