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Tags: biden | capital gains tax plan | fixes | nothing | rate | business owners

Biden's Capital Gains Tax Plan Fixes Nothing

Biden's Capital Gains Tax Plan Fixes Nothing
(Joe Sohm/Dreamstime)

Jared Dillian By Friday, 23 October 2020 08:59 AM EDT Current | Bio | Archive

Democratic Presidential challenger Joe Biden’s proposed tax plan includes raising long-term capital gains tax rates and taxes on dividends to 39.6% for those making more than $1 million a year. That would be an increase from the current 23.8%, marking the biggest hike in capital gains taxes in history.

Given all that is going in with elections, the topic is not getting much attention, but it has the potential to cause a great deal of economic distortions.

The capital gains tax rate has historically been lower than taxes on ordinary income, which is the taxes paid on salary or business income. Wealthy people pay a disproportionate amount of these taxes, because they are more likely to hold financial assets such as stocks, bonds and real estate. This is why it is not unusual for the wealthy to pay lower effective tax rates than lower income people. Warren Buffett famously said in 2012 that he paid a lower effective tax rate than his secretary, an anecdote that found its way into one of President Barack Obama’s State of the Union speeches.

But it is not like raising the capital gains tax rate will suddenly fix the inequities in the U.S. tax code. The Tax Foundation estimates that increasing capital gains taxes in the fashion suggested by Biden would result in just $469.4 billion in revenue over 10 years. That may seem like a lot, but most of the forecasted tax revenue will be back-end loaded and is actually paltry when compared with projected total government outlays of $6.6 trillion in fiscal 2020 alone. Capital gains taxes account for about 5.2% of tax revenue on average. It was only during the dot-com bubble did the bulge in capital gains taxes make a material difference in revenue, and also in 1986, when capital gains revenue made up 12.8% of the federal budget.

The most radical part of Biden’s tax plan—discussed here before—is to impose payroll taxes on income above $400,000. For people who draw a salary, this means paying an additional 6.2% in tax on top of a 39.6% marginal rate. For business owners and other self-employed people, both the employer and employee side of the tax must be paid, resulting in an additional 12.4% in tax on top of the 39.6% marginal rate, leading to an actual top marginal rate of 53%.

So even after raising capital gains taxes on the wealthy, we’ll still have a situation where small business owners will likely be paying a higher marginal tax rate than wealthy people with investments -- and possibly a higher effective rate, too. And while a 39.6% rate on capital gains would be close to the highest in history, the difference now is that there would be no exclusions to lower the effective rate.

Such a high rate will likely result in a situation where those sitting on substantial gains will choose to hold those assets far longer than otherwise. A 2010 paper from the Congressional Research Service describes behavioral responses to changes in capital gains tax rates as a “lock-in effect,” imposing “efficiency losses because investors may be encouraged to hold suboptimal portfolios.”  This means that investors will hold onto a stock for tax reasons, rather than selling it and buying a better one, which leads to market inefficiencies. Also, low tax rates on capital gains encourage investment, which is good for the economy over the long term. Alternatively, high rates encourage present consumption, which is only good for the economy in the short term.

Raising the capital gains tax will result in creative attempts to sell assets synthetically for the purpose of avoiding taxes. For example, if a wealthy person holds shares of an exchange-traded fund, he or she can sell short an ETF that is a close proxy, resulting in a nearly hedged position and leaving it to the Internal Revenue Service to determine whether transactions like these constitute a constructive sale that will trigger a gain for tax purposes. I am sure the tax people at reputable brokerages are hard at work devising hedging strategies that fall within the letter of the law, if not the spirit.

If Biden wins, any new tax legislation probably wouldn’t take effect until 2022. Even so, wealthy people might be inclined to harvest any gains they are sitting on before the end of this year, sparking a wave of selling on the chance that Democrats - assuming Democrats retain a majority in the House and gain enough of a majority in the Senate - would impose a capital gains tax hike retroactive to the start of 2021. Taxes were raised retroactively in 1993 under President Bill Clinton.

Here’s another thing to consider: A significant portion—about 17%—of household wealth is held in the form of private businesses, which have a “large stock of unrealized capital gains,” according to the Tax Foundation. The group describes capital gains taxes as an “asymmetric tax on successful business ventures.” That means if you start a business and it fails, you have a limited ability to deduct the losses from your taxes. The gains, though, are fully taxed. This asymmetry provides a powerful disincentive from entrepreneurship.

Of course, not many people are thinking about taxes when they start a business, and the rate of business formation has never been higher, mostly out of necessity due to the pandemic. But at this particular point in history, it would seem unwise to take legislative action that would make starting a business harder. 

Jared Dillian is the editor and publisher of The Daily Dirtnap, investment strategist at Mauldin Economics, and the author of 'Street Freak' and 'All the Evil of This World.' He may have a stake in the areas he writes about.

© Copyright 2023 Bloomberg L.P. All Rights Reserved.

Small-business owners may still pay a higher marginal tax rate than wealthy people with investments -- and possibly a higher effective rate too.
biden, capital gains tax plan, fixes, nothing, rate, business owners
Friday, 23 October 2020 08:59 AM
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