How to tax the rich? Let us count the ways.
New taxes on capital income? Higher income tax rates? A wealth tax? Some mash-up of all these ideas? All aim to raise taxes on the very rich, driven by the twin desires to boost revenue and address growing wealth inequality. But while these taxes may seem similar, they operate quite differently and may have diverse economic effects.
Here are some of the options on the table:
A tax on accrued capital gains. The basic idea: Much of the increase in wealth of the super-rich never is taxed because the owners of these appreciated assets never sell them. To address this, any increase in the value of assets would be subject to an annual capital gains tax, whether they are sold or not.
Senate Finance Committee Chair Ron Wyden proposed a version that would apply to the very wealthy. My TPC colleague Eric Toder and his co-author Alan Viard (then of the American Enterprise Institute) proposed a detailed and more far-reaching version that would partially replace the corporate income tax.
Taxing capital gains at death. Under current law, increases in the value of unsold assets not only go untaxed during the owner’s lifetime but can pass tax-free to a decedent’s heirs. That’s because any increase in asset values is exempt from tax when the property passes to the next generation. A simple example: Jane buys stock for $10. It is worth $100 when she dies. When her heir John inherits the stock, he’s only taxed when he sells it and only on any increase in value in excess of the $100. That $90 in capital gain during Jane’s life never is taxed.
There are two ways to address this. One is to repeal the current rule, called step-up in basis, so when John eventually sells, he would pay tax on the difference between the sales price and that $10 Jane originally paid. A more effective way would tax those unrealized gains at death, just as if the stock had been sold.
Raise top income tax rates. This wouldn’t entirely address the capital income problem since investment profits still would not be taxed until assets are sold, but it would raise effective tax rates on the highest-income households. President Biden repeatedly proposed increasing both the capital gains tax rate and the individual income tax rate but the ideas have gone nowhere in the Senate. A variation on the theme is a millionaire surtax that Democrats floated late last year but seems to have faded from view.
Limit tax preferences. There is little interest in either party for curbing targeted tax breaks. Indeed, Congress seems intent on expanding them, even for the wealthy. Just this week, the House approved more generous tax breaks for the retirement accounts of high-income savers.
Biden’s budget plan. The president’s new budget proposed a belt-and-suspenders initiative that includes three of these ideas. For very high-income households, he would raise individual tax rates, tax accrued capital gains annually, and impose a tax at death on any gains that are untaxed during the investor’s lifetime.
A wealth tax. Senators Bernie Sanders (I-VT) and Elizbeth Warren (D-MA) both have proposed versions of a straight-up tax on the wealth of very rich people. There are some differences between their plans but, in general, both tax nearly all the assets of the mega-rich, rather than their income from wealth.
While all these ideas may seem alike, there are some important differences.
Economically, taxing accrued gains each year and taxing them one time at death are similar. That is especially true when interest rates are low and the benefit of deferring taxes is modest.
But there is a key budget accounting difference. A president looking to claim revenue inside Congress’s traditional 10-year budget window much prefers annual taxation of unrealized gains. It may be a long time before Biden could collect those taxes at death.
And there are important administrative differences: It is much easier to tax unrealized gains one time than to do it year-after-year.
Brokers routinely calculate the change in value of stocks and bonds but it is much more complicated to value a privately held business or art collection. And doing it annually can be costly and contentious. That is why Wyden would limit the annual tax to publicly-traded securities.
There also are important economic differences between taxing wealth and taxing capital gains. With a wealth tax, normal returns (equal to, say, the prevailing interest rate) are taxed at very high rates. For example, if interest rates are 2 percent, a 2 percent tax on wealth is equivalent to a 100 percent tax on that interest income. But, perversely, excess returns such as monopoly profits would be taxed at a relatively low rate.
By contrast, a capital gains levy—whether imposed annually or at death– taxes all returns at the same rate, an idea most economists prefer. Biden, for example, would tax income from wealth at 20 percent.
“Tax the rich” fits nicely on a bumper sticker. But doing it well is much more complicated.