In proposing changes to taxes on capital gains, President Barack Obama raised an important issue, in terms of both economic efficiency and societal fairness.
The issue strikes home in Minnesota, where thousands of long-time shareholders of Medtronic face a huge tax hit following the company’s merger last month with Irish company Covidien.
There are Republicans, like Wisconsin Rep. Paul Ryan, who seem willing to look at the federal tax system in depth. So optimists may hope that productive reforms actually will be made. Realists counter that in the current political climate, especially as the 2016 presidential election already seems underway, continued deadlock is far more likely than compromise.
I think the latter probably are correct, but we at least have an opportunity to discuss the issues.
Capital gains income is generated when someone buys a long-term asset and later sells it at a higher price. This may be a share of corporate stock bought for $40 and sold a few years later for $70, an acre of Martin County farmland purchased for $800 and sold decades later for $8,000 or a rental duplex purchased for $100,000 some 25 years ago and sold now for $300,000.
In the Medtronic case, the gains are dramatic. On a split-adjusted basis, the stock was trading at around 40 cents a share in 1981. This is the “cost basis” for anyone who bought the shares at that time.
On Jan. 26, the day the Covidien merger was final, Medtronic stock closed at $75.59.
The difference for someone who bought the shares in 1981 and held on, multiplied by hundreds or thousands of shares, and including shares bought at different prices through the years, is what they must pay taxes on.
Capital gains differ from “earned income” like wages or salaries in that they come from capital rather than labor. They are also distinct from interest and dividend income, which are periodic returns generated by an investment while ownership of the asset continues. A capital asset may increase in value over time, but taxable income from it only arises when the asset is sold.
For most, but not all, of the past century, since the U.S. federal personal income tax has existed, capital gains have been taxed at a lower rate than wages and salaries. For decades, the rate was simply half of that for ordinary income. Now, for the highest income people, it now is 20 percent on long-term capital gains versus 39.6 percent on other income. Obama proposes increasing the top capital gains rate for high-worth taxpayers to 28 percent.
Rates fluctuate — we had a 28 percent rate on capital gains during most of the Reagan administration. But Obama’s other proposal, to eliminate “step-up basis” on assets held at death is more historic, eliminating a rule that existed since the income tax was first imposed more than a century ago.
A personal example serves to illustrate how it works, why economists think “step-up basis” is terrible, and to disclose my own possible conflicts of interest on the matter.
I purchased farmland 39 years ago at a cost of $50,000. Ignoring some minor adjustments for depreciation taken, that is my “cost basis.” At an auction today it might sell for $800,000 or more. I would owe income tax at the preferred capital gains tax on the difference, my profit, of $750,000.
However, if I die still owning it, the cost basis “steps-up” to the market value of the property at the time of my death. As it passed to my heirs, that current market value would be the figure on which any eventual capital gain to them would be computed. If they sold it immediately, neither my estate nor my heirs would ever pay any income tax on that $750,000.
The perverse incentives here should be obvious. For the best economic use of the land, I probably should just sell it to the cousin who farms it. But if I sell now, I would pay $150,000 in tax at the current rate and $210,000 at the rate Obama has requested. Hang onto it until death and my heirs get it with no tax due at all. This promotes potentially years of inefficiency.
I don’t know of a single economist who thinks this provision is a good one in terms of economic efficiency. And the amount of money involved is huge. At least a third of all the capital gain income is exempt from tax because of this. Obama’s move to eliminate it would be a good thing.
For Medtronic shareholders, many of whom probably intended to bequest their shares, the “step-up basis” doesn’t apply because the merger occurred while they were alive. They would have received shares in the new Medtronic PLC, but they’ll have to pay the tax on the transfer come April of 2016.
I have written columns criticizing it in the past and do so in all my classes or talks where it is relevant. But I’d be very surprised if it is repealed, despite its unfairness in addition to its inefficiency.
The unfairness is not just that I can pass a wad of gained money to my heirs that has never been taxed, while my friends and neighbors who want to leave something to their kids have to pay income tax at “ordinary income” rates on every dime they squirrel away. It’s not just my heirs getting a greater net amount than theirs while we have equally comfortable lifestyles. It is that, knowing my capital income stored in a long-term asset will be tax free, I can spend more of my earned income right now, knowing my heirs will still get a windfall.
Obama is correct that the bulk of this benefit flows to the wealthiest 10 percent of the population and even to the top 1 percent. But those are not all plutocrats like Bill and Melinda Gates, Warren Buffett, Larry Ellison or Shel Adelson. Nearly every farm family in Minnesota benefits from this rule, as do a great many small-business owners. Elaborate farm and small-business estate plans have been built around the rule for decades. So expect a firestorm of opposition if this comes up, even if it would get cheers from economists.
In contrast to near-unanimity on the economic iniquity of “step-up basis”, economists are divided on the issue of a lower tax rate for capital gains.
All taxes generate disincentives. If we tax consumption, people consume less. If we tax income from labor, people work less. Tax income from capital and people accumulate less capital.
Especially since the dawn of the Industrial Revolution, capital has played a vital role in multiplying human productivity.
People produce much more today than one or two or three centuries ago not because they are working harder, but because they have more and better machines and technology to work with. These require capital.
Thus, many economists have built economic models that tell them an economy will be richer if income from capital is taxed at a lower rate than that from labor. A few argue for a tax rate of zero. But others believe that capital income should be taxed at or near that of labor. There is no consensus view.
Inflation is a complicating factor.
Much of the apparent gain in value of any asset held over a long time is simply inflation. To simply have kept up with consumer inflation over 39 years, my $50,000 farm would have to be worth $208,660. Nearly $32,000 of the tax at today’s rates would be on inflation.
All this suggests a compromise. Yes, do away with step-up basis. Then tax only inflation-adjusted capital gains. Set the rates somewhat below those for “ordinary income,” but well above zero and perhaps somewhat above current rates.
If you want to hit the really well-off, but not the family with 160 acres of land near Fairmont or 200 shares of Medtronic, then establish a life-time exempt amount for capital gains that could be free from tax, similar to that under the unified estate and gift tax.
Over the last 30 years, we already have moved from taxing capital gains on owner-occupied homes if not immediately rolled over to a near total exclusion of such income from taxes. Remove the restriction to housing and establish a general exempt amount for gains from any source. Adjust this ceiling for inflation, but bring past gains up to current real values, the way Social Security indexes past earnings.
Yes, this requires more complicated accounting. But tax preparation software, now used widely, especially by people of the income classes most likely to be affected by these changes, can handle this easily. The benefits from a more efficient economy would be magnitudes greater than any added administrative costs.