A tax system for all Americans
By Ray D. Madoff
Dec 12, 2019
Who bears the brunt of taxes in America?
A cursory glance at the tax code might suggest that it is predominantly the wealthy. After all, taxes due on wages rise with income. However, closer inspection of the tax code reveals that it is actually workers — and not the wealthiest Americans — who bear that burden.
The root of this misconception is the failure to take into account that the wealthiest Americans generally acquire their income not from wages, but from investments. Rather than working themselves, wealthy taxpayers put their money to work for them by investing in stocks, art, real estate, or other property, and then earn “capital gains” when these investments rise in value. While some argue that such investments are good for our economy, these endeavors are no better than the good that comes from labor. Yet, taxes imposed on investments are significantly less burdensome than taxes imposed on wages.
There are three ways that our tax system gives preferential treatment to capital gains over wages. First, the tax rates on wages are significantly higher than those on capital gains. Wages are subject to income tax rates up to 37 percent while capital gains are taxed at a maximum rate of 20 percent. This preferential rate on capital gains cost the federal government $130 billion in 2017 — approaching double the $72 billion spent on all veteran’s benefits and services in the same year. In addition to losing substantial revenue, this special treatment adds significant complexity to the tax code as Congress has needed to adopt additional rules to thwart taxpayers from finding crafty ways to make their income look like capital gains. Of course, Congress often has a hard time keeping up with clever tax planners, and we ultimately end up with schemes like the infamous carried interest loophole — which allows hedge fund managers to pay tax at a 20-percent rate instead of 37 percent.
The second way that investments are taxed more favorably than wages is due to timing. Workers pay taxes on their wages as their income is earned, and there is very little opportunity to shift income across years to lower their tax bill. However, investors have significant latitude when it comes to timing their capital gains. The reason for this flexibility is “the realization requirement,” which provides that no taxes are levied on capital gains until the investment is sold or exchanged — allowing investors to pick the year in which their taxes are due. The realization requirement has been described as “the primary source of distributional inequity and complexity in the tax system.”
The third, and most significant, advantage of all for investors is that taxes on capital gains can be avoided altogether if the investment is held until death. Under American tax law, investors are not subject to tax on their capital gains if they don’t sell the property during life. This is unlike Canadian law, which taxes previously untaxed capital gains on the owner’s final income tax return. The most troubling aspect of the American system is that investors’ heirs will also avoid capital gains on the assets they inherit because, under the tax code, the heirs are treated as if they had purchased the inherited property for its fair market value at the time of the investor’s death. This means that the heirs can sell the property and avoid taxes on all gains accrued during the investor’s life. This is known as step-up in basis.
Step-up in basis is deeply troubling for a number of reasons. First, it has a distortionary effect on markets, called the “lock-in effect,” because investors are encouraged to hold on to property until death, even if they think it is not the best investment from a financial point of view. This is harmful not only to the investor, but to the market as a whole that is deprived of valuable information about how this investor assesses the value of the investment. Step-up in basis is also troubling because it disproportionately benefits the wealthy who are most likely to hold investment assets outside of retirement accounts, which do not benefit from step-up in basis. Finally, this tax benefit is expensive for the government. Step-up in basis at death is expected to cost the federal government $30 billion in 2018 — roughly the same sized tax break as the deduction for mortgage interest.
Market economies will always feature some inequality, as those who are more talented, work harder, or are just plain luckier are going to generate more income. This type of inequality on its own is not a problem. However, it is a problem when the tax system exacerbates this inequality by giving extra tax benefits to those who are already better off.
To make our tax system fairer for all Americans, Congress should eliminate the preference for capital gains over wages. To achieve this, Congress should first eliminate step-up in basis and either provide that capital gains are taxed at death, as they are in Canada, or provide that heirs eventually pay tax on capital gains whenever the underlying investment is sold. Second, Congress should eliminate the preferential tax rate afforded to capital gains. Finally, Congress should consider adopting a system that taxes capital gains as they materialize, not only when the investment is sold.
Combined, these reforms would raise billions in tax revenue annually, which could then be directed toward lowering rates on wage earners. A tax system with these reforms would finally recognize that workers, not just investors, are key to a healthy economy.
Ray Madoff is a professor at Boston College Law School and the co-founder and director of the Boston College Law School Forum on Philanthropy and the Public Good. She writes frequently on matters of tax policy.