Capital gains and why they matter – a tax expert explains
The Trump administration wants to change the way
capital gains are taxed to factor in inflation.
To many, this may sound like a technical change of little
consequence. To others, such as the Tax Policy Center’s
Len Burman, it’s a “windfall” for the very rich who are still
adding up their gains from the 2017 tax cut.
As a tax policy expert, I agree that the proposed change
could make sense as part of broader tax reform that
simplifies the tax code and benefits all taxpayers. But on
its own, this policy would only make the tax code more
regressive and less efficient.
To understand why, let’s review some of the basics.
What are capital gains?
In economics, a person’s income in a given year should
include all inflows of new financial resources that can be
used for either consumption or gains in net worth.
A familiar example is your paycheck. But financial
resources don’t always come in the form of cash. Income
can also come from the appreciation of non-cash assets
such as stocks and real estate, also known as capital
Most Americans get the vast majority of their income
from wages and salaries. Among the top 1 percent,
however, capital gains make up 36 percent of total
How are capital gains taxed?
The IRS needs to know how much money a taxpayer
makes in a year in order to tax her properly under the
16th amendment, which was ratified in 1913 and gave
the U.S. the power to tax incomes “from whatever
Unlike wages, capital gains are harder to calculate – and
harder to tax.
Ideally, we’d need to know how much value her
investments gained. The value of some assets like stocks
and mutual funds is straightforward because they are
bought and sold frequently. But that’s not the case for
assets like real estate or fine art that don’t change hands
often. So it’s harder to know their value.
The solution has been to only tax capital gains when
they are realized – that is, when the asset is sold. The
gain is the difference between the sale price and the
original purchase price, ignoring the impact of inflation,
which erodes its real value.
As long as you hold onto an asset, you don’t have to
pay capital gains taxes on it. In fact, if you die, your
heirs don’t have to pay either and the gain will never be
How much is the tax?
In the early years of the income tax, capital gains were
taxed at the same rates as ordinary income, or as high
as 77 percent in 1918 as the rate soared to cover the
cost of World War I.
After the war, conservatives began to make the case
for tax cuts. So Congress lowered the top individual tax
rate to 58 percent in 1922 and split off capital gains
from regular income, slashing the rate to 12.5 percent.
Since then, capital gains tax rates have been changed
frequently, climbing as high as 40 percent but typically
remaining much lower than the top rate on ordinary
What are the effects of capital gain taxes?
Supporters of lower rates for capital gains argue that it
stimulates economic growth, mitigates double taxation
of corporate income and alleviates the “lock-in” effect
that discourages investors from selling assets to avoid
taxes. They also point out that inflation erodes the real
value of capital gains. Lower rates help offset this
penalty – as would the administration’s proposal.
Other research, however, suggests that capital gains
tax breaks have no significant effect on economic
growth and create other distortions that hurt economic
efficiency. For example, hedge fund managers exploit
the “carried interest” loophole to categorize their
income as capital gains instead of wages.
Whether capital gains tax policy actually increases
economic efficiency, we do know it makes the tax
system more regressive. Since capital gains are highly
concentrated among high-income taxpayers, tax breaks
for capital gains primarily benefit the wealthy. The Tax
Policy Center estimates that in 2016 taxpayers with
incomes over US$1 million received over three quarters
of the benefits of lower rates while taxpayers earning
less than $75,000 received just 2 percent.
As for the administration’s proposal, given the vast
complexity of our tax system, it would be a very minor
fix that benefits a small number of wealthy people.
Or in the words of Burman, also a professor of public
administration and international affairs at Syracuse
University, the proposal would result in tax savings of
“up to $20 billion a year for the richest Americans and
open the door to a raft of new, inefficient tax shelters.”
Lecturer in Public Policy, University of Michigan
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