As the Biden administration approaches its one-hundred days milestone, there is a lot to cheer about. Vaccine uptake has been better than expectation and presidential communication has become more normative relative to the chaos of President Trump. The $1.9 trillion American Rescue Plan was passed and the $1.5 - $2.0 trillion American Jobs Plan will most likely pass through the budget reconciliation process. A part of the spending within this latest plan will be offset with tax rises on high income taxpayers and on corporations. The rationale of increasing taxes on the most affluent and raising business taxes certainly seems equitable and fair.
But I believe parts of this new tax strategy are not the smartest way to go. There are many pitfalls in raising the capital gains tax rate for those with AGI (adjusted gross income) of over $408,000 from 28.8% (25.0% capital gains rate plus 3.8% Medicare surcharge) to as high as 43.4% (39.6% capital gains rate plus 3.8% Medicare surcharge).
Economists already recognize that there is a strong “lock-in effect” on the portfolios of the top quintile of US households, which represent about 90% of total capital gains income (the top 1% represent 69% of total capital gains income). The “lock-in effect” is because our tax system discourages otherwise financially rational selling of appreciated assets, principally financial assets (i.e., stocks and bonds). This is because the tax, in effect, offsets any potential future losses.
Here is a simple example using Vanguard’s Total Stock Market Index Fund ETF (Symbol “VTI”). Suppose you purchased a share on March 31, 2011 and were contemplating selling it 10-years hence, on March 31, 2021. Here’s a chart of tax outcomes based on current tax policy and the proposed policy:
Under the proposed increase, VTI would have to decline more than 29% for him to be better off selling it, on an after tax basis. That is quite a market drop!
This is the "lock-in effect" in action. An investor might want to sell a stock that he thinks is over priced, but on an after tax basis, it may not make any sense to do so. Compounding this tenancy are two other factors. First, if this investor holds onto this stock until he dies, and bequeaths it to his heir, there is no capital gains tax ever paid. Second, the heir does not inherit the share's original basis, rather his new adjusted basis is "stepped up" to the current price of VTI. The result of these two policies, if the asset is not sold in the investor's lifetime, is complete and total capital gains tax avoidance for both investor and heir. And as of my writing, a couple's estate must be over $11 million for there to be any estate tax paid.
One can easily see that these tax policies muddy up an investor's rational economic decisions about buying and selling. In the market in aggregate, they unintentionally discourage efficient redeployment of capital and rational rebalancing of portfolios. The effect is to prop up inflated values and discourage capital movement to more productive assets.
Unfortunately at certain times investors must sell. These are times of extreme fear, or out of a need for liquidity. I am describing a panic, a market meltdown, a crash. I believe this tax policy will magnify market sell offs. The analogy is with a landslide. If conditions somehow restrain the eventual collapse, when the landslide eventually comes, it will be more catastrophic. Our bubbles will be bigger!
There are better ways for the Biden administration to raise these funds and mitigate the "lock-in effect." They estimate that this capital gains tax change would generate, in the best case, approximately $350 billion over the decade. There are other ways to accomplish this. If the "stepped up" basis were eliminated, it would raise $105 billion over the decade, and lowering the estate tax threshold to $3.5 million ($7.0 million for couples), where in was in 2009, would raise $281 billion. These in total, would be $386 billion. The added benefit is that "lock-in effect" would diminish.
There are many other sensible ways to raise revenues. If income tax rates on the top two income tiers were raised one-percent (35% to 36%, 37% - 38%), which would only effect households with AGI greater than $408,000, $125 billion would flow to the treasury over the decade.
There are other wonderful ideas out there, like retrospective taxation of capital gains income, which would raise the tax rate over increased holding periods. But in this political climate, it is best to keep things simple. Ultimately, however, America needs a "clean sheet of paper" approach to taxation, perhaps including VAT and carbon pricing, among other progressive solutions.
A well regulated and competitive capitalist system has proven to be a superior mechanism for the productive deployment of resources. Our government should avoid tax regimes that inhibit its process.
