Capital Gains Hike Faces Budget Issue Without Other Changes

The Biden administration will likely need to pair an expected capital gains rate hike on the wealthy with a major tax change related to life’s other certainty: death.

President Joe Biden plans to propose nearly doubling the capital gains rate for high earners to 39.6%, plus an additional 3.8% Affordable Care Act tax on investment income, people familiar with the plan told Bloomberg. The capital gains rate hike is one of several expected tax proposals Biden will detail next week to pay for roughly $1 trillion in increased spending on childcare, paid leave, and other social programs.

The more money Biden’s plan can raise from taxes, the more permanent spending Democrats could pass using the Senate’s budget reconciliation rules. But economists say the capital gains rate hike on its own is so large that it would actually be projected to cost the government billions, potentially complicating efforts to get the plan through the Senate.

The government “would almost certainly lose revenue” unless the rate hike is accompanied by major changes to the tax treatment of assets passed on after death, said Kyle Pomerleau, a resident fellow specializing in federal tax policy at the American Enterprise Institute.

The current policy, called “a step-up in basis,” doesn’t tax unrealized gains in the value of the asset during the life of the original owner. Instead the government treats the inheritance as an acquisition for those who receive it, as if they had just bought the stock, house, business, or other asset at the value it had when it was passed onto them. Inheritors only have to pay taxes when or if they sell it, or if the value reaches the estate tax threshold, which is $11.7 million in 2021.

$146 Billion Difference

Progressives see the current treatment as a major loophole.

“It’s by far the biggest way to avoid capital gains taxes, to avoid realizing capital gains,” said Seth Hanlon, a senior fellow at the Center for American Progress and a former special assistant for tax policy to former President Barack Obama. “Biden has been talking about eliminating step-up, personally, for a long time.”

White House Press Secretary Jen Psaki, when asked about capital gains changes during a Thursday briefing, said the administration is still finalizing the “pay-fors” of the proposal. But Biden’s campaign called for changing the treatment of capital gains at death, likely with a $1 million cap on what can be passed along without paying the proposed top capital gains rate, as well as a smaller cap—likely $400,000—to avoid paying capital gains at all.

Treating death as a taxable event would mean a higher capital gains rate could raise far more money, because it would be much harder to avoid paying. Pairing the capital gains rate hike with changes to the step-up in basis would mean a nearly $150 billion swing in the overall cost of Biden’s economic plan, according to research released Friday by the Penn Wharton Budget Model. That figure could change as more details of what property exceptions Biden’s plan might include—an Obama administration proposal to tax gains at death included an exemption for primary residences—and more study of the issue takes place.

Raising the top rate to 39.6% without treating death as a ‘realization’ of the gains on those assets would cause federal revenue to decrease by $33 billion over fiscal 2022-2031, according to the Penn Wharton projection. But if Congress were to also end the current tax treatment of assets passed on after death in line with Biden’s campaign platform, raising the top rate would instead raise $113 billion over the same time-frame.

Hill Outlook

That extra revenue would be key to actually advancing Biden’s social spending plan.

Democrats will likely use budget reconciliation, a procedural maneuver that would avoid a filibuster in the evenly-split Senate. Under reconciliation, policies can’t add to the deficit past 10 years, so they have to be paid for in order to be made permanent beyond that decade-long window.

While the extra projected revenue would help, the politics of tweaking the tax treatment around death are be tricky. It will essentially be an escalation of the long-standing fight over the estate tax, which opponents often refer to as the ‘death tax.’

“Things that look like the estate tax are unpopular, and things that look like increasing taxes on the rich are popular,” Pomerleau said.

Threading the needle between what will be politically palatable and what would raise enough money for Biden’s spending plans would also be delicate. It is unclear whether exemptions for specific types of property, like houses, could be included.

Marc Goldwein, senior policy director for the Committee for a Responsible Federal Budget, said he “wouldn’t be surprised if we end up raising the capital gains rate to something more like 28%,” because of the political complications of changing the way capital gains taxes apply to death.