openpolitics.com

Lawmakers and 2020 candidates offer a range of options focused on capturing some of the trillions of dollars in assets belonging to the nation’s richest

The problem, Democrats say, is that capital gains are taxed only when gains are realized through a sale and become income. An investor who buys $10 million in stock that pays no dividend and watches it grow to $50 million doesn’t pay income tax on that appreciation unless the stock is sold.

If that investor dies before selling, the unrealized gains get wiped out, for income-tax purposes. The heirs treat the assets’ cost basis as $50 million, not $10 million; they face no income tax on the $40 million of capital gains if they sell, although an estate tax may be due. This long-standing elimination of unrealized gains at death, for tax purposes, is called “stepped-up basis.”

It means the optimal tax strategy for the very rich, fine-tuned and promoted by the wealth-planning industry, is straightforward: Hold assets until death, borrow against them for living expenses and barely pay income taxes.

Democrats are attacking the foundations of that strategy. They talked for years about raising taxes on high-income investors, citing Warren Buffett ’s claim of paying a lower tax rate than his secretary. They’ve succeeded in raising the top capital gains rate from 15% under President George W. Bush to 20%, plus the 3.8% tax on investment income added to fund the Affordable Care Act. The top ordinary-income rate is 37%.

Just raising capital-gains tax rates further wouldn’t require the likes of Mr. Buffett to report more of their growing wealth on their returns, make them more willing to sell assets or raise much revenue. In fact, if the capital-gains rate went above 28.5% without other changes, investors would delay so many sales that federal revenue would drop, according to the Tax Policy Center, a research group.

That would be a rare instance of the U.S. being on the wrong side of the Laffer Curve, named for economist Arthur Laffer, who projected that government revenue drops if tax rates get high enough.

Republicans see the same money accumulating and want to deploy it by not taxing it. Their goal, rather than generating money for expanded government programs, is to incentivize the private holders of capital to realize the gains and spur economic growth. The 2017 tax law created opportunity zones, which offer deferral and rate discounts for reinvesting capital gains in low-income areas. GOP lawmakers are pushing the Trump administration to consider the idea of indexing capital gains to inflation, reducing taxes on sales of long-held appreciated assets.

Still, some conservatives are moving closer to Democratic positions. In June, the Peterson Foundation, which favors budget-deficit reduction, invited plans from others, and three conservative groups proposed limiting or repealing stepped-up basis.

The Manhattan Institute’s Brian Riedl said it was the sort of concession conservatives would be willing to make “in exchange for tax reform or a grand deal” to curb entitlement spending.

In campaigns, Congress and academia, Democrats are shaping tax plans for 2021, when they hope to have narrow majorities. There are three main options.

The Biden Plan

President Obama left office with a list of ideas for taxing the rich that might have raised nearly $1 trillion over a decade. The most important was taxing capital gains at death.

The idea was too radical for a serious look from Congress at the time. Now, to a Democratic base that has moved left, it looks almost moderate.

Rethinking Capital Gains Taxation

Democrats are looking at major changes to the way capital gains taxation works. The effects of their tax proposals would depend on each taxpayer’s circumstances and on market performance.

CURRENT LAW

BIDEN PLAN

WYDEN PLAN

WARREN PLAN

Net worth above $50 million subject to a 2% annual tax, plus a 1% tax on net worth above $1 billion.

Assets can appreciate without capital gains taxes and heirs pay taxes only on gains in value after the original owner’s death.

Death would be considered a realization event, triggering capital gains taxes on appreciated assets, paid at ordinary income tax rates.

Each year, investors would pay income taxes on the gain in their assets. This is called a mark-to-market system.

Example one: Asset value begins at $40 million, 5% growth until person dies in year 25

Taxes taken out when transferred to heirs

$150 million

Current law

100

50

0

Year 1

25

Total taxes taken under law/plans:

$0

$35.6 million

$21.4 million

$11.9 million

Example two: Asset value begins at $200 million, 7% growth until year 12, person dies in year 25

$450 million

Current law

400

350

300

Taxes taken out when transferred to heirs

250

200

Year 1

25

Total taxes taken under law/plans:

$0

$88.4 million

$58.3 million

$121.2 million

Notes: Assumptions include one asset with annual taxes coming out of that asset’s value. Assumptions also include 40% tax rate for Wyden plan, though he hasn’t detailed a specific rate.  All totals in nominal dollars. Estimates don’t include estate taxes.

Sources: Campaign plans; WSJ analysis; Tax Foundation review

Former Vice President Joe Biden, the candidate most prominently picking up where Mr. Obama left off, has proposed repealing stepped-up basis. Taxing unrealized gains at death could let Congress raise the capital gains rate to 50% before revenue from it would start to drop, according to the Tax Policy Center, because investors would no longer delay sales in hopes of a zero tax bill when they die.

And indeed, Mr. Biden has proposed doubling the income-tax rate to 40% on capital gains for taxpayers with incomes of $1 million or more.

But for Democrats, repealing stepped-up basis has drawbacks. Much of the money wouldn’t come in for years, until people died. The Treasury Department estimated a plan Mr. Obama put out in 2016 would generate $235 billion over a decade, less than 10% of what advisers to Sen. Warren’s campaign say her tax plan would raise.

That lag raises another risk. Wealthy taxpayers would have incentives to get Congress to reverse the tax before their heirs face it.

Mr. Obama’s administration never seriously explored a wealth tax or a tax on accrued but unrealized gains, said  Lily Batchelder, who helped devise his policies.

“If someone’s goal is to raise trillions of dollars from the very wealthy, then it becomes necessary to think about these more ambitious proposals,” she said.

The Wyden Plan

Instead of attacking favorable treatment of inherited assets, Mr. Wyden goes after the other main principle of capital-gains taxation—that gains must be realized before taxes are imposed.

The Oregon senator is designing a “mark-to-market” system. Annual increases in the value of people’s assets would be taxed as income, even if the assets aren’t sold. Someone who owned stock that was worth $400 million on Jan. 1 but $500 million on Dec. 31 would add $100 million to income on his or her tax return.

The tax would diminish the case for a preferential capital-gains rate, since people couldn’t get any benefit from deferring asset sales. Mr. Wyden would raise the rate to ordinary-income levels. Presidential candidate Julián Castro also just endorsed a mark-to-market system.

For the government, money would start flowing in immediately. The tax would hit every year, not just when an asset-holder died. Mr. Wyden would apply this regime to just the top 0.3% of taxpayers, said spokeswoman Ashley Schapitl. Mr. Castro’s tax would apply to the top 0.1%.

There are serious challenges. Revenue could be volatile as markets rise and fall. Also, the IRS would determine asset increases annually, requiring baseline values and ways to measure change. That’s easy for stocks and bonds but far more complicated for private businesses or artwork.

The rules would have to address how to treat assets that lose instead of gain value in a year, and how taxpayers would raise cash to pay taxes on assets they didn’t sell. Under Mr. Castro’s proposal, losses could be used to offset other taxes or carried forward to future years.

Mr. Wyden would include exemptions for primary residences and 401(k) plans. For assets that aren’t publicly traded, Mr. Castro would impose taxes only upon a sale, plus a charge applied to limit the benefits of tax deferral.

“We’re obviously going to spend a lot of time working this through because when you’re talking about an issue this important, this substantial, it’s important to get it right,” Mr. Wyden said.

The Warren Plan

The most ambitious plan comes from Sen. Warren of Massachusetts, whose annual wealth tax would fund spending proposals such as universal child care and student-loan forgiveness.

The ultra-rich would pay whether they make money or not, whether they sell assets or not and whether their assets are growing or shrinking.

Ms. Warren, who draws cheers at campaign events when she mentions the tax, would impose a 2% tax each year on individuals’ assets above $50 million and a further 1% on assets above $1 billion. Fellow candidate Beto O’Rourke has also backed a wealth tax, and it is one of Vermont Sen. Bernie Sanders ’ options for financing Medicare-for-All.

Ms. Warren’s plan appeals to some Democrats because it would raise a lot of money from a tiny number of people. According to economists working with her campaign, it would generate $2.75 trillion over a decade from 75,000 households. That would be roughly a 6% boost in federal revenue from under 0.1% of households.

For Democrats, the Warren plan has advantages: Money would come only from the very wealthiest. The IRS could focus enforcement on very few people. Revenue would come quickly.

“Look at Mark Zuckerberg, ” said Gabriel Zucman, an economist at the University of California, Berkeley, who advised Ms. Warren, speaking of the Facebook Inc. founder. “Are you going to wait 50 years before you start taxing him through the estate tax?”

In the real world, a wealth tax would emerge from Congress riddled with gaps that the tax-planning industry would exploit, said Jason Oh, a law professor at the University of California, Los Angeles. For example, if private foundations were exempted, the wealthy might shift assets into them.

“We’ve never seen in the history of taxation a pristine tax of any form,” Mr. Oh said. “People who want to pursue a wealth tax for the revenue may be a little disappointed when we see the estimates roll in.”

European countries tried—and largely abandoned—wealth taxes. They struggled because rich people could switch countries and because some assets were exempt. Mr. Zucman said Ms. Warren’s tax would escape the latter problem by hitting every kind of asset, from artwork to stock to privately held businesses to real estate.

While he and fellow economist Emmanuel Saez assume 15% of the tax owed would be avoided, former Treasury Secretary Larry Summers and University of Pennsylvania law professor Natasha Sarin wrote a paper estimating the plan would raise less than half what Mr. Zucman projects, based on how much wealth escapes the estate tax.

A paper by economists Matthew Smith of the Treasury Department, Eric Zwick of the University of Chicago and Owen Zidar of Princeton University contends top-end wealth is overstated. Acccording to their preliminary estimate, the top 0.1% have 15% of national wealth, instead of the 20% estimated by Mr. Zucman. Their findings imply that Ms. Warren’s tax might raise about half of what’s promised.

For an investment yielding a steady 1.5% return, a 2% wealth levy would be equivalent to an income-tax rate above 100% and cause the asset to shrink. That leads to the criticism that wealth taxes could push people to seek higher returns, possibly discouraging productive investment and adding risk to the financial system.

“You hear 1%, 2%, doesn’t sound that much. Paying 1%, 2% on an asset you have every single year, that can add up,” said Ben Ritz of the Progressive Policy Institute, a centrist Democratic-affiliated think tank. “You’re basically having the asset shed money over time.”

To audit 30% of wealthy taxpayers, as Mr. Zucman recommends, would involve tens of thousands of complex investigations, a challenge even if the IRS were beefed up as Ms. Warren proposes. The agency already struggles with similar calculations for estate taxes, engaging in long battles over valuing such things as fractional shares of family businesses. Under the wealth tax, those once-per-lifetime audits would become annual affairs.

The wealth tax also has an extra asterisk: it would be challenged as unconstitutional.

The Constitution says any direct tax must be structured so each state contributes a share of it equal to the state’s share of the population. A state such as Connecticut has far more multimillionaires per capita than many others, so its share of the wealth tax would far exceed its share of the U.S. population. How Ms. Warren’s wealth tax might be categorized or affected is an unsettled area of law relying on century-old Supreme Court precedents.

Still, the wealth tax polls well, and Democratic candidates are eager to draw a contrast with President Trump, a tax-cutting billionaire.

Republicans will push back. Rep. Tom Reed (R., N.Y.) says tax increases aimed at the top would reach the middle class. “It easily goes down the slippery slope,” he said. “If it’s the 1%, it’s the top 20%.” he said.