The United States budget deficit has tripled to a record $3.1 trillion as the nation continues to grapple with the economic fallout of the COVID-19 pandemic. As a share of gross domestic product, the federal debt is now at levels unseen since World War II and is projected to substantially increase by 2050, as demonstrated in Exhibit 1.
Exhibit 1: Federal Debt Is on an Unsustainable Path
Given the extent of the coronavirus-related fiscal stimulus, there is growing pressure to raise revenue through tax increases. President Joe Biden proposed sweeping tax hikes while on the campaign trail, including a near doubling of the capital gains rate. If these increases were to become policy, they would be some of the largest increases since 1968.
Tax increases, while justified by the new administration for raising revenue, have also been advocated as a way to even out the balance of wealth. On March 1, 2021, Sen. Elizabeth Warren (D-MA), Rep. Pramila Jayapal (D-WA) and Rep. Brendan Boyle (D-PA) unveiled their Ultra-Millionaire Tax Act, which would impose an annual wealth tax on households and trusts that have a net worth in excess of $50 million. The proposed legislation is designed to narrow the wealth gap.
The legislation would impose a 2% annual tax on the net worth of households and trusts in excess of $50 million. It would also impose an additional 1% surtax (3% tax overall) on the net worth of households and trusts in excess of $1 billion.
While tax increases may appear to be a solution for addressing the federal debt and narrowing the wealth gap, wealth taxes and higher capital gains tax rates affect capital formation and growth in a variety of ways, some of which are unexpected and seemingly contradictory. In this piece, we explore the potential consequences of raising the capital gains rate, as well as those of adding a wealth tax. We also discuss what taxpayers can do to mitigate any negative impact the increased taxes may have on their investment portfolios.
Tax Increases and Economic Growth
What is a Capital Gain?
A capital gain is realized when a capital asset, such as a business, real property or security, is sold at a price higher than its purchase price. The profit made on the sale of this asset is called the capital gain and is included in an individual’s taxable income.
Capital gains income from assets held for less than one year is included in ordinary income as short-term and is taxed at ordinary rates. Income from capital gains qualifies for “preferential treatment” if the asset is held for longer than one year. Biden’s proposed policy changes may significantly impact the treatment of long-term capital gains. The Penn Wharton Budget Model, a nonpartisan, research-based initiative that provides economic analysis of the fiscal impact of public policy, estimates that Biden’s proposals (Exhibit 2) would raise $3.37 trillion in revenue over 10 years. The model further shows that with these tax changes, public debt would decline by 6.1%.
Exhibit 2: Biden’s Tax Rate Proposals
What is a Wealth Tax?
A wealth tax is a tax imposed on the wealth possessed by individuals in a country. The wealth tax is collected annually on net household wealth and higher rates typically apply as the amount of wealth increases. Net wealth includes the sum of all financial assets (cash, securities, corporate equity) and nonfinancial assets (real estate, vehicles, artwork) minus debt. Some consider property taxes to be a form of wealth tax, as the government taxes the same asset year after year.
Effect of Higher Capital Gains and a Wealth Tax on GDP
So, will higher capital gains taxes and a wealth tax boost the economy? Despite legislators’ intent, in the past neither higher capital gains taxes nor a wealth tax have consistently resulted in GDP growth.
According to the Penn Wharton model, the proposed higher capital gains taxes would lead to a decline in GDP during the short-term through 2030 and eventually an increase of 0.8% in 2050. Exhibit 3 charts a 60-year period showing the lack of any significant correlation between higher capital gains tax rates and a meaningful change in economic growth. The correlation of 0.12 confirms there is a relationship between capital gains taxes and GDP, but not a material one.
Exhibit 3: Top Capital Gains Tax Rates and Economic Growth
Because wealth taxes suppress savings and investment, they also undermine economic growth (see Exhibit 4). The Cato Institute, a public policy research organization, estimates that such a tax would reduce the U.S. capital stock in the long run by 13%, which in turn would reduce GDP by 4.9% and further reduce wages by 4.2%. Research by Dr. Eric Pichet, professor of economics at the Bordeaux Business School, indicates that between the years 1988 and 2006, the French wealth tax reduced GDP growth by 2%, or €3.5 billion.
Exhibit 4: Wealth Tax and Economic Growth
Effect of Higher Capital Gains Tax and a Wealth Tax on Revenue Collection
Neither increased capital gains taxes nor a wealth tax have resulted in greater taxes being collected.
While in theory increasing the capital gains tax rate from 23.7% to 43.4% should raise revenues, studies show that tax collections and realized capital gains are lower when long-term capital gains rates are higher. See Exhibit 5.
Exhibit 5: Federal Capital Gains Tax Collections (1954-2009)
The higher cost of capital due to increases in rates can act as a disincentive by deterring individuals from investing in the capital markets and selling existing investments (including businesses), therefore decreasing velocity (the rate at which money changes hands within an economy). The consequence of a capital gains tax increase is an increase in the cost of capital and the marginal tax rate on savings and investment. This might not be the best trade-off for policymakers.
From an economic viewpoint, savings and investment (including early-stage investment in innovative companies) increase the amount of capital in the economy and hence the amount of goods and services available. However, an increase in the capital gains rate often triggers the “lock-in” effect, which in turn does little to improve the long-term level of output and long-term economic growth.
The “lock-in” effect can lead to market inefficiency, where taxpayers fail to rebalance portfolios in order to avoid realization of gain. For example, historically taxpayers show proclivity for employing strategies to defer capital gains taxes to a future tax year as a consequence of dealing with tax increases.
Similarly, wealth taxes have not historically resulted in greater taxes being collected. In 1990, 12 countries had a wealth tax, which all but four (Norway, Spain, Belgium and Switzerland) have since abolished. (See Exhibit 6.) Pichet’s study indicates that France’s wealth tax resulted in an annual revenue shortfall of €7 billion, or about twice what it yielded. So, while in theory increasing the rate at which assets are taxed by 2-3% should raise revenue and balance the wealth among individuals, studies show that net tax collections were lower and GDP grew at a slower rate when there was a wealth tax.
Exhibit 6: Wealth Taxes in Europe
As with the increases in the capital gains tax rate, the implementation of a wealth tax has resulted in seemingly unexpected consequences. Failure in France was blamed on problems with administration, enforcement and capital flight, as well as the disappointing revenue results. Pichet’s study showed that with a wealth tax in effect, wealthy taxpayers tend to leave the country, and those who aren’t already residents tend to avoid moving there.
So governments, like individuals, encounter a delicate balancing act when dealing with budgets to rein in spending and increase revenue while trying to promote economic growth.
Strategies for Taxpayers Impacted by Capital Gains Increases
According to the Penn Wharton Budget Model, tax revenue in the Biden plan would be borne mostly by those with high household incomes, with the top 1% shouldering 80% of the tax increase. Taxpayers with adjusted gross income (AGI) of $400,000 per year or less would not see their taxes increase directly but would see lower investment returns and wages as a result of corporate tax increases. They would also see an average decrease in after-tax income of 0.9%, compared to a decrease of 17.7% for those with AGI above $400,000.
Despite these headwinds, there are ways that taxpayers can mitigate the possible consequences of significant changes to the capital gains tax. One powerful advantage –– which has already been mentioned in the earlier discussion of the “lock-in” effect –– is that individuals can delay realizing their capital gains by choosing when they want to pay taxes on the capital gain, which reduces the present value of the tax burden.
Additional strategies investors can employ to mitigate the long-term impact that new tax changes present include:
- The careful rebalancing of overall asset allocation and collaboration with an investment advisor to employ tax-managed strategies in an effort to manage realized gains and losses in an efficient manner.
- Borrowing against an investment portfolio in a low-rate environment while also avoiding the realization of additional unwanted capital gains.
- Utilizing gift and estate planning techniques that shift embedded capital gains to taxpayers who are tax-exempt or in lower tax brackets (e.g., charitable gifting of an appreciated asset, substitution of assets in an entity or gifting to family members or descendants in lower tax brackets).
- Accelerating realized gain before tax changes become law (attractive for holders of low basis assets considering current effective capital gains rates are still relatively low compared to other sources of capital income, i.e., dividends and interest income).
Stymied Strategies for Taxpayers Impacted by the Wealth Tax
In the event of a wealth tax, individuals may deploy strategies to mitigate the impact that new tax changes present. Clearly the sponsors of the current wealth tax bill are aware of this as well as the problems encountered by other countries that have attempted similar taxes. The proposed legislation includes several tough provisions designed to address these issues and avert the efforts of taxpayers seeking ways to avoid the tax.
- Capital flight: France’s wealth tax led to a reported 42,000 millionaires leaving the country between 2000 and 2012. To prevent offshore evasion, the proposal in the U.S. would impose a 40% tax on the net worth above $50 million of any U.S. citizen who attempts to avoid the tax by renouncing their citizenship.
- Administrative and enforcement: European countries cited the cost of monitoring and enforcement as exorbitant. This heavy cost of enforcement caused Austria to kill its wealth tax in 1993. In the U.S., the current proposal includes $100 billion in funding to the IRS to ensure the agency has the resources needed to implement and enforce the new tax. Furthermore, the proposal suggests a 30% minimum audit rate for households and trusts subject to the tax while also requiring additional resources to help the IRS value difficult-to-value assets. Obligating financial institutions to aid in compliance increases regulation and puts the onus (and added expense) on third-party reporting.
- Equity: Despite the goal of mitigating the inequity as evidenced by the wealth gap, a wealth tax will also have a disproportionate effect on certain groups. For instance, wealth taxes often hit individuals with plenty of assets but little cash on hand. The legislation would need to adjust for individual circumstances with remedies, while blocking the loopholes that creative taxpayers will try to find in these provisions.
Many economists have examined history and produced studies that explore the far-reaching implications that capital gains rates have on capital formation. These studies indicate that changes in the capital gains rates have multiple consequences, some intended and some likely unintended. However, with Active Wealth management, taxpayers can plan accordingly to maximize returns in uncertain times.