Tax Increases: Implications on Capital Formation and Growth

Belinda Herzig, Richard Nelson, Joan Crain

A look at the potential consequences of an increase in the capital gains rate.

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-elect 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 since 1968.

While this may appear to be a solution for addressing the federal debt, tax increases –– specifically increases to the capital gains 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. We also discuss what taxpayers can do to mitigate the negative impact the increased rates may have on their investment portfolios.

Capital Gains, Tax Increases and Economic Growth

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 will significantly impact the treatment of long-term capital gain. 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

However, in the past higher capital gains taxes have not consistently resulted in growth in GDP, which, according to the model, would decline during the short-term through 2030 and eventually increase by 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 (GDP). 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

Further, increased capital gains taxes have not resulted in greater taxes being collected. So 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 4.

Exhibit 4: 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.

So governments, like individuals, have a delicate balancing act when dealing with budgets to rein in spending and increase revenue while trying to promote economic growth.

Strategies for Taxpayers

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:

  1. 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
  2. Borrowing against an investment portfolio in a low-rate environment while also avoiding the realization of additional unwanted capital gains
  3. 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)
  4. 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)

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.

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