As Super Tuesday approaches, the top six Democratic presidential candidates continue to refine their tax proposals to address income inequality and generate additional federal tax revenue. Some candidates propose changing the tax treatment of deferred assets, particularly assets that are passed on to heirs after death.
For example, shortly after launching his campaign, President Biden proposed removing the capital gains basis increase. While repealing the base increase would raise significant revenues compared to current law, it would reduce national saving and overall wealth, and increase compliance costs for the government and taxpayers.
basis and implementation
The purchase price of an asset is typically referred to as the base of the asset. Capital gains or losses refer to the difference between the purchase price (base) of an asset and its value at the time of sale. Only when an individual realizes a capital gain (sells an asset for a profit) is capital gains tax due.
Some assets are held for generations and passed from their original owners to heirs. In the event that these investors never sell their assets, those assets will not be subject to capital gains tax.
As investors acquire and hold assets over time, the value of those assets fluctuates. Under current law, the tax base of property transferred to an heir upon death is increased to its current market value. This process, called a step-up-in basis, means that any appreciation in the property that occurred during the original owner’s lifetime is not taxed. If the heir decides to sell the property, any tax would be assessed on the new basis, meaning that only capital gains tax will be charged on capital gains after the property has been inherited.
Unstep-up in base
There are many trade-offs in lifting base increase. Under the current system of taxing capital gains, increasing the tax base discourages people from realizing their gains. Eliminating the step-up basis would encourage more realizations, increase federal revenue and eliminate a tax break that allows taxpayers to completely exempt income from savings from taxation.
While it is far from neutral for capital gains to escape taxation entirely, as can occur due to an increase in the tax base, the Directive also mitigates an otherwise significant effective tax rate on savings. This is due to the taxes that would apply without an increase in property transferred to heirs: an estate tax on the total value of the assets of an estate, and capital gains taxes on an increase in the value of the property’s assets.
On the other hand, repealing the base increase would make the code more neutral in relation to wealth relative to income and gifts. It would also make the code more progressive and increase auditing costs for the Internal Revenue Service (IRS). Unlike previous laws where those assets were not taxable, the IRS would be responsible for the taxpayers’ accounting and auditing of their assets upon death, sometimes without all the information necessary to determine the price or basis of the asset.
Repeal would also likely increase compliance costs for taxpayers, as they would have to review the original cost basis of each capital gain to ensure they are compliant. This is often difficult when a donor is alive, but could be nearly impossible for an heir if a deceased did not leave proper documentation of an asset’s original cost basis.
Economic, income and distributional implications of lifting the base increase
Using the Tax Foundation’s General Equilibrium Model, we find that removing the base increase would decrease national income (GNP) by 0.11 percent and result in a 0.88 percent decrease in wealth. This is because the removal of the top-up basis for inherited assets makes previously untaxed income subject to capital gains tax rates on death or transfer. Removing the base increase would affect domestic investors who are subject to capital gains tax, reduce the level of domestic savings and lower domestic income (GNP). This decline in domestic saving would be offset by greater foreign investment and greater foreign borrowing of American assets.
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Source: Tax Foundation General Equilibrium Model, November 2019. |
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| GDP | E.G | share capital | Change of Assets |
|---|---|---|---|
| -0.00% | -0.8% | 0.00% | -0.88% |
The removal of the base increase would bring in $116 billion over the 10-year window on a conventional basis.
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Source: Tax Foundation General Equilibrium Model, November 2019. Values cannot be added due to rounding. |
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| Year | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2020-2029 |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Conventional | $11 | $11 | $11 | $11 | $12 | $12 | $11 | $12 | $12 | $12 | $116 |
The lifting of the baseline affects almost exclusively taxpayers in the top 20 percent. Most notably, the distributional effect is almost four times larger for the top 1 percent compared to the top 20 percent. Because the top 1 percent owns a larger percentage of the assets subject to the deferral treatment provided by step-up-in basis, a waiver affects those claimants more.
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Source: Tax Foundation General Equilibrium Model, November 2019. |
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| income group | Conventional |
|---|---|
| 0% to 20% | 0.00% |
| 20% to 40% | 0.00% |
| 40% to 60% | 0.00% |
| 60% to 80% | 0.00% |
| 80% to 100% | -0.13% |
| 80% to 90% | 0.00% |
| 90% to 95% | -0.01% |
| 95% to 99% | -0.01% |
| 99% to 100% | -0.49% |
| In total | -0.07% |
Removing the base increase would directly affect those in the highest income brackets, while leaving most taxpayers unaffected.
Conclusion
There are pros and cons to lifting the base increase, particularly independently of reforms in other areas such as inheritance, capital gains and gift taxes. For example, repealing the base increase would make the code more neutral by removing a tax break that allows taxpayers to fully exempt income from savings from taxation. It makes the code more stable by broadening the tax base and increasing revenue.
Abolishing the step-up base would make the code more progressive by removing a tax break that primarily benefits wealthy taxpayers and taxing a previously untaxed base of accrued gains over a lifetime. As our model shows, revenue would increase and those in the higher income brackets would pay more compared to the current law. In addition, the removal of the step-up basis makes the Code more transparent to current investors and their future heirs, as they will be given early notice that they will be subject to tax on their assets on death.
However, following this practice would increase compliance costs to taxpayers and the government, requiring more hours to be devoted to tax compliance than other productive activities, and requiring more money for IRS accounting and auditing. Without a reduction in the capital gains tax rate, removing the base increase would increase the tax burden on saving, reduce the overall share of income Americans earn, and shrink total wealth by a substantial margin.
Presidential candidates and policymakers must weigh these tradeoffs when looking for ways to address income inequality and tax law progressiveness.
