Monday, January 19, 2015

Taxing capital gains at death

I'm pleased by the headline item in the tax proposals issued by the White House in connection with tomorrow's State of the Union address: the proposal to tax capital gains at death.

Current law, with its stepped-up basis at death, is  rightly called, by the write-up "perhaps the single largest loophole in the entire individual income tax code."  It means that asset appreciation that accrued during one's life will never be taxed.  (The possible, but today relatively limited, application of the estate tax, is quite different - it applies to value without respect to appreciation.)

Here is a simple hypothetical illustration of why this matters.  Despite my personal fondness for Apple products, I will take the late Steve Jobs as my example.  Suppose - no doubt exaggerating the actual facts, but probably in close relationship to them of Jobs, and even if not for him than for others - that he paid $1 for his initial stake of Apple stock when it was founded, and that the value of this stock appreciated to $1 billion by his death.  The income tax will never reach this enormous gain under stepped-up basis.

What about Jobs' salary from Apple?  With his famous dollar-a-year salary, this wouldn't have done anything either.  But even if Apple had paid him an arm's length salary, rather than effectively compensating him via stock and option appreciation, each dollar of salary it paid him would be includable by him yet deductible by it, leading to zero net tax revenue if their tax rates were the same (as during the long period when the top marginal rate was 35 percent for both individuals and corporations).

What about taxing Apple at the entity level?  In principle, taxing Apple at the corporate level could be a proxy for taxing Jobs as an individual, subject only to the question of whether its marginal tax rate was as high as the rate that one might have wanted to apply to him.  But Apple famously has minimized its tax liabilities through clever international tax planning.

In sum, Jobs' income may never be taxed to any significant degree absent a tax on capital gains at death.  And note that, in this instance, we are talking about labor income that any sensible tax base - including, for example, a well-designed consumption tax - would have reached at some point.  It is not just a question of taxing "capital income."

The tax on capital gains at death really is directed at the top 0.1 percent, especially with the bells and whistles that the White House proposal adds to address political concerns about "small business" and the like.  Note also that, in at least one respect, it actually increases the efficiency of the tax system.  Lock-in, or tax-induced reluctance to sell appreciated assets even if one would otherwise like to do so, is greatly worsened by the tax-free step-up in asset basis at death.  With step-up, selling one's appreciated assets while alive means that one is not merely accelerating a tax that will be due at some point in any event, but incurring a tax liability that would simply go away if one waited.  Hence, it encourages the simple tax planning trick that Ed McCaffery has labeled "buy, borrow, die."  Without step-up, capital gains taxes can achieve a decent tradeoff between revenue raised and distortionary costs from lock-in at a higher rate than is possible today.

The White House fact sheet calls tax-free step-up the "trust fund loophole," which is fair enough although we will see whether or not it catches on.  Obviously, there is not a snowbill on the Sun-facing side of Mercury's chance that the repeal of tax-free step-up will be enacted any time soon, but, if it enters the conversation as a serious reform proposal, this could matter down the road.  And note that sincere progressive consumption tax advocates should recognize that present law's step-up undermines their vision, not just the achievement of more comprehensive income taxation.

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