INcite: Cap gains raise requires two big tweaks

From Warren Buffett's secretary to Mitt Romney's tax returns to the general uprising against the 1 percent, tax reform is on everybody's radar. In the cross hairs is the preferential treatment for capital gains. Profits from investments are taxed at a maximum rate of 15 percent, which is less than half the 35 percent maximum tax rate imposed on wages and other ordinary income. One can hardly open a newspaper or click on a blog without seeing a call to eliminate this special rate for capital gains to increase fairness and raise federal revenue. To achieve true fairness and generate increased revenue, however, it is necessary to make two more changes -- to allow capital-gains taxpayers to account for inflation and to close the loophole that allows wealthy Americans to avoid capital-gains taxes altogether by passing on assets at death. Before elaborating, I'll explain why it's smart to eliminate the preferential tax rate for capital gains. First, the lower rates cost the government a significant amount of revenue. In 2008, if capital gains had been taxed at 35 percent instead of 15 percent, the federal treasury would have received an additional $100 billion. (Capital gains were unusually low that year; in 2007, the increase would have been closer to $200 billion.) In the next five years, the capital- gains preference will cost the government more than $450 billion, according to estimates from Congress's Joint Committee on Taxation. Benefit for Wealthy Second, preferential treatment of capital gains disproportionately benefits the wealthy. In the past 20 years, more than 80 percent of capital gains have gone to the wealthiest 5 percent of Americans, and half have gone to the wealthiest 0.1 percent -- that is, the richest 1/10th of the 1 percenters. Most Americans who own stock don't benefit from the lower rate because they own their stock through retirement plans. When proceeds from these plans are distributed to the taxpayer, they are subject to tax at ordinary income rates. Finally, the special capital-gains rate makes it difficult to simplify the tax code. Much of its complexity is due to the myriad rules that are meant to ensure that income is properly categorized as ordinary income or capital gains. Eliminate the rate differential, and the tax code could become far less complex. It's no wonder that people from across the political spectrum -- from President Ronald Reagan to the Bipartisan Policy Center to the liberal tax policy group Citizens for Tax Justice -- have supported the idea of taxing capital gains and ordinary income at the same rate. Nonetheless, to ensure that a rate change would be fair and effective, two more changes are needed. First, the tax should be imposed only on real gains, and not inflationary ones. One important justification for the lower rate on capital gains has been that if property is held for a long time or during a period of significant inflation, the gains may be illusory. Consider the person who invested $100,000 in a building in 1980 and sold it 30 years later for $250,000. Under current rules that taxpayer would be subject to tax on $150,000. Yet, because $100,000 in 1980 had about the same buying power as $250,000 in 2010, the investment arguably produced no real profit for the taxpayer. The lower tax rate on capital gains mitigates this problem. The tool is too crude, though, to provide true fairness, because the same advantage given to property held for 18 years is given to property held for only 18 months. Account for Inflation A fairer system would impose regular tax rates, but allow taxpayers to account for inflation when calculating gain. This fix was proposed in the 1980s, but rejected at the time as being too complicated for the average taxpayer. However, with the advent of the Internet, it's easy for anybody to calculate inflation -- and therefore true gain -- with a few keystrokes. (Try it for yourself using this calculator from the Bureau of Labor Statistics.) The second, and more important, needed change is to close the “angel of death” loophole. Under current rules, capital- gains taxes are imposed only when property is sold. This means that in any given year, people can easily avoid capital-gains taxes by holding on to their property. Moreover, if property is held until death, then no capital-gains taxes are ever paid, because the tax code treats heirs as if they had purchased the inherited property for its fair market value. This loophole is available even though heirs pay no income taxes on their inheritance and regardless of whether any estate taxes are imposed on the donor. Thus, if a taxpayer invested $100,000 in Apple Inc. in 2006 and died in 2012 when the stock was worth $1 million, that $900,000 profit is never subject to tax. The decedent is not taxed because he didn't sell the stock, and the heirs are not taxed because they are treated as if they had purchased it for $1 million. Even at 15 percent capital-gains rates, this angel of death loophole costs the federal government about $60 billion each year. It also creates a powerful incentive for people to hold on to their appreciated property until death. This so-called lock- in effect impedes the efficient flow of capital. A lower tax rate on capital gains presumably counters lock- in by making it less onerous for taxpayers to sell. However, no matter how low the tax rates are set, they can never compete with a rate of zero. Nonetheless, increasing the rate on capital gains would only increase the lock-in effect, and do little to generate federal revenue. The simple solution is to modify the tax code to require that all capital gains and losses be realized on a decedent's final income tax return. In our example, this would mean that the decedent's profits from his investment in Apple (adjusted for inflation) would be subject to tax at ordinary income rates. This would not only ensure that profits are fairly taxed but also free people to make their best investment decisions. Meaningful reform of the capital-gains tax is a good idea. Let's make the change logical and effective as well. --Bloomberg News-- (Ray Madoff, a professor at Boston College Law School, is the author of “Immortality and the Law: The Rising Power of the American Dead.” The opinions expressed are her own.)