The fiscal-cliff agreement reached this week covered only the easiest issues -- although not easily. The difficult work of deficit reduction and tax reform will be dealt with later, and the outcome doesn't look promising. Congress loves to talk about tax reform, but every major piece of legislation only makes our tax system more complicated, including this one.
The reason tax reform is so elusive is that there are so many fundamental policy disagreements between the two parties. Take, for example, the controversy over why superrich investors like Warren Buffet pay a lower effective tax rate than many workers whose modest incomes come primarily from wages. Looking at the rationale for the rate differential helps explain why there will be no quick or easy bridge over the philosophical divide.
For individuals, capital gains arise from the sale of personal-use or investment assets. The assets -- whether a vacation home or a stock -- must have been held more than a year to get the preferential rate.
The maximum rate for long-term capital gains has been 15 percent since 2003. The fiscal-cliff agreement is to increase that rate to 20 percent for those making over $400,000 ($450,000 on joint returns). Along with the 3.8-percentage-point rate increase on investment income for high-income taxpayers that is part of the health care provisions that kick in for 2013, the top capital gains rate now increases to 23.8 percent.
The rationale for the capital gains preference can be broken into two themes. The first is that the gain from capital assets should not carry a full tax burden due the long-term nature of the gain.
If we assume that the vacation home or stock is held for 30 years, then sold at a significant gain, the entire gain is recognized in the year the property is sold, even though the gain was slowly realized over the longer period.
The recognition of the gain all in one year may very well push the individual into a higher marginal tax bracket, resulting in more tax than if the gain had been realized over those 30 years. Moreover, how much of the recognized gain was only the result of inflation over such a long period? Finally, part of this rationale is that saving should be encouraged.
But that entire rationale loses much of its potency when "long term" is defined as simply more than one year. So why not define it as something significantly longer, say 10 years?
Well, this runs squarely against the second theme for the preference -- market efficiency.
One hallmark of a good tax system is that it minimizes decisions made solely for tax reasons. Note that there is no tax on capital gains until an asset is sold. This creates an incentive to hold onto property, especially if tax consequences are severe. Indeed, the gain, for tax purposes, disappears entirely if the asset is held until death. This is why one of the best tax planning strategies (albeit with a severe downside) is to die.
The damage to economic efficiency is that people may not sell their vacation homes to someone who will better utilize them if the tax rate is too high. The stock market won't be as efficient if people don't sell stocks and make better investments due to tax consequences. This rationale argues for a low tax rate with a short definition of "long term."
So how do we balance the legitimate reasons for a capital gains preference against the inherent unfairness of favoring this type of income over compensation income? Economists vary widely in what they consider the "ideal" capital gains rate.
One indisputable point is that the tax code would be made simpler by eliminating the capital gains preference altogether. Numerous provisions are necessary to try and prevent taxpayers from converting "ordinary income" into long-term capital gains.
However, with the exception of a brief three-year period, Congress has always given a preferential tax rate to long-term capital gains. Those three years were following the 1986 Tax Reform Act. President Reagan agreed to an increase in the capital gains rates in exchange for a substantial reduction in the top marginal tax rate from 50 percent to 28 percent. The Bowles-Simpson deficit-reduction plan would eliminate the preference as part of an exchange for the lowering of marginal rates.
There is little question that the theoretical underpinnings of the capital gains preference are undercut if marginal tax rates are reduced. Yet, sadly, this discussion isn't even on the table. Does anyone really see this happening in 2013?
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Paul G. Gutterman is director of the Masters of Business Tax Program at the University of Minnesota's Carlson School of Management.