President Biden’s proposed American Families Plan provides educational support to preschoolers and to those attending community colleges or other approved programs. It also would extend the recently enacted one-year refundable child tax credit. It envisions $1.8 trillion of aid and proposes to raise the capital gains tax and top marginal individual income tax rate for high-income individuals to pay for it.
The underlying tax proposal is a hike in the capital gains tax from a top rate currently of 23.8 percent to 43.4 percent, which is set to equal a simultaneously raised top rate on individual income (rates include the additional 3.8 percent tax rate required on high-earners’ income). The biggest objection to raising the capital gains tax rate is it is based on a false premise. Realized capital gains — the tax base for this tax — are largely not income. They mainly reflect inflationary gains in the value of assets since they were acquired. The appreciation is partial compensation for the rising replacement cost of the asset, so the tax falls essentially on the compensation for past inflation, not on any sort of income, the proper focus of such a tax. The effect of taxing inflationary gains in asset value is to tax the capital itself, not its income.
The second problem is that raising the tax rate will not raise tax revenue. Whenever the capital gains tax is raised, investors hold on to assets longer (the “lock-in effect”) to avoid a capital gains realization upon which they would be taxed. Capital gains realizations rise before an expected tax hike, but even ignoring this, revenue is lower than before the tax cut.
A prime example of this inverse relationship occurred before and after the Reagan administration took office in 1981. The capital gains tax rate had been as high as 39.875 percent in 1977 and then was reduced twice — first in 1978, to 33.85 percent, and then to 28 percent in 1979-80. Revenue rose from $8.2 billion in 1977 to $9.1 billion in 1978, and then rose further to an average of $12.1 billion in 1979-80 because of each respective lower tax rate. A further reduction in the tax rate to 20 percent in 1981 saw revenue average about $12.9 billion in the recession years of 1981-82, and the tax revenue climbed steadily to more than twice as much — $26.5 billion — by 1985 while the tax rate was unchanged at 20 percent.
In 1986, in anticipation of an increase in the tax rate to 28 percent in 1987, realizations of gains ballooned, pushing tax revenue up to $52.9 billion. From 1987 to 1990, the capital gains tax rate was the higher 28 percent, but average tax revenue from capital gains fell back to $33.9 billion. The increase in the capital gains tax rate in 1986, to match the top individual tax rate, was probably the worst mistake President Reagan made on tax policy, but it was necessary to get agreement for lower individual tax rates — and it did prove a point: Raising the capital gains tax rate reduces revenue from the tax, just as lowering the rate earlier raised tax receipts.
The Penn Wharton budget model shows the proposed Biden capital gains tax rate increase would lose $33 billion in revenue over 10 years. The Tax Foundation estimates the loss more likely would be $124 billion over the period — and even that is probably an underestimate of the loss, as realizations of gains would decline on lower-valued assets.
Why would the president tie a spending plan to a capital gains tax increase? The answer is misdirection from his advisers. It sounds like an increase in the tax rate would provide funds to help pay for more spending, but it would not. Instead, it would lock investors into more unrealized gains and punish all taxpayers, especially those with higher incomes, to provide greater “fairness,” though the tax itself is extremely unfair. It taxes asset values, specifically price increases that compensate for inflation losses, not wealth gains or income gains.
Finally, a higher capital gains rate raises the cost of capital for businesses. Investors will demand to be compensated for this tax hike, as they would for any other tax increase, so a rise in the capital gains tax rate will raise businesses’ cost of capital, reducing the incentive to invest. Lower investment will reduce the capital available for workers to use, which in turn will reduce productivity and real wages for all workers. The cost in lost income will be comparable to shooting oneself in the foot to stop an itch.
John A. Tatom is a fellow at the Institute for Applied Economics, Global Health and the Study of Business Enterprise at Johns Hopkins University, and a former research official at the Federal Reserve Bank of St. Louis.