The action or inaction of Congress on the federal tax changes contemplated in the Build Back Better plan could have significant implications for states on many fronts. One critical area to note is the basis of income tax law: establishing the definition of income that most states will use to administer their own income taxes.
Lawmakers are still debating whether to reform the capital gains taxes or income taxes that investors, especially wealthy investors, receive when their assets appreciate over time. Congress and the Biden administration agree fairly broadly that the preferential and low tax rates on capital gains income should be increased. But real reform will require looking beyond the headline tax rate and to the more fundamental question of ensuring that the capital gains income of extremely wealthy families is never taxed. For states, which rely heavily on the federal government to define what counts as income for tax purposes, this issue is far more important than the choice of federal tax rate.
Under the current federal tax code, capital gains are only taxable if the asset generating those gains is sold during the taxpayer’s lifetime. That is to say if the gain is “realized” during the lifetime of the owner. Unlike workers, who regularly pay income taxes through automatic deductions from their paychecks, investors can watch their assets generate huge gains for decades without ever having to set aside a dime for taxes. If these investors hold onto their assets until they die, which only very wealthy people can afford to do on a large scale, all income generated by their investments is tax-free forever. Neither the original owner nor the heir to this property will pay income tax on the gain and, more importantly for state governments, the gain will never appear on federal income tax forms.
Because nearly all states with income taxes are grafted onto the federal government’s definition of income, this means that capital gains that the federal government chooses to overlook end up being invisible to state governments. In other words, deep flaws in the federal definition of taxable capital gains are mimicked in state income tax codes across the country.
Before the advent of the digital age, the taxation of earnings only at the time of their realization could be defended as an administrative convenience. And for ordinary families today, who see a large chunk of their earnings through incremental increases in the value of their homes, realization tax still works quite well. But the super-rich, who have come to own an inordinate share of our nation’s wealth, is another story. The vast majority of their earnings come from unrealized capital gains. To avoid taxes, they regularly exploit these gains through low interest loans on their portfolios instead of selling the asset.
Surprisingly, the current federal definition of taxable capital gains omits more than half of the earnings accruing to extremely wealthy families. A result of this was revealed in a recent Pro Publica analysis showing that Warren Buffet, Jeff Bezos and Michael Bloomberg were each facing federal income tax rates below 1.5% compared to the increase in their financial resources between 2014 and 2018 â all. because the way they got rich was invisible to federal and state tax authorities. Looking at a somewhat larger group of households, the nation’s 400 richest families, White House economists estimate an average tax rate of just 8.2% by this measure.
This gaping hole in the federal tax code undermines both economic and racial fairness not only by allowing wealthier households to accumulate their wealth tax-free, but also by reducing state tax bases, by limiting the growth of state revenues; and by exacerbating the regressive nature of state tax systems in general. . The problem runs so deep that it hampers the efforts of analysts, including those of us at ITEP, to fully gauge its reach. As long as the IRS continues to collect and report incomplete income data – that is, data that excludes unrealized capital gains – most tax models will underestimate the financial resources of the largest families. wealthy people in the country and overestimate the progressivity of federal and state income taxes.
There are at least two options for correcting the federal tax code’s deeply flawed definition of capital gains income. The first is known as anti-carry-over (or mark-to-market) accounting, under which very wealthy people would pay taxes on the growth of their assets each year rather than being allowed to defer those. tax bills until they sell their assets. This type of system already exists in some narrow areas of the tax code related to futures and stockbrokers and expanding it to include America’s richest families more broadly would be an important step towards equalization. the tax treatment of wealth and labor. Senator Ron Wyden, chairman of the US Senate Finance Committee, has long been a supporter of this reform, and President Biden also supports it.
The second approach would consist in ending or restricting a so-called increased base provision, which is the characteristic of the law which definitively exempts capital gains from tax when a wealthy person dies and transfers an estate to an heir. . Under this approach, investors would continue to benefit from a deferral throughout their life (unlike workers, who will continue to pay withholding from every paycheque), but at least one tax bill will eventually be due upon death. of the investor. President Joe Biden defended this reform.
Sadly, these two reforms were not included in the soon-to-be-voted US House of Representatives revenue package, but Senate leaders have shown more interest in these ideas. Historically, states have looked to the federal government for the lead in creating a reasonable definition of income for tax purposes, and states have tended to follow this lead for the most part. This allows for a certain degree of harmony between state and federal law, which simplifies the administration and enforcement of taxes. But if Congress misses this opportunity to correct the fact that a huge amount of capital gains income will never be taxed by any level of government, states will have to be prepared to fend for themselves and adopt more reasonable systems that do not. not suffer from this blind spot.