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Capital Gains Taxation 58 Capital gains taxation Capital gains taxation joint returns). The new exclusion can be claimed whenever the taxpayer meets the eligibility require- Gerald Auten ment of owning and occupying the residence for at Department of the Treasury least two of the previous five years and using the exclusion only once in a two-year period. Prior law Treatment of the changes in value of capital had been criticized as being complex, distorting assets such as corporate stock, real estate, certain housing decisions, and generating little tax or a business interest. revenue. When appreciated assets are transferred by be- quest, the basis is stepped up to the value of the as- Under a pure net accretion (Haig-Simons) approach sets on the date of death. Thus, the accrued gains on to income taxes, real capital gains would be taxed assets held at death are not taxed under the income each year as they accrued and real capital losses tax, although they may be subject to the estate tax. would be deducted. Capital gains are generally A 50 percent exclusion for capital gains from taxed only when “realized” by sale or exchange, the sale of certain small business stocks purchased however, because it would be difficult to estimate at the time of issue and held for at least five years the value of many assets, it would be viewed as un- was introduced in 1993. Eligible businesses must fair to tax income that had not been realized, and it have less than $50 million in assets (including the could force the liquidation of assets to pay the proceeds of the stock issue) and meet certain other tax on accruals. Taxation upon realization, how- requirements. The 1997 act allowed a rollover pro- ever, leads to other problems, which require policy vision for such gains and provided for a maximum compromises. rate of 14 percent. Current law History of capital gains taxation Since 1987, realized capital gains have been fully in the United States included in adjusted gross income. Beginning with From 1913 to 1921, capital gains were taxed at or- assets sold on or after May 7, 1997, long-term capi- dinary rates, initially up to a top rate of 7 percent. tal gains on assets held at least 18 months will be Because of concern that the higher income tax rates taxed under a separate rate schedule. Long-term introduced during World War I reduced capital gains in the 15 percent tax bracket will be taxed at a gains tax revenues, from 1922 to 1934 taxpayers 10 percent rate, and those in higher tax brackets will were allowed an alternative tax rate of 12.5 percent be taxed at 20 percent. Gains on assets held from 12 on capital gains on assets held at least two years. to 18 months will be taxed at ordinary tax rates but From 1934 to 1941, taxpayers could exclude per- will be eligible for an alternative rate of 28 percent centages of gains that varied with the holding pe- (as under prior law). Beginning in 2001, capital riod. For example, in 1934 and 1935, 20, 40, 60, and gains in the 15 percent bracket on assets held at least 70 percent of gains were excluded on assets held 1, five years will be taxed at 8 percent. Capital gains 2, 5, and 10 years, respectively. Beginning in 1942, in the 28 percent and higher brackets on assets taxpayers could exclude 50 percent of capital gains purchased in 2001 or later and held for at least on assets held at least six months or elect a 25 per- five years will be taxed at 18 percent. Depreciation cent alternative tax rate if their ordinary tax rate ex- on real estate is “recaptured” subject to a maximum ceeded 50 percent. Capital gains tax rates were in- rate of 25 percent. creased significantly in the 1969 and 1976 Tax Capital losses can be used to offset capital Reform Acts. The 1969 act imposed a 10 percent gains, and a maximum $3,000 of capital losses can minimum tax, excluded gains, and limited the alter- be used to offset other taxable income. Unused native tax to $50,000 of gains. The 1976 act further capital losses can be carried forward to future years. increased capital gains tax rates by increasing the The limit on the capital loss deduction is necessary minimum tax rate to 15 percent. In 1977 and 1978, to prevent taxpayers from recognizing capital losses the maximum tax rate on capital gains reached but not capital gains. 39.875 percent with the minimum tax and 49.875 The Taxpayer Relief Act of 1997 also substan- percent including an interaction with the maximum tially changed the taxation of capital gains on prin- tax. In 1978, Congress reduced capital gains tax cipal residences. The one-time exclusion of up to rates by eliminating the minimum tax on excluded $125,000 of capital gains on residences for taxpay- gains and increasing the exclusion to 60 percent, ers age 55 and over, and the rollover of capital gains thereby reducing the maximum rate to 28 percent. from one residence to another, were replaced with The 1981 tax rate reductions further reduced capital an exclusion of up to $500,000 ($250,000 for non- gains rates to a maximum of 20 percent. Capital gains taxation 59 The Tax Reform Act of 1986 repealed the ex- effective tax rates much higher or lower than the clusion of long-term gains, raising the maximum statutory tax rates.) rate to 28 percent (33 percent for taxpayers subject to certain phaseouts). When the top ordinary tax Lock-in effects rates were increased by the 1990 and 1993 budget acts, an alternative tax rate of 28 percent was pro- Because capital gains are taxed only when realized, high capital gains tax rates discourage the realiza- vided. Effective tax rates exceeded 28 percent for many high-income taxpayers, however, because of tion of capital gains and encourage the realization of interactions with other tax provisions. The new capital losses. Investors induced to hold appreciated lower rates for 18-month and five-year assets were assets because of capital gains tax when they would adopted in 1997. Nominal and effective tax rates for otherwise sell are said to be “locked in.” Lock-in ef- fects impose efficiency losses when investors are the period 1984–1995 are shown in table 1. induced to hold suboptimal portfolios with inappro- Economic issues in capital gains taxation priate risk or diversification, or forgo investment opportunities that may offer higher expected pretax Inflation returns. Investors with appreciated property may Taxing nominal gains raises the effective tax rate on also incur unnecessary transaction costs to avoid real capital gains and can lead to imposition of a tax capital gains taxes if they obtain cash from their in- in cases of real economic losses. Several studies vestment by using it as security for a loan, or reduce have shown that a large percentage of reported their risk by selling short an equivalent asset (short capital gains reflect the effects of inflation, with the against the box). The financial incentive to be capital gains of lower- and middle-income taxpayers locked in is greater for long-held, highly appreciated commonly representing nominal gains but real eco- assets and is increased by the step-up in basis at nomic losses. The indexing of the cost or basis of an death. asset has frequently been proposed to correct for inflation. Behavioral responses and revenues Behavioral responses associated with capital gains Deferral tax rates are complex. In the absence of tax law From the standpoint of economic accretion, the de- changes, transitory fluctuations in income and tax ferral of capital gains taxes until realization reduces rates may induce taxpayers to accelerate or defer re- the present value of the tax, thereby reducing the alizations of gains. Similarly, taxpayers time reali- effective tax rate below the statutory tax rate. (The zations to take advantage of differential tax rates on combination of deferral and inflation can produce short- and long-term gains. Statutory changes in tax T A B L E 1 Realized Capital Gains and Taxes Paid on Capital Gains, 1984–95 Total Positive Realized Taxes Paid on Effective Tax Gains as Percent of Maximum Tax Rate Capital Gains Capital Gains Rate on Capital Gross Domestic on Long-Term Year ($ billion) ($ billion) Gains (%) Product (%) Gains (%) 1984 140.5 21.5 15.3 3.7 20.0 1985 172.0 26.5 15.4 4.3 20.0 1986 327.7 52.9 16.1 7.7 20.0 1987 148.4 33.7 22.7 3.3 28.0 1988 162.6 38.9 23.9 3.3 28.0 1989 154.0 35.3 22.9 2.9 28.0 1990 123.8 27.8 22.5 2.2 28.0 1991 111.6 24.9 22.3 2.0 28.9 1992 126.7 29.0 22.9 2.1 28.9 1993 152.3 36.1 23.7 2.4 29.2 1994 152.7 36.2 23.7 2.2 29.2 1995 180.1 44.3 24.6 2.5 29.2 Notes: Realized gains include positive amounts of both short- and long-term capital gains. The maximum rate includes the effects of the 3 percent phaseout of itemized deductions for high-income taxpayers (computed for 1994 as 29.188 = 28 + 0.03 • 39.6). Taxpayers in the income range over which personal exemptions are phased out or subject to certain other phaseout provisions could pay higher effective tax rates.
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