Biden testing Democratic appetite for taxing the wealthy with capital gains proposal

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Some Democrats on Capitol Hill are wary of President Joe Biden’s pitch to nearly double the capital gains tax for the wealthy, meaning that the proposed hike will almost certainly land at a lower level.

Biden wants to pay for his American Families Plan, a $1.8 trillion package focused on childcare and families, by increasing the top individual income tax rate to the pre-2017 level of 39.6% and taxing capital gains for households making more than $1 million as ordinary income.

While Republicans are balking at the idea, it will also be a tough sell within Biden’s own party, as Democrats hold a wire-thin majority in the Senate, and one vote against the plan could completely derail the proposal. The scale of the tax increase, if passed as is, would also be historic.

Erica York, an economist with the Tax Foundation, a nonpartisan think tank that generally prefers lower taxes, told the Washington Examiner that with the 3.8% net investment income tax included, Biden’s current plan would result in a top marginal rate of 43.4%, a high “not seen since the 1920s.”

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“It would be a significant increase, higher than the highs that were seen in the 1970s and the 1990s,” she said.

And while Democrats have not been eager to trash the proposal openly, some have worried about the effect such a drastic change in the tax code could have on the economy. Democrat Joe Manchin of West Virginia is one of the most influential senators in the country because of his tendency to buck partisanship and take a more centrist tack on issues.

Manchin’s vote is crucial because, as it stands, Democrats and Republicans each hold half of the Senate, with Vice President Kamala Harris acting as the tiebreaking vote. Because an increase in the capital gains tax will likely not achieve enough GOP support to pass with a 60-vote majority, Democrats may try to use a budgetary tactic known as reconciliation to pass it with a simple majority, meaning that Manchin’s vote is a must-have.

But Manchin appears to be hesitant about the current iteration of the increase, opening the door to inevitable negotiation.

“That’s a heavy lift,” Manchin recently said of the proposed capital gains increase. “We just can’t make ourselves noncompetitive. We have an economy that’s ready to take off and boom. We can’t put the brakes on it.”

Democratic Sen. Mark Warner of Virginia, who is a member of the Senate’s powerful Finance Committee as well as a former venture capitalist, also expressed willingness to tamp down the level of the proposed capital gains tax increase.

“I think that there needs to be some differential, but the differential between ordinary income and capital gains is much too great, so I’m open to narrowing that,” he told the Wall Street Journal.

While some Democrats such as Sens. Chris Murphy of Connecticut and Brian Schatz of Hawaii have hinted that they wouldn’t be opposed to some degree of deficit financing to pay for Biden’s plans, Manchin, who has said he wants the corporate tax rate raised less than Biden’s proposal to increase it from 21% to 28%, wants more revenue to be raised by enforcement of existing tax law.

“It intrigues me to understand that we have $400 billion to a trillion dollars that people have stated that we haven’t collected; don’t you think we ought to look at that first?” he said. “I’ve been very clear on 25% corporate, but I want to see basically where our loopholes are and why we’re not collecting and why the IRS has been eviscerated.”

Another crucial component of the capital gains tax plan is that it would end the step-up in basis for gains above $1 million. The step-up in basis is a part of the current tax code that allows inherited assets to be taxed at the basis value of when they were inherited rather than the basis value of when they were first purchased.

For example, imagine a father bought $10 million in stock two decades ago, and its value appreciated to $20 million over that time period. If he dies and his child inherits that $20 million asset, when the child wants to sell it, say at $25 million two years after it was inherited, the child would only pay capital gains taxes on $5 million. If the stepped-up basis were to be eliminated, the child selling the $25 million asset would have to pay capital gains taxes on $15 million because that is the amount its value appreciated from when it was first purchased by the father 22 years ago for $10 million.

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The Wharton School at the University of Pennsylvania released a report that predicted that increasing the top statutory rate on capital gains to the level Biden has proposed would decrease tax revenue by $33 billion over the next decade. Though, if the stepped-up basis were eliminated, its model found that the capital gains change would raise $113 billion in revenue. This is because research indicates that when taxes on capital gains increase, realizations of capital gains fall.

“Because taxes are due upon realization rather than accrual, taxpayers can use several strategies to time realizations in [a] way that reduces liability,” the university said. “For example, investors may defer realization [of] a capital gain in hopes of lower tax rates in the future, or they may tend to realize gains only in years when they experience other losses.”

Eliminating the step-up in basis would make it harder for investors to partake in tax avoidance opportunities and thus would increase revenue when combined with the hiked capital gains tax. It is also important to note that if the stepped-up basis is eliminated, those who inherit assets would still also have to pay the estate tax on those assets.

“The combination of the high rate plus taxing capital gains at death in addition to the already existing estate tax would be too much for even some Democratic members,” York said.

York said that while it is unclear at what level a new top capital gains rate would land after negotiations, she said that the Joint Committee on Taxation estimates the revenue-maximizing capital gains tax rate is around 28%, a number that would likely be more palatable to some of the Democratic lawmakers who are feeling a bit of heartburn from Biden’s sweeping proposal. The Joint Committee on Taxation is a nonpartisan committee with its own independent staff and features members from both the House and the Senate. It works to assist lawmakers on both sides of the aisle with tax policy.

While the capital gains proposal directly targets the wealthy, some Democrats in high-tax states have already made waves for advocating for another tax change that predominantly affects high earners. Several Democratic lawmakers, and some Republicans, have demanded the elimination of the cap on deductions for state and local taxes paid, known as SALT.

Despite being the party that is usually interested in taxing the wealthy more, removing the cap would largely benefit its upper-class constituents. The Tax Policy Center found that only 3% of middle-income households would pay less in taxes if the $10,000 cap imposed as part of the 2017 Trump tax cuts is excised.

Some of the Democrats have even threatened not to vote for hiking the corporate tax rate as a way to pay for Biden’s $2.3 trillion American Jobs Plan infrastructure package unless the limit is removed.

In addition to the American Families Plan and the American Jobs Plan, Biden has already passed the $1.9 trillion American Rescue Plan, which was designed to help the economy recover from the COVID-19 pandemic.

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Because of the sheer cost of these plans, Biden is testing the limits of how far his party, one which says it emphasizes help for working- and middle-class workers, will go to tax the rich.

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