Capital Gains Tax: What Is It, And How Can It Be Reformed?

As debates about economic inequality in the United States grow more vigorous, one thing that’s often part of the discussion is capital gains tax — formally defined as a tax assessed on profit received from the sale of capital assets like stocks, bonds, and real estate.

Like with many taxes, there are loopholes and ways to minimize the amount of taxes owed on capital gains. Some argue that this is a source of inequality because it disproportionately advantages the wealthy, allowing them to avoid taxes that go toward funding services used by people in lower income brackets. 

According to the Peter G. Peterson Foundation, stocks and mutual funds are the most common assets subject to capital gains tax, accounting for about 75 percent of all transactions. 

The foundation also reports that individuals in the top 1 percent income bracket receive about 22 percent of their income from capital gains — far and away the highest percentage of any income category. Those at or below the median income report little or no income as a result of capital gains. 

There are two types of capital gains, short-term and long-term. Short-term refers to assets that are owned for less than a year. These assets are taxed at rates up to 37 percent when sold, depending on one’s income bracket and tax filing status. Long-term assets, or those owned for more than a year, are taxed at around 20 percent, according to the Tax Policy Center.

However, these tax rates only apply if the assets are sold for a profit. Capital losses can be used to offset capital gains, reducing the amount of taxes owed. The total gains, minus any losses, reflect the net capital gains that are taxed by the IRS.

The Peterson Foundation reports that capital gains taxes account for about 11 percent of all tax revenue collected by the IRS, or about $193 billion. This equals 0.9 percent of the U.S. GDP.

Although capital gains taxes account for a small portion of overall tax revenue, potential reform is still a hot-button topic in politics. Advocates say that collecting more taxes on capital gains could help decrease the national debt and create a strong financial foundation for future generations.

One proposed reform is to tax annual increases in capital asset value, rather than waiting until the asset is sold to collect taxes. This would require significant resources from the IRS to track the growth of these assets every year, but could generate about $1.7 trillion in revenue over 10 years from the top 1 percent alone, according to analysis from New York University — making it the potential solution with the greatest financial impact.

The simplest reform is to increase the capital gains tax rate. This could increase tax revenue by $66 billion over 10 years, according to the University of Pennsylvania. However, it could also lead to people hanging onto assets longer to avoid paying taxes for as long as possible.

Capital assets can be bequeathed upon the holder’s death, which further defers tax collection. The current tax law also allows for a “step up” at the time of death. The Peterson Foundation explains that if an asset’s owner passes away, something purchased for $10,000, inherited at a value of $18,000, and later sold for $20,000 would only be subject to capital gains tax on the original value of $10,000. 

Removing this provision and taxing bequeathed assets at their current value when sold could increase revenue by $105 billion over 10 years, according to the Congressional Budget Office.

Grassroots Pulse covers public policy and political issues aimed at engaging highly-active policy makers, donors, and grassroots leaders at the forefront of the political process in America today.

Image Credit: Photo by Kelly Sikkema on Unsplash

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