The Fascinating Federalism of Capital Gains Taxes
By David Henderson
Or, Why California Governor Gavin Newsom Should Hope that the Federal Capital Gains Tax Rate is Not Increased
One thing that economists are fairly sure of is that a cut in the tax rate on capital gains increases the amount of gains subject to the tax and that, conversely, an increase in the tax rate on capital gains decreases the amount of gains subject to the tax. This is especially true in the short run.
This is so because capital gains taxes are levied in the United States only when the capital gains are realized, i.e., when the asset is sold, and the decision about whether to sell the asset is up to the owner.
Here’s how George Washington University economist Joseph J. Cordes put it in, “Capital Gains Taxes,” in the first edition of my Concise Encyclopedia of Economics:
Because capital gains are not taxed unless an asset is sold, investors choose when to pay the tax by deciding when to sell assets. Payment of the tax can be delayed by holding on to an asset with a capital gain, which is financially worthwhile because the amount owed in taxes remains invested in the asset and continues to earn an investment return. Payment of capital gains can be avoided altogether if an asset is held until death. After weighing the advantages of not selling, a rational investor may conclude it is better to keep an asset rather than sell it. When this happens, the capital gain becomes “locked in.” No tax is collected because no capital gain is realized through sale. The gain from staying locked in is greater at higher tax rates, so that the volume of capital gains that are realized falls as the tax rate rises, and vice versa.
Cordes notes that this point is made by proponents of the view that decreasing capital gains tax rates increases capital gains tax revenue, but the point holds whether or not the net effect is to increase tax revenue.
Cordes points out that the net effect on capital gains tax revenues from cutting the capital gains tax rate will depend on how sensitive capital gains realizations are to the capital gains tax rate. If they rise by a higher percent than the percentage drop in the tax rate, that is, if realizations are highly elastic with respect to the tax rate, then capital gains tax revenues will rise. And if they aren’t very sensitive, capital gains taxes will fall. It’s an empirical issue and Cordes deals nicely with the state of knowledge at the time he wrote, namely in the early 1990s.
Stephen Moore makes the same point about capital gains realizations in “Capital Gains Taxes” in the second edition of the Concise Encyclopedia of Economics. He writes:
The capital gains tax is different from almost all other forms of federal taxation in that it is relatively easy to avoid. Because people pay the tax only when they sell an asset, they can legally avoid payment by holding on to their assets—a phenomenon known as the “lock-in effect.”
The effect is symmetric: If the federal government increases the tax rate on capital gains, as Democratic candidate Joe Biden proposes, the effect will be to make capital gains realizations lower than otherwise. Biden proposes to increase the top marginal income tax rate on long-term capital gains to 39.6 percent for taxpayers earning more than $1 million annually. The 39.6 percent is the same rate Biden would have on the ordinary income of the highest-income taxpayers. The top federal tax rate on ordinary income is now 37 percent and the top federal tax rate on long-term capital gains is now 20 percent. (Although, as Scott Eastman of the Tax Foundation points out, “Individuals with Modified Adjusted Gross Income surpassing $200,000 ($250,000 for married couples) pay an additional 3.8 percent tax on net investment income.)
In short, Biden’s proposed tax rate increase on capital gains is huge, especially for the highest-income taxpayers, who, by the way, have a large percent of overall capital gains.
Here’s what’s not ambiguous: the result of an increase in the federal tax rate on capital gains would be less capital gains tax revenue for California’s state government.
California’s government taxes capital gains at the same rate it taxes ordinary income. With lower capital realizations by California residents, the state government will get less tax revenue from capital gains taxes than otherwise.
And California’s government relies more on capital gains tax revenues than many other states do. In 2019, the latest year for which we have the data, capital gains tax revenues, at $13.8 billion, were 9.5 percent of general fund tax revenues.
Which is why Gavin Newsom, who is facing a large state government budget deficit (although he has substantially overstated it) should hope that whoever is elected in November will not raise the federal tax rate on capital gains.