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The capital gains tax is a levy on the profit received from the sale of a capital asset. That profit, known as a capital gain, is taxed at a lower marginal rate than ordinary income. While revenues received from taxing capital gains are modest, accounting for 11 percent of individual income tax receipts, changes to the tax could have significant implications for the country’s fiscal and economic health.
Below is a brief look at how the tax on capital gains works, what assets and individuals are most affected by it, and the fiscal implications of some commonly discussed changes.
Capital gains are realized when a capital asset is sold for a profit. For example, if shares of corporate stock were purchased for $100,000 and sold 10 years later for $200,000, the $100,000 profit would be considered a capital gain and enjoy a preferential tax rate. Additionally, if a capital asset is sold at a loss, some or all of that loss may offset other gains or be deducted from taxable income. Finally, if the owner of an asset passes away and bequeaths it to someone else, the value for tax purposes will be adjusted to reflect its current value at that time; that readjustment in value is known as the step-up basis.
Capital gains on assets that are held for less than one year are known as short-term capital gains and are currently taxed at the same rate as ordinary income for individuals. Capital gains on assets that are held for more than one year are known as long-term capital gains and most are taxed at rates of 0, 15, or 20 percent depending on an individual’s income. Historically, the capital gains tax rate for long-term assets has been lower than the maximum ordinary income tax rate.
Most of what an individual owns, including securities like stocks and bonds or even “hard” assets such as real estate, can be considered a capital asset. However, most transactions subject to the capital gains tax consist of investments such as stocks and mutual funds. In 2012, the latest year for which data are available, 75 percent of taxable transactions were from stocks and mutual funds.
While the capital gains tax affects anyone selling a capital asset, higher-income individuals are typically subject to the tax more so than average Americans. In 2017, individuals in the top 1 percent received about 26 percent of their income from capital gains. That figure compares to less than 1 percent of income for individuals in the bottom 80th percentiles.
Revenues from the tax on capital gains are categorized as part of individual income tax revenues, but they generally account for a modest portion of such collections. In 2019, the most recent year for which data are not affected by temporary distortions resulting from the pandemic, taxes from capital gains constituted about 11 percent of individual income tax revenues, totaling $183 billion or 0.9 percent of gross domestic product (GDP).
Revenues from the capital gains tax can be volatile, reflecting changes in economic activity — especially during recessions. For example, revenues from capital gains dropped from $100 billion in 2001 to $58 billion in 2002, a 41 percent decrease in just one year. That same pattern occurred during the financial crisis over a decade ago, with capital gains revenues decreasing by 49 percent from 2008 to 2009. However, that trend was not repeated during the current downturn; revenues from capital gains are expected to increase marginally during 2020 and 2021, driven by rapid growth in housing sales — which saw existing home sales increase by 6 percent in 2020 — and the stock market (the S&P 500 rose 16.3 percent in 2020).
Despite the recent growth in capital gains revenues, the Congressional Budget Office anticipates that receipts from the tax will decline to 0.7 percent of GDP, or 7 percent of individual income tax revenues, by 2031.
Recently, the Biden Administration proposed reforms that would restore the top marginal income tax rate to 39.6 percent, and, for households making over $1 million in a year, apply that rate to long-term capital gains. The plan also calls for the elimination of the step-up basis. In general, proponents of increasing the tax’s burden note that it could raise additional revenues and promote a more equitable tax system that treats different kinds of income more uniformly. On the other hand, advocates for reducing the tax’s impact argue that doing so may increase economic growth and promote entrepreneurship. Below are a number of potential changes — including those proposed by the Biden Administration — that have been discussed in recent years and their fiscal impact:
The capital gains tax is a relatively small but crucial component of our tax system. Modifying the tax treatment of capital gains is one way that the current administration has proposed to collect more revenues to offset the cost of other proposals. The discussion about our fiscal foundation is an important one; as the country recovers from the pandemic, lawmakers should look at both the revenue and spending sides of the budget and work together to find solutions that chart a more sustainable fiscal path.
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