During last week’s hearing of the Senate Finance Committee, the Joint Committee on Taxation (JCT) reported that the effective tax rate for the nation’s highest-income taxpayers was 34 percent in 2019. In a rare “rejoinder” of the well-respected tax-scoring experts, Chairman Ron Wyden (D-OR) described JCT’s estimate as misleading, labeling it “funny math.”
On the other hand, Ranking Member Crapo (R-ID) lauded JCT’s estimate, explaining “[t]he Biden-Harris Administration has repeatedly—and falsely—claimed that the federal tax rate for high-income earners is only 8 percent, but [JCT] recently confirmed their average rate is quadruple that amount, at 34 percent.”
Their dispute dances around the deeper problem: Trillions of dollars of unrealized capital gains permanently escape taxation, disproportionately benefitting the richest Americans. Rather than argue about rates, Congress could close this loophole, and there is a sensible way to do so, taxing these unrealized gains at death at a higher rate than during life.
Which is it: 34 or 8 percent?
Most estimates—including those by TPC, Treasury, CBO, and JCT—put the effective individual income tax rate on the highest-income households somewhere in the middle, about 25 percent for 2021.
The top marginal tax rate on the highest-income households is 37 percent. Marginal rates apply to segments (or brackets) of income, not all of it. That 37 percent, for instance, applies in 2024 only to income over roughly $600,000 for an individual). All the income below that level faces several different lower rates.
An effective tax rate is the average of all those marginal rates (a taxpayer’s total tax paid divided by her total income). In our progressive tax system, both average and marginal tax rates are designed to rise with income.
But Wyden is correct: JCT’s 34 percent is “funny,” compared to 25 percent, the effective individual income tax rate at the top for the same year, which JCT reported in the appendix of its report. In part, that's because the 34 percent also attributes Federal corporate, payroll, estate, and excise taxes to individuals, which the Senator may not have expected.
But Crapo is also correct. The Biden Administration’s 8 percent tax rate is “funny” because it counts unrealized capital gains, which are increases in the value of stocks, bonds, and other assets that have not yet been sold, as income.
Unrealized gains are massive, and benefit those who hold them.
My TPC colleague, Rob McClelland, in a forthcoming paper estimates unrealized capital gains now total about $50 trillion based on the Federal Reserve’s 2022 Survey of Consumer Finances, combined with Forbes 400 information (which is excluded from the Fed’s survey). He estimates the top .05 percent, those households with more than $100 million of wealth, have about $10 trillion in unrealized gains.
The tax code generally does not count unrealized capital gains as income. But, if they were counted, effective tax rates would be much lower, closer to that 8 percent figure. The Biden Administration acknowledges its different measure of income, noting that its “tax rate estimates are substantially lower than commonly cited top Federal individual income tax rates” that have ranged from 23 percent to 26 percent.
Why would the Biden administration use a figure that includes income that has not yet been turned into cash? Because economists generally consider unrealized gains "economic" income, conferring an economic benefit on the investor. The investor can use her benefit in a variety of ways but should, by this reasoning, pay taxes on it, just like she would on her wages, realized gains, or other forms of income.
Wyden also contends, mistakenly, that JCT’s higher rates result from ignoring the “buy-borrow-die” technique used by some high-income taxpayers to exploit the increased value of their investments. These taxpayers borrow against the appreciated value (unrealized gains) of their purchased property. When they ultimately pass on their appreciated property at death, their heirs take the asset at a stepped-up basis, which resets the inherited asset’s cost basis to its fair market value—effectively erasing that unrealized gain and avoiding any tax.
But borrowing by centimillionaires (those worth a hundred million dollars) and billionaires “makes up only a relatively small fraction of their gains.”
And the real problem is not the “borrow” but the “die,” or the tax code’s permanent exclusion of unrealized gains which escape tax at death.
Wyden would require the billionaires to treat their assets as sold annually, and realize the gain as income for that year. President Biden would require the same of those with assets of more than $100 million. But both proposals raise serious administrative and legal issues.
Taxing unrealized gains at death is both possible and necessary.
Taxing the wealthiest households on their unrealized gains at death is much easier to administer and defend legally than annually taxing unrealized gains during a lifetime.
Taxing at death could use estate tax returns, including valuations, that wealthy people already file. Collecting tax on transfers by gift or bequests is well-established under the US Constitution. And setting tax rates at death higher than tax rates during life–such as by charging the top ordinary tax rate rather than the discounted capital-gains rate, a difference right now of 17 percentage points—could induce more sales during life, freeing up assets in the marketplace and accelerating tax receipts.
Rather than argue about tax rates of the super-rich, policymakers would do well to focus on how best to collect taxes on the trillions of dollars that escape income taxation permanently.
