L12: Capital Gains and Estate Taxation

Question 1

why lump capital gains and estate taxes?

Answer 1

neither accounts for a large share of federal tax revenue but are interesting

progressive elements of the tax system in terms of where they fall in the income distribution

concentration among wealthy and their design make them subject to considerable behavioural responses

modified frequently, allowing for research

Question 2

capital gain

Answer 2

difference between an asset’s purchase price and sale price

Question 3

key tax provisions for capital gains taxation

Answer 3

taxation on realisation (when they choose to sell the asset)

maximum tax rate of 20% (nearly half of top rate on other income)

step up of basis at death
- if you die, capital gains accrued over lifetime go away

no capital gains on housing are taxed

limited loss offset: only $3000 of net losses deductible against other income

Question 4

effects of capital gain taxation: risk taking

Answer 4

capital gains tax applies to gains but only allows a limited deduction for losses

discourages risky investments that are subject to uncertain returns

Question 5

effects of capital gain taxation: lock in

Answer 5

tax applies only when asset is sold
- creates a lock-in effect which encourages investors not to sell assets even if they otherwise would wish to do so

encourages individuals to hold appreciated assets because government allows them to defer paying taxes on gains they already earned

if assets have lost value, incentive is opposite - sell as soon as possible to get a deduction for the loss against other income

Question 6

effects of capital gain taxation: timing

Answer 6

taxes on realisations lead to large behavioural responses with respect to changes in tax rates

if tax rate is expected to fall, individuals have a stronger reason to wait to realise gains, to benefit from a lower tax rate

Question 7

effects of capital gain taxation: entrepreneurship

Answer 7

a large share of earnings from successful new enterprises come as capital gains

arguments for lower taxes:
- startups are risky and many fail so lack of loss offset strongly discourages this activity unless the tax rate is reduced
- innovation has positive externalities so tax policy should encourage it

but even if entrepreneurship faces a lower rate, most capital gains do not come from entrepreneurial activities

Question 8

effects of capital gain taxation: taxation of ‘phantom’ gains from inflation

Answer 8

capital gains tax applies to nominal earnings not adjusted for inflation
- gains overstate increases in purchasing power

argument in favour of lower tax
- some gains you pay tax on aren’t real gains

Question 9

possible reforms to capital gains tax

Answer 9

tax all or some of capital gains as ordinary income
- progressive, but wrong side of Laffer curve

tax capital gains at death
- reduces lock-in but discourages saving

tax capital gains on accrual
- feasible to reduce lock-in and timing

tax delayed realisations at higher rates

Question 10

estate taxation

Answer 10

raises less than capital gains taxes

more concentrated than capital gains
- applies to <0.1% of decedents
- raises taxes from a very small group of people

Question 11

effects of estate taxation

Answer 11

providing resources for children/heirs
- government makes it less worthwhile to save since they take more
- if you want to leave something to your kids, but the government takes some of it away, you have to save more

ensuring against ‘outliving’ assets
- motivations for saving won’t be influenced by tax under this argument
- accidental bequests shouldn’t be responsive to taxes imposed after death

Question 12

evaluating estate taxation

Answer 12

social welfare
- get a bonus if parents add to the SWF and they leave money to their children, which also goes to the SWF

negative social effects to the persistence of wealth
- wealth dynasties have bad social effects (i.e. changing direction of public policy)

complicated to implement in valuing assets

welfare effects balance strong progressivity against potential behavioural responses
- figuring out ways to shield assets or make them look like they’re worth less
- inequity - extent that those who are aggressive and pay lower taxes are rewarded for their activity that doesn’t contribute to equity

Question 13

possible reforms

Answer 13

tightening rules to reduce scope for estate planning

shift to progressive inheritance tax, based on recipients’ ability to pay
- the more people the amount is spread over with the progressive tax means the lower the total tax liability is

get rid of estate tax but tax capital gains at death

shift to annual tax on wealth