Could an increase in the capital gains tax be a tax revenue detractor?
If we were to examine the same example but apply a 25% capital gains tax rate, as shown in figure 2 below, we can see that the tax drag over the same ten-year time period diminishes the investment return by $192,393.68 or 19.2%.
Figure. 2 (assumes annualized growth of 11.55% and a 25% capital gains rate)
This example does not include state income taxes or the Medicare surtax of 3.8%, which is a tax on investment income for individuals with a combined net investment income and modified adjusted gross income of more than $200,000 for single filers and more than $250,000 for married filing jointly. If an individual were to live in a high tax state such as New York or New Jersey, taxes on investment income could be nearly 40%! How might investors react to these increased tax rates?
Investors typically sell investment assets for one of two reasons. First, they may need to sell assets to generate cash for liquidity needs. For example, an individual may need to sell down assets if they are looking to purchase a new home or to simply support general living expenses. Second, investors may look to reposition their investable assets to take advantage of changes in the economic landscape (i.e., rotating from Large Cap to Small Cap or U.S. to International) or may be adjusting their overall risk profile as they adapt to changes in life events. In either case, a higher taxation on realized gains creates a “lock in” effect. Investors will find that they are financially rewarded by deferring the sale of assets for as long as possible. As a result, investors are likely to seek out alternatives to selling their assets to achieve liquidity or diversification goals.
For investors looking to sell assets and raise cash, who may have a need to coordinate different timing for tax planning, one alternative they may consider is using margin or security backed loans, rather than selling their investments. A margin or security backed loan allows you to borrow against the value of the investments in your portfolio, while using the assets in the portfolio as collateral for the loan. For example, an investor who is looking to raise $500,000 for cash needs and has a $5,000,000 portfolio with a cost basis of $1,000,000, could face a tax liability of approximately $100,000 if the capital gains rate were to increase to 25% (excluding Medicare surcharge and state taxes). Rather than selling assets, let us assume that same investor borrows the $500,000, while letting the original $5,000,000 continuing to grow. Over a five-year time-period, the investor could net approximately $100,000 in additional return, even after paying back the loan. In addition to yielding nearly $100,000 in investment return, the investor now has additional time to weigh their decisions around realizing taxable gains.
While borrowing is one alternative to deferring gains, portfolio hedging strategies can also be an effective strategy for investors who are looking to adjust the risk profile of their portfolio, while continuing to defer gains. Portfolio hedging strategies typically involve the use of financial derivatives, such as options, to minimize the negative impact of an investment. Option contracts give the buyer the right, but not that obligation to buy or sell an underlying asset at an agreed upon price and date. There are two types of option contracts, “calls” and “puts.” Call options allow the holder to buy an asset at a specified price, while put options allow the holder to sell at a specified price. For example, if an investor owns a large position in Apple stock and is concerned about short-term price swings and wants to protect the portfolio from losses, they could consider purchasing “put” options on Apple. Because put options appreciate when the underlying asset falls, a decline in the price of Apple would be offset by the profits of the put option. Investors may benefit from utilizing options to protect their portfolio, but hedging strategies come at a cost and investors should weigh the costs of the hedge against the potential benefits. Additionally, it is important to keep in mind if the stock price exceeds the strike price of call options, it is likely those options will be exercised, and you will have to sell the stock and trigger the gain on the sale.
Not only will investors find ways to generate liquidity and diversification through the means mentioned above, but a higher tax on capital gains may even encourage investors to hold their investments until death and receive a step up in cost basis. The stepped-up basis at death allows the cost basis of an inherited asset to be stepped up to its value at the time of the original owner’s death, reducing the capital gain liability for the individual inheriting the asset. This can be a very tax-efficient way to accumulate and pass on wealth to next generations. For example, let’s say an individual buys 1,000 shares of stock at $10 a share for a total cost of $10,000 and leaves them to their heir. If the stock is worth $100 per share at the individual’s date of death, the legatee’s cost basis would now be the current market value of $100 per share. The appreciation from $10 to $100 would not be taxed, and any future capital gains taxes paid in the future would be based on the $100 per share cost basis.
The step-up in basis provision is widely criticized as a loophole for the ultra-wealthy. Although the Biden administration had previously proposed eliminating the stepped-up basis at death, the most recent proposal contained no such provision. Additionally, there would be many administrative challenges in implementing an elimination of step-up such as determining when a recognition event took place (at death or when a beneficiary sold the asset) and generally tracking basis over a long period of time between owners.
Overall, a higher capital gains rate may seem like an easy solution to raising tax revenue, but it can come with many adverse effects as well. Whether an investor borrows against their portfolio, hedges the portfolio, or simply holds the assets to death, the options wealthy individuals have available to defer gains could potentially lead to being a tax revenue detractor rather than a revenue enhancer. Not only do individuals have options to defer gains, but a higher capital gains rate may discourage risk taking and entrepreneurship, which could lead to slower economic growth.