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2 Big Mistakes in Democrats' Tax-Hike Plan

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What You Need to Know

  • Attempting to please both progressives and moderates has led to messy compromises that create more problems than they solve.
  • Raising the rate on capital gains without eliminating a key loophole won’t work.
  • Nor will a provision aimed at fund managers.

The tax committee in the House of Representatives released some long-awaited details Monday of how Democrats plan to raise taxes on top earners to help pay for social programs. It’s an effort to split some of the wide differences between the soak-the-rich tendencies of the party’s activist progressives and the be-careful-what-you-wish-for centrists.

That’s a tough balance to strike, and the strain shows, especially in two messy compromises that would create more problems than they solve.

The first is a failure to close a long-standing loophole in the tax code, which will sabotage a key tax increase Democrats were relying on to deliver enough revenue to finance their programs. The loophole involves the special treatment of investment gains when taxpayers die, a boon to wealthy families when they pass these gains along from generation to generation. As the proposal now stands, the special treatment would be maintained in a way that undermines the revenue benefits of raising the capital gains tax.

Under the current system, most investors aren’t taxed on any appreciation in their portfolios when they die. In other words, in the eyes of the Internal Revenue Service, dying isn’t a taxable event (unless your estate is worth more than $11.7 million). As an added bonus, heirs get to ignore any appreciation of assets that happened prior to when they inherited them.

Here’s a hypothetical example: Let’s say an investor had bought $200,000 worth of Apple shares that appreciated to $2 million. She wouldn’t owe capital gains tax on the $1.8 million of appreciation when she died. In turn, her heir would inherit the $2 million of Apple shares and only owe capital gains tax on the difference between the $2 million and any subsequent appreciation of the Apple stock if and when she sells.

Earlier this year, President Joe Biden proposed a way to get at that $1.8 million of untaxed gains. Under his plan, the deceased would owe capital gains tax on any unrealized gains. He called for an exclusion of $1 million per person, or $2 million per couple, so amounts under that wouldn’t be subject to the tax. And he made accommodations for family-owned businesses.

In Monday’s tax package, Democrats remained silent on the question of how to handle investment gains at death, arguably one of the biggest loopholes in the tax code. But they still proposed increasing the top capital gains rate to 25% from 20% for wealthy investors. (An earlier Biden proposal had called for nearly doubling the top rate to almost 40% for those earning more than $1 million.)

By raising the rate without eliminating the loophole, the plan gives investors a powerful incentive to just hang onto their stocks to avoid the higher rate and pass investments tax-free to their heirs. That’s inefficient, distorts the market and won’t raise the kind of revenue Democrats need to offset their spending package.

In another misstep, the Democrats suggested a superficial fix for the special tax treatment enjoyed by fund managers. Under the current tax code, hedge fund and private equity managers are eligible for a much lower tax rate than most other earners. Their compensation is called carried interest and is considered to be a capital gain, qualifying for a top rate of 20% instead of the current top ordinary income tax rate of 37% paid by most wage earners.

For years, Democrats and some Republicans have said the preferential treatment is unfair. In 2017, the tax law enacted by President Donald Trump and a Republican Congress took a swipe at carried interest and said managers had to hold assets they were earning compensation on for at least three years (instead of one year) to qualify for the 20% rate. In Monday’s proposal, Democrats moved the goalpost slightly by extending the holding period to five years.

Since the average holding period for assets in private equity funds is more than six years, what Democrats are proposing seems highly ineffectual. At the very least, lawmakers should consider extending the holding period to a period of time greater than six years.

There are other proposals in the Democrats’ package that target high earners, such as increasing the top personal income tax rate to 39.6% from 37% and a surtax on those making more than $5 million a year. If Democrats want to level the playing field, raising rates on top earners is a start, but they’ll have to go a lot further to create a more equitable tax system that delivers enough money to pay for the things they want to do.

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Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.

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