Capital Gains Taxes: A Huge Economic Drag

Washington politicians are back discussing and even trying to reinvent the capital gains tax. 

The Biden Administration, in Spring of 2024, proposed increasing the top tier of the tax to 39.6%. The administration also seeks a 25% levy even on unrealized capital gains (growth in investments that haven’t yet been sold), and to eliminate an existing exception for real estate gains. The move has reignited a debate over the wisdom of the entire capital gains tax concept. Already, it seems to reduce liquidity and cause misallocation in the economy, and Biden’s proposals would worsen things.

Capital gains taxes work by taxing the proceeds from the sale of an asset, like a property or a company share. That same asset may grow in value throughout the years, but does not get taxed until those gains are realized by the owner through a sale. 

The danger is that this policy harms overall economic growth by disincentivizing investors from selling assets. This hampers the economy in two ways: first, it keeps capital in unproductive firms, limiting the market signal that they would need to change course. Secondly, it limits the capital supply that would flow into productive firms, particularly upstart ones that haven’t yet received much investment. In short, it makes the economy less liquid. 

Biden’s proposal would further worsen things. For one, capital gains represent income that is already taxed multiple times. The Tax Foundation’s Kyle Pomerleau illustrates the scenario of a person who invests his savings in the stock market: 

“First, when he earns his wage, it is taxed once by the federal and state individual income tax. He then purchases stock and lets his investment grow. However, that growth is smaller than it otherwise would have been due to the corporate income tax … [When he sells his stock], the gains…are taxed once more by the capital gains tax.”

It should be noted that long-term capital gains tax rates are lower than short-term ones – a policy that purportedly is meant to prevent the instability caused by short-term trading. Nonetheless, the above scenario is a real dynamic.

For another, the U.S. already has high capital gains tax rates relative to peer countries. The top capital gains tax rate (which is based on income) is now 20%. Pomerleau notes that the current federal capital gains rates exceed the OECD average by 51%. Then there are state capital gains taxes: some states, like Florida, don’t have them, while the highest, California, charges 13.3%.  

The proposed increase, which includes a 5% increase in Medicare and net investment income taxes, “would raise the top tax rate on capital gains to 49.9 percent—the highest in the OECD,” claims the Tax Foundation, while combined corporate and capital gains taxes would reach 66%, also the largest among OECD countries.

Taxing unrealized capital gains might create the opposite problem – high earners would likely sell their shares, reducing their tax liability but triggering market instability. 

“Amazon, Microsoft and other big-name companies represent a significant percentage of many Americans’ 401(k)s and retirement funds,” notes Forbes, “and these could take a huge hit if high-earning founders and executives had to dump their shares.”

This has potential ramifications for real estate and the housing crisis facing America, as home and investment property sales also incur capital gains taxes. For example: if an investor in the top tax bracket bought a home back in 2000 at the then-national median sales price of $165,000, and sold it today at the median of $421,000, he would pay about $51,000 in capital gains tax. This becomes even more burdensome for short-term flippers, who often work on thin margins relative to the risk they take. 

There are some ways to reduce or defer the burden: homesellers who live in the home as their primary residence can write off high amounts of capital gains; and the 1031 exchange policy allows investors to defer capital gains obligations after selling property, so long as the sale proceeds go to purchase another investment property. Still though, it is a case of the government using tax policy to steer investment capital into certain sectors not others. 

But under Biden’s current budget proposal, the 1031 exchange would be eradicated. Then the same inefficient “buy and hold” mentality that inflicts the stock market would become even stronger in real estate, which is an illiquid sector to begin with. Homeowners and institutional investors alike will become all the more discouraged from, say, selling their properties in declining markets to reinvest in growing ones. 

Capital gains tax proponents argue that these drawbacks are overstated. The Center on Budget and Policy Priorities argues that exemptions for capital gains enables tax avoidance, and primarily benefit the wealthy, contributing to deficits. A Congressional Research Service memo holds that most evidence points to an ultimately limited impact on the economy from reduced capital gains taxes. 

For their part, the critics of capital gains taxes can point to countries that don’t have such taxes, or have them at low rates, and experience sustained capital inflows, including Singapore, Hong Kong, United Arab Emirates and Saudi Arabia. 

The capital gains increase proposed by Biden, and backed by an increasingly radicalized and populist American Left, poses real economic risks. In particular, ending the 1031 exchange is poised to harm Americans looking for housing, by discouraging reinvestment and turnover in the market. Policymakers ought to weigh the tradeoffs carefully. 

This article contained additional reporting from Market Urbanist content staffer Ethan Finlan.

Cover image authorized for public domain use under the CC0-1.0 Universal Deed.