How Does the Capital Gains Tax Work Now, and What Are Some Proposed Reforms?
Last Updated August 26, 2024
The capital gains tax is a levy on the profit received from the sale of a capital asset. That profit, known as a capital gain, is taxed at a lower marginal rate than ordinary income if the asset is held for more than a year. While revenues received from taxing capital gains are modest, accounting for 11 percent of individual income tax receipts in 2023, changes to the tax could have significant implications for the country’s fiscal and economic health.
Below is a brief look at how the tax on capital gains works, what assets and individuals are most affected by it, and the fiscal implications of some commonly discussed changes.
How Does the Capital Gains Tax Work?
Most of what an individual owns — including securities like stocks and bonds, real estate, or even personal-use items like jewelry and furniture — is considered a capital asset and therefore may be a capital gain when sold. In 2015, the latest year for which Internal Revenue Service (IRS) data are available, 83 percent of transactions where a capital asset was sold were from stocks and mutual funds. However, gains from pass-through entities (like sole-proprietorships or partnerships) accounted for most of the value of capital gains reported to the IRS in 2015: $349 billion out of $686 billion.
How Does the Tax on Capital Gains Work?
Currently, capital gains are only taxed when they are “realized,” meaning a capital asset is sold for a profit. For example, the gain in value of a stock is only taxed when the stock is sold. The tax rate for a capital gain is based on the amount of time the capital asset was held:
- Short-term capital gains occur when assets are sold after being held for less than one year and are taxed as ordinary income, with a top marginal rate of 37 percent (the same as wages or salaries).
- Long-term capital gains occur when assets are sold after being held for more than one year and are taxed at lower rates than ordinary income, with a top marginal rate of 20 percent.
However, if a capital asset is sold at a loss, taxpayers can use that capital loss to offset any capital gains in the same year. If capital losses exceed gains, taxpayers can deduct up to $3,000 a year from taxable income; net losses larger than that amount can also be carried forward to deduct against income in future years. Taxation of capital gains can also be excluded or further reduced under certain scenarios. For example, capital gains from the sale of a primary residence can be excluded up to a certain limit. Similarly, the “stepped-up basis” on capital gains, where the tax basis of an asset is adjusted to reflect the asset’s current value upon the owner’s death, can reduce the amount of gains claimed when the asset is sold.
Who Pays the Capital Gains Tax?
While the capital gains tax affects anyone selling a capital asset, high-income taxpayers are typically subject to the tax more than average Americans because more of their income comes from capital gains. In 2021, those with adjusted gross income (AGI) of more than $1 million reported an average $1.6 million in capital gains, accounting for 42 percent of their income. By comparison, taxpayers with AGI less than $100,000 in 2021 reported an average of $708 in capital gains, or only 2 percent of their income.
How Much Does the Government Receive From Capital Gains Taxes?
Revenues from the tax on capital gains are categorized as part of individual income tax revenues, but they generally account for a modest portion of such collections. Over the past two decades, receipts from capital gains averaged about 9 percent of such revenues per year, totaling $137 billion, or 0.7 percent of gross domestic product (GDP).
However, annual revenues from the capital gains tax have historically been volatile, reflecting changes in economic activity — especially during recessions. For example, such revenues dropped from $100 billion in 2001 to $58 billion in 2002, a 41 percent decrease in just one year. That same pattern occurred during the financial crisis over a decade ago, with capital gains revenues decreasing by 49 percent from 2008 to 2009. That trend did not recur during the pandemic-related recession in 2020, and such receipts increased by 10 percent that year and 64 percent in 2021 partially due to a strong stock market. Capital gains revenues eventually moderated, reaching $246 billion, or 0.9 percent of GDP, in 2023, and are projected to continue declining over the coming decade.
Modifications to the taxation of capital gains, including the reduced tax rate and the stepped-up basis, are considered tax expenditures in the federal budget and result in foregone revenues. The amount of tax expenditures from capital gains have typically exceeded the amount of revenues the federal government brings in from the tax. In 2023, such expenditures totaled $361 billion — exceeding revenues from the tax by nearly 50 percent.
What Are Some Proposed Reforms to the Capital Gains Tax?
If, and how, the capital gains tax should be reformed is a subject of many tax policy debates. Some economists and policymakers contend that the tax’s burden on certain taxpayers should be increased to help mitigate any undesirable economic effects, promote a more equitable tax base, or increase federal revenues. Others suggest that the tax’s impact should be reduced to spur investment and promote entrepreneurship. Some common proposals to reform the tax include:
- Increasing the capital gains tax rate. Proponents of raising the tax rate on capital gains argue it would increase tax fairness by limiting the preferential treatment of long-term capital gains, which mostly benefits high-income taxpayers. The Tax Policy Center estimates that the revenue-maximizing rate on capital gains is about 28 percent, but warn that increasing the tax rate without other reforms could exacerbate existing lock-in effects. Accounting for such tradeoffs, the Penn Wharton Budget Model estimated that increasing the top rate from 20 percent to 24.2 percent would increase revenues by $66 billion over a 10-year period.
- Removing the ‘step-up’ basis of capital gains at death. Currently, if the owner of a capital asset passes away and bequeaths that asset to someone else, the basis of the asset will be adjusted to reflect the asset’s current value. For example, if an asset was purchased for $100,000, then bequeathed and inherited at $150,000, the tax basis of the asset would be adjusted to $150,000. If the heir then sold the asset at that price, they would not owe any taxes on the gains accrued prior to their inheritance (the $50,000 in profits). Removing that step-up basis would subject the full $50,000 profit to taxation. In 2020, the Congressional Budget Office estimated that such a policy would increase revenues by $110 billion over a 10-year period.
- Taxing capital gains on an accrual basis. Instead of taxing capital gains when an asset is sold, an accrual system would tax the annual increase in an asset’s value, even if the asset were not sold (also known as a mark-to-market system). While such a system would involve an annual valuation of capital assets and likely require significant resources from the Internal Revenue Service, it would limit the amount of capital gains that are deferred and raise a significant amount of revenues. Tax policy experts at New York University estimated that an accrual system limited to only marketable assets for the top 1 percent of households would raise around $1.7 trillion over 10 years.
- Indexing capital gains to inflation. Currently, capital gains are not adjusted for inflation over the time the asset was held. Such an adjustment would decrease the income subject to taxation, thereby reducing tax liabilities. For example, a $10,000 purchase in January 2014 had the same buying power as $13,185 in January 2024; if sold on that date for $20,000, the seller would be subject to taxes on an inflation-adjusted $6,815 gain opposed to the nominal $10,000 gain. The Tax Policy Center estimated that such a change could decrease federal revenues by $20 billion per year.
Conclusion
The capital gains tax accounts for a relatively small portion of all individual income taxes, but it is a crucial component to maintaining a fair tax system. Reforms to the capital gains tax could increase revenues, increase the progressivity of federal income taxes, and reduce its distortionary effects. As the United States faces growing deficits and larger interest costs, lawmakers should look at both the revenue and spending sides of the budget and work together to find solutions that chart a more sustainable fiscal path.
Image credit: Photo by Spencer Platt / Getty Images
Further Reading
The Next Fiscal Cliff: Big Tax Decisions to Make in 2025
Some TCJA provisions were made temporary to limit the negative fiscal impact of the 2017 bill. It sets up a significant decision point for policymakers next year.
How Do We Tax the Top 1% — And What That Means for the Federal Budget
The top 1 percent pay a significant share of all federal taxes, while also benefitting disproportionately from preferential tax treatment.
What is Stepped-Up Basis on Capital Gains and How Does it Affect the Federal Budget?
The step-up in basis is a provision in tax law that relates to how assets — such as stocks, bonds, or real estate — are valued and taxed after their owner passes away.