Uncertainties Associated with Biden’s Capital Gains Tax Proposal Likely to Weigh on Markets

By Stuart E. Leblang, Michael J. Kliegman and Amy S. Elliott

Leaks of details on how President Joe Biden will pay for his human infrastructure plan—the American Families Plan—hit the popular press April 22.¹  And as headlines such as “Biden Eyeing Tax Rate as High as 43.4% in Next Economic Package” ² started to sink it, the market reacted negatively, causing the S&P 500, Dow and Nasdaq to all fall more than 1 percent week-to-date. ³ 

The proposals are not new.  Taxing long-term capital gains at 39.6 percent instead of 20 percent for those making over $1 million—not including the 3.8 percent tax on net investment income— and repealing stepped-up basis at death were both Biden campaign promises.  We wrote about the impact they would have on business back in September 2020. ⁴  According to an April 23 Penn Wharton Budget Model estimate that assumes the changes do not go into effect until 2022, the proposals would raise $113 billion over the next 10 years.  However, if repeal of stepped-up basis at death is not included, then the capital gains tax hike would actually lose revenue (by $33 billion over the next 10 years). ⁵ 

The possible tax hikes are becoming more real now that Biden plae ns to communicate details of the American Families Plan, which is expected to increase investments in childcare and education and include a proposed way to pay for such investments (namely by increasing taxes on high-incomindividuals), during his April 28 Joint Session Address to Congress. ⁶ 

What is new is rumors that Biden may make the effective date for such a capital gains tax increase retroactive to January 1 of this year, so as to avoid a market sell-off. ⁷  While we suspected that a retroactive capital gains tax increase proposed at the start of the year could be in play (even though it would raise less revenue), we predicted that the narrow margins in Congress would ultimately only allow for something more tempered.  Our view has not changed.

History of Retroactive Tax Increases

We still believe that the chances of enacting a retroactive capital gains tax increase this Congress are slim.  But there is a risk.  As we have previously reported, past increases to the capital gains tax rate have generally been prospective. ⁸   For example, the Tax Reform Act of 1986 had the effect of raising the maximum capital gains rate from 20 percent to 28 percent.  But the change was prospective—effective for taxable years beginning on or after January 1, 1987.  Similar increases enacted in 1976 and 1969 were also prospective (with some exceptions in the latter case for amounts received under certain binding contracts, installment payments or distributions pursuant to sales or liquidations in effect as of the time of enactment).

That said, retroactive tax increases have been upheld by the courts.  On August 10, 1993, President Bill Clinton (who had just taken office that year) signed into law the Omnibus Budget Reconciliation Act of 1993 (P.L. 103-66).  It increased the top estate and gift tax rate from 50 percent (a reduced rate that had just gone into effect on January 1, 1993) back to 55 percent (for taxable estates over $3 million) effective for “decedents dying and gifts made after December 31, 1992.” The retroactive tax increase was challenged, but the courts held that it did not violate the Due Process or Takings Clauses of the Fifth Amendment.  They found that that tax increase had “a rational legislative purpose and its period of retroactivity is modest.” ⁹ 

Specifically, retroactive changes are more likely to be upheld when they are set to “apply to the full calendar year in which they are enacted.” ¹⁰ 

Likely Rate and Effective Date

Just because the tax on capital gains could go to 43.4 percent effective back to January 1, 2021 does not mean that it likely will.  We expect that legislation such as the American Families Plan will originate in the House (bills for raising revenue are supposed to originate in the House, and the committee of jurisdiction would be Ways and Means, chaired by Massachusetts Democrat Richard Neal (D-MA)).  Until November, Democrats in the House can only lose the support of two of their members and still have enough votes to pass partisan legislation. ¹¹ 

We suspect that there will be many more than two House Democrats who will have trouble with these proposed tax changes.  This is because there is a perception that increasing the capital gains tax rate and repealing stepped-up basis at death will rile not only the stock market (impacting everyday American workers with a 401(k) retirement account) but also the extremely vocal and persuasive constituency against increased estate taxes ¹² (think American family farmers).

Because of that, we suspect a much more likely change would be to increase the top rate on capital gains to only around 28 percent and make no change to the rules regarding stepped-up basis at death.  That more modest increase in the rate might have some chance of raising revenue without scaring off too many moderate Democrats.  The most likely effective date for such a capital gains tax increase would be the date the planned increase is announced ¹³ (which could be April 28 or tied to committee action later in the year).

While politics will play a significant factor in what gets enacted and when it goes into effect, the revenue score will also be critical.  As mentioned, moving from a 20 percent top rate on capital gains to a 39.6 percent top rate actually loses money unless it is paired with a repeal of stepped-up basis at death.  In December 2018, the Joint Committee on Taxation (JCT) estimated that raising the tax rate on long-term capital gains by 2 percentage points across the board (from 20 percent to 22 percent for the higher bracket) without repeal of stepped-up basis at death would generate nearly $70 billion over 10 years.  ¹⁴ 

Details of Basis Step-up at Death Repeal

If repeal of stepped-up basis at death is included in legislation this year, it will be critical to pay attention to the exact proposal.  Biden’s plan may simply provide that any assets that are transferred upon death would get a carryover basis in the hands of the recipient.  That transfer upon death would not trigger a capital gains tax (only, possibly, an estate tax).  The impact of the carryover basis would not be felt unless and until the assets are actually sold.  In December 2018, JCT estimated that such a change would generate $104.9 billion over 10 years. ¹⁵ 

On the other hand, President Barack Obama called for repeal of stepped-up basis at death that would also trigger gain recognition upon death—meaning death would be treated as a realization event.  This is also what is proposed in a bill recently introduced by Democrats called the Sensible Taxation and Equity Promotion or STEP Act. ¹⁶   Such proposals would essentially require that any inherited unrealized capital gains are taxed, because they would be treated as sold for fair market value at the time of gift or death.

The STEP Act would provide for a deduction for estate tax purposes so that you are not double taxed (having to pay both capital gains taxes and estate taxes), and it would provide an exemption of only $1 million.  There are some special rules and exceptions (including for transfers to spouses and charities and for tangible personal property other than collectibles).  The bill would also do away with valuation discounts.

In conclusion, this development is yet another sign that the gold standard for tax reform— bipartisan plans that do not increase taxes on the middle class, that are enacted through regular order (not reconciliation) and that avoid deficit-financed tax cuts—is unrealizable in today’s political climate.  Capital gains taxes have become a third rail, because there is a perception that changes to them can have a dramatic impact on the markets.  We will be closely following developments in this area and will provide updates as warranted.

^{[1] Jim Tankersley, Biden Will Seek Tax Increase on Rich to Fund Child Care and Education, N.Y. Times, April 22, 2021 (https://www.nytimes.com/2021/04/22/business/economy/biden-taxes.html).}

^{[2] Laura Davison and Allyson Versprille, Biden Eyeing Tax Rate as High as 43.4% in Next Economic Package, Bloomberg, April 22, 2021 (https://www.bloomberg.com/news/articles/2021-04-22/biden-to-propose-capital-gains-tax-as-high-as-43-4-for- wealthy).}

^{[3] Yun Li and Thomas Franck, Stocks rise slightly, but head for losing week on higher tax fears, CNBC, April 22, 2021 (https://www.cnbc.com/2021/04/22/stock-market-futures-open-to-close-news.html).}

^{[4] See our report “Predicting How Biden’s Tax Hikes Would Impact Business” (Sept. 10, 2020).}

^{[5] John Ricco, Revenue Effects of President Biden’s Capital Gains Tax Increase, Penn Wharton Budget Model, April 23, 2021 (https://budgetmodel.wharton.upenn.edu/issues/2021/4/23/revenue-effects-of-president-bidens-capital-gains-tax-increase).}

^{[6] “[Y]ou can expect that he’ll outline the details of the American Families Plan in his Joint Session Address to Congress next Wednesday, April 28th. . . . the package will be laid out in the speech next week,” said Biden Press Secretary Jen Psaki during the April 22, 2021 press briefing at the White House (https://www.whitehouse.gov/briefing-room/press-briefings/2021/04/22/press-briefing-by-press-secretary-jen-psaki-special-presidential-envoy-for-climate-john-kerry-and- national-climate-advisor-gina-mccarthy-april-22-2021/).}

^{[7] Steve Goldstein, Get ready for $178 billion of selling ahead of the capital-gains tax hike.  These are the stocks most at risk., MarketWatch, April 23, 2021 (https://www.marketwatch.com/story/get-ready-for-178-billion-of-selling-ahead-of-the-capital-gains-tax-hike-these-are-the-stocks-most-at-risk-11619174251).}

^{[8] See our prior reports:  “Handicapping Potential Effective Dates for Tax Reform Based on Historical Precedent” (Feb. 8, 2017) and “Predicting How Biden’s Tax Hikes Would Impact Business” (Sept. 10, 2020).}

^{[9] Kane v. U.S., 118 F3d 1576 (3d Cir. 1997), which relied on U.S. v. Carlton, 512 U.S. 26 (1994).}

^{[10] See Retroactive Legislation:  A Primer for Congress authored by Joanna R. Lampe and published by the Congressional Research Service Aug. 15, 2019 (https://fas.org/sgp/crs/misc/IF11293.pdf).}

^{[11] At this time, we suspect that legislation such as the American Families Plan will make its way through Congress via a budget reconciliation vehicle and would likely bypass committees in the Senate (avoiding a mark-up and going straight to the floor).}

^{[12] Although Biden has not yet made clear that he wants to use a reduction in the estate tax exemption as a pay-for for his American Families Plan, there is speculation that he might consider reducing it from its 2021 level of $11.7 million per individual to possibly as low as $3.5 million per individual.  However, even if he does not touch the exemption, repealing stepped-up basis at death has a huge impact on estate tax considerations.  Basis step-up at death permanently wipes away the potential capital gains taxes otherwise due on the appreciation that occurred during the decedent’s lifetime if the assets are later sold.}

^{[13] It could also be tied to committee action (i.e., a mark-up) or to when a discussion draft or press release announcing the details of the tax hike is released (maybe by one of the tax committees).}

^{[14] https://www.cbo.gov/budget-options/2018/54788; However, see The Tax Elasticity of Capital Gains and Revenue-Maximizing Rates, a Dec. 23, 2020 working paper by Ole Agersnap and Owen Zidar, which argues that “proposals to raise capital gains tax rates may raise substantially more tax revenue than official scorekeepers expect.” Specifically, the paper states that “raising capital gains tax rates by 5 percentage points (in the current regime with unlimited deferral and step-up-basis at death) would yield 18 to 30 billion in annual tax revenue, which is roughly twice the amount implied by the current approach of the Joint Committee on Taxation (https://scholar.princeton.edu/sites/default/files/zidar/files/capgains.pdf).  See also the working paper by Natasha Sarin, Lawrence H. Summers, Owen M. Zidar & Eric Zwick entitled Rethinking How We Score Capital Gains Tax Reform, which states that “raising capital gains rates to ordinary income levels could raise $1 trillion more revenue over a decade than other estimates suggest” (https://www.nber.org/system/files/working_papers/w28362/w28362.pdf).}

^{[15] Options for Reducing the Deficit:  2019 to 2028, Congressional Budget Office, December 2018 https://www.cbo.gov/system/files/2019-06/54667-budgetoptions-2.pdf}

^{[16] Introduced by Rep. Chris Van Hollen (D-Md.), Sen. Cory Booker (D-N.J.), Sen. Bernie Sanders (I-Vt.), Sen. Sheldon Whitehouse (D-R.I.) and Sen. Elizabeth Warren (D-Mass.).}