When individuals sell an asset for more than the purchase price, they generally realize a capital gain that is subject to taxation. Most taxable capital gains are realized from the sale of corporate stocks, other financial assets, real estate, and unincorporated businesses. Long-term capital gains--those realized on assets held for more than a year--are taxed at various rates, most of them below the rates applied to other types of income (typically referred to as ordinary income). The tax rate depends on the year in which the taxpayer realizes the gain, the type of asset, how long the asset has been held, and the taxpayer's other income.
For example, in 2013, under current law, a taxpayer who is in the 28 percent tax bracket, or higher, for ordinary income and who sells corporate stock owned for more than a year will pay a basic tax rate of 20 percent on the realized gain.1 For taxpayers in the 15 percent tax bracket, the comparable basic rate is 10 percent. If the stock has been held for more than five years, special tax rates apply--generally, 18 percent for higher-income taxpayers and 8 percent for taxpayers in the lowest tax bracket.
The tax rate on gains realized from many other assets is the same as that for corporate stock. However, special tax treatment is allowed under certain circumstances:
Beginning in 2013, this option would raise the basic tax rates on realized gains by 2 percentage points--from 20 percent to 22 percent for people in the 28 percent tax bracket or higher and from 10 percent to 12 percent for those in the 15 percent bracket. The special rates for assets held for more than five years, including those for small-business stock, would be repealed. Gains realized after the sale of an asset that was held for productive use or investment could no longer be deferred when the taxpayer purchased a like-kind asset; similarly, no deferral would be allowed when an investor purchased equity in a small business after selling stock in another small firm. The recapture of depreciation from real estate gains would be taxed as ordinary income, without any ceilings on the tax rates. Finally, profits from the sale of livestock also would be treated as ordinary income and taxed as such. If implemented, the changes outlined in this option would raise revenues by a total of $10 billion from 2012 through 2016 and by $49 billion from 2012 through 2021.
An advantage of disallowing special tax treatment for certain types of assets is that it could improve economic efficiency by encouraging investors to focus more on economic factors than on the tax advantages associated with different types of investments. When tax rates are lower on assets held for at least five years, taxpayers may hold on to those assets longer just to lower their tax liability-- even though it might make sense to sell sooner, given economic conditions. Another example is that current law allows taxpayers to defer gains when switching from one real estate investment to another, thus encouraging investment in land and buildings rather than in stocks and other financial assets where deferral is not allowed. In addition, recapturing depreciation deductions as ordinary income would reduce the tax advantage accorded to people in the highest tax brackets who invest in real estate. Simplification of the tax system is another argument for eliminating the special treatment of various assets; with fewer exceptions, most people would find it easier to compute capital gains taxes.
Increasing the basic tax rates on capital gains from corporate stock and most other assets--rather than on ordinary income--also could encourage people to base investment decisions on economic factors rather than on tax advantages. For example, the tax code will encourage businesses to retain profits rather than paying them out as dividends after 2012, when dividends will once again be taxed as ordinary income. By raising the rates on capital gains, the option would reduce that incentive to retain profits. Furthermore, by reducing the difference between the tax rates on ordinary income and those on realized capital gains, people would have less incentive to engage in tax planning to characterize compensation and profit as a capital gain.
Raising the rates at which capital gains were taxed also could have a negative effect on economic efficiency, however, even if those rates were applied uniformly. Raising rates would discourage some people from selling assets when doing so makes sense for economic reasons. Instead, people would hold on to the assets longer to defer the tax--or they might avoid taxes altogether by passing the asset on to their heirs when they die. (The resulting decline in the sales of assets would also reduce the amount of revenue that could potentially be collected from the higher capital gains tax rates.)
Another disadvantage of the option is that lower rates on certain types of capital gains may reduce barriers to investment. Capital gains from the sale of a stock often occur because a corporation reinvested profits--which were already taxed under the corporate income tax--in the business. A lower tax rate on such gains would mitigate that double taxation of profits, which discourages equity investment in the corporate sector. Yet another reason for taxing some forms of capital gains at lower rates is that investors may view certain investments-- such as starting a new business or investing in a new technology-- as too risky and thus undervalue their benefits for the economy. A drawback of recapturing the depreciation deductions on real estate is that some depreciation probably occurred, reducing the value of the property since the time of purchase. Finally, denying deferral on like-kind exchanges would increase the tax burden on people who rent out property in their own community but must sell it when they have to move to another community.