Many middle income taxpayers would see their taxes on long-term capital gains double or triple under the pending Senate Finance Committee tax bill, a much larger increase than most discussion of the bill has indicated.
The measure would tax long-term gains at the same rate as other income, which would raise the maximum effective rate on gains from the sale of stock, real estate and other such assets held for at least six months from 20 percent to 27 percent.
However large the increase would be for a particular taxpayer, most tax analysts expect the prospect of higher long-term capital-gains taxes next year to cause many taxpayers to sell their assets and realize the gains in 1986 -- assuming the higher rates would be effective on Jan. 1.
For taxpayers with gains on assets they would have owned for less than six months at the end of this year, the elimination of the distinction between short- and long-term gains ought to cause them to defer sales until next year. Currently, short-term gains are taxed at the same rates as other income and, under the Senate bill, those rates would be lower for most taxpayers.
With many more long-term than short-term gains, analysts say an increase in sales of assets this year should boost federal revenue in 1987 and lower it in 1988 and 1989. Some analysts believe raising the capital-gains rate will permanently reduce federal revenue as owners of assets generally hold on to them for longer periods to avoid paying the tax. Other analysts, working with the same historical data, believe raising the capital-gains rate will increase revenue in the long run.
In any event, virtually all of the discussion of the treatment of capital gains in the Senate bill has focused on the increase in the maximum effective rate from 20 percent to 27 percent. However, only people in the top income tax bracket of 50 percent -- about one-twentieth of all taxpayers -- now pay a 20 percent rate on their long-term capital gains. Other taxpayers pay a lower, and perhaps much lower, rate under current law.
The vast majority of taxpayers report no net capital gains at all. Only about 15 percent did so in 1984, according to the Internal Revenue Service, but of those that did, relatively few paid at the top rate.
Taxpayers with long-term gains are allowed to exclude 60 percent of the gain from their gross income. For instance, someone with a $10,000 gain must pay tax on only $4,000 of it. The Senate bill would drop the exclusion and tax the entire gain.
Under current law, the effective tax rate on long-term capital gains is 40 percent of whatever a taxpayer's income tax rate may be. Thus, a taxpayer in the top 50 percent bracket pays 40 percent of 50 percent, or 20 percent, on his gain.
The arithmetic works the same way for a middle-income taxpayer in, say, the 25 percent bracket. Under current law, married taxpayers filing a joint return who have two dependents and average itemized deductions probably would be in the 25 percent bracket next year if their adjusted gross income was in the $40,000 to $50,000 range.
If such a family has long-term capital gains, under current law the gains would be taxed at a 10 percent rate, or 40 percent of 25 percent. Under the Senate bill, some families in that income range would have their capital gains and other income all taxed at a 27 percent marginal rate.
Similar families with adjusted gross income in the $50,000 to $56,000 range in 1987 probably would be in the next higher bracket, 28 percent, and would pay a long-term capital gains rate of 11.2 percent. Those in the next income tax bracket, 33 percent, would pay a 13.2 percent rate on gains. Under the Senate bill, essentially all such taxpayers would pay a 27 percent rate on gains.
Single taxpayers would face the same sort of tax increase on long-term capital gains. Some with adjusted gross incomes as low as about $23,000, who would pay a 9.2 percent or 10.2 percent rate on gains under current law, would pay a 27 percent rate if the Senate bill is passed.
If long-term capital gains happened to be a large share of these taxpayers' total income, their total tax could rise significantly as a result of dropping the 60 percent exclusion. But most taxpayers in these middle brackets tend to have relatively small gains, so that the overall reduction in income tax rates still might give them an overall tax cut.
Neither the provisions covering deferral of gains realized when a principal residence is sold if the proceeds are reinvested in another residence nor the one-time $125,000 exclusion of gain on such a sale available to a taxpayer age 55 or over would be changed by the Senate bill.
Just how sensitive decisions to sell assets are to changes in the effective tax rates on capital gains is a matter of considerable dispute among economists.
Lawrence B. Lindsay of Harvard University concluded in a recent paper published by the National Bureau of Economic Research that, all other things being equal, a one-percentage-point increase in capital-gains tax rates would reduce asset sales by 6.2 percent that year.
Working with data covering the period 1965-1982, Lindsay found that, because of interaction with other parts of the tax code, effective tax rates on long-term gains were often higher than was apparent. Only in 1982 did the true maximum effective rate fall to 20 percent for upper-bracket taxpayers, but the average effective rate for taxpayers with less than $50,000 in income that year was 11.2 percent, not much different than at any time during the period. (See table.)
Some other analysts, such as Joseph J. Minarik of the Urban Institute, challenge both Lindsay's methodology and conclusions.
If the average rate on capital gains rose 10 percentage points, as appears would be the case under the Senate bill, Lindsay's approach would indicate sales of assets would plunge by about 60 percent, reducing federal revenue by several billion dollars a year. Minarik, on the other hand, thinks that, under such circumstances, sales of assets would go down only about one-tenth as much, and that revenue therefore would rise as a result of the higher rates.