The Washington PostDemocracy Dies in Darkness

Here’s one way you fight inequality: President Obama goes after a big, high-end loophole and uses the revenues to help the middle class.

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To their great credit, progressive policy makers have decided that “can we get this through the current Congress?” is not a useful question for crafting the necessary policy agenda in our age of inequality.

And tonight, with a pre-State-of-the-Union addition to the mix, President Obama’s out with a set of smart tax ideas that go directly at aspects of the tax code that exacerbate wealth inequality, tax avoidance, and financial market volatility. Even better, he uses some of the revenue from these measures to provide incentives for work, education, and savings among the poor and middle class.

At the heart of the president’s new plan is the closure of a big loophole that benefits the wealthy and inefficiently skews the tax code. When an asset (like a stock) you own appreciates, that income is known as capital gains (what’s that? you depend on your paycheck, not your cap gains? that’s kinda the point…read on). If you sell that asset, you’re taxed, and taxed at a preferential rate, on the so-called “realized” gains.

But if you hold onto that asset you pay no tax on the “unrealized” gains. That income currently escapes taxation, even when—get ready because here comes the loophole, one the White House says is “the largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code”—you check out of this crazy thing called life, i.e., you die, and you turn those appreciated assets over to an heir.

It’s a loophole called “stepped-up basis.” From the White House fact sheet (my bold):

Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.

Here’s the thing with the tax code, especially when you’re talking about the type of people who take advantage of loopholes like this—people with tax planners. If you tell such people that they can pass billions onto their progeny tax free, they’re going to structure their income to take advantage of that opportunity. You can call them greedy or you can call them dedicated parents. But you can’t blame them. They’re doing exactly what the tax code is pushing them to do.

But what’s good for them is bad for the economy. It’s called a “lock-in” effect: instead of investing such gains in potentially productive activities with a payback for the broader economy, the wealthy have a big incentive to a) define whatever income they can as capital gains, and then b) never realize those gains.

The president is also proposing to raise the capital gains tax rate, not up to the top rate of ordinary income, but to the same rate the prevailed under President Reagan: 28 percent. (Currently, realized cap gains are taxed at 20 percent but there’s 3.8 percent surcharge; the new proposal keeps the surcharge in place while raising the underlying rate to 24.2 percent—so 28 percent, all in.)

So, who would get hit if we were to close this loophole and tax the unrealized gains passed on to heirs at the Reagan rate? Well, the CBO has found that 21 percent of the benefits from “step up” go the richest 1 percent of households, while half of the benefits accrue to the top 5 percent. The White House estimates that 99 percent of the impact of this new proposal would be on the best-off 1 percent, and more than 80 percent on the top 0.1 percent (with incomes that start at a cool $2 million).

So, the wealthy would still get a preferential rate on income that’s realized from appreciated assets, but less than is currently in place, especially for the billions bequeathed to their heirs. These changes—ending “step-up” and the rate hike—raise $210 billion over 10 years.

The other revenue raiser is the expansion of a proposal that’s been in President Obama’s budgets for a number of years now: a fee on highly leveraged financial institutions. It’s a small tax (7 one-hundredths of a percent) on the liabilities of the 100 U.S. financial firms with assets over $50 billion. It would raise about $110 billion over 10 years and is designed to dis-incentivize the extent of leverage that so damagingly amplified the impact of the financial crisis. The White House notes that this fee is “broadly consistent with a proposal from former Ways and Means Chairman Camp’s tax reform plan that would have imposed an excise tax on large financial firms.”

They’d use some—not all—of these new revenues in three ways to help middle and lower-income families:

–A tax credit of up to $500 for second earners in two-earner households, a measure that would benefit 24 million working couples.

–An expansion of child care benefits that would reach 5 million families covering almost 7 million kids.

–Collapsing six existing education provisions down to two, while improving the American Opportunity Tax Credit to provide more students up to $2,500 each year over five years of college. This part of the plan should cut taxes for 8.5 million families with kids in college.

–Expand access to a variety of employer-based retirement savings options, including auto-enroll IRAs, providing new access for tax-favored savings plans for 30 million workers.

One can hear the blowback to all of this from the usual suspects opposed to raising any new taxes. But to them I say the following: First, even fervent anti-tax types agree that loopholes ought to be closed, and I’d really like to hear a cogent argument in support the step-up loophole.

Those folks have more of a case when it comes to the increase in the cap gains rate, but that income—unearned income, I should note—still gets favorable treatment relative to ordinary, earned income. If I’d been at the table, I’d have argued for revoking cap gains favored status, as it just stokes tax avoidance and doesn’t correlate with investment in any meaningful way.

And remember, the White House is honoring President Reagan by taxing capital gains at his old rate.

The other line of argument about these proposals is “what’s the point? They’re not going anywhere.” As noted above, if President Obama decided that was the benchmark for thinking about necessary policy changes in America today, he’d shut down his operation, which is of course exactly the opposition’s goal.

Instead, he appears to be fighting back more progressively than ever, which actually makes a lot of sense. For years, he had to worry about getting growth back in place following the Great Recession, and getting major legislation—health reform, Dodd-Frank—through Congress. Those measures are in place and must be defended. The recovery, while not complete, is solidly underway.

But the inequalities of wealth, income, and even opportunity are as embedded as ever in our economy, and the goal now must be not merely to sustain the growth we have, but to craft the policy agenda that will give the middle class, and the aspiring middle class, the chance to claim their fair share of that growth.

No, these policies won’t become law in this Congress. But we still need to get them out there, build support for them and promulgate them. So kudos to the president and his team for not folding up their tents in the face of ardent opposition and for instead fighting back against the embedded inequalities that remain very much with us.