Rethinking How We Score Capital Gains Tax Reform
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Capital gains tax revenue potential understated: Reform could yield +$1tn/decade above estimates. Lower elasticity (-0.7) + eliminating step-up basis drives gains despite 20→40% rate impact.
"...We argue the revenue potential from increasing tax rates on capital gains may be substantially greater than previously understood. First, many prior studies focus primarily on short-run taxpayer responses, and so miss revenue from gains that are deferred when rates change. Second, the composition of capital gains has shifted in recent years, such that the share of gains that are highly elastic to the tax rate has likely declined. Third, focusing on capital gains tax collection may understate fiscal spillovers from decreasing the preferential tax treatment for capital gains. Fourth, additional base-broadening reforms, like eliminating stepped-up basis and making charitable giving a realization event, will decrease the elasticity of the tax base to rate changes. Overall, we do not think the prevailing assumption of many in the scorekeeping community—that raising rates to top ordinary income levels would raise little revenue—is warranted. A crude calculation illustrates that raising capital gains rates to ordinary income levels could raise $1 trillion more revenue over a decade than other estimates suggest.Given the magnitudes at stake, scorekeeping procedures employed in evaluating capital gains should be made more transparent and be the subject of external professional debate and review..."
Core of their calculation. They argue currently elasticity is wrong and that realizations deferred when cap gain tax rates rise are unlikely to be deferred indefinitely, "...We conclude with crude estimates of the wide range in revenue potential from raising capital gains rates to the top ordinary income levels under different elasticity assumptions. Applying the conventional elasticity e = −0.7 leads to the conclusion that this substantial rate increase would raise less than $150 billion in revenue. In stark contrast, using an elasticity that incorporates medium-term dynamics suggests that raising rates to the top ordinary income level could raise more than $1 trillion over a decade. Put differently, e = −0.7 implies that once capital gains rates reach around 30 percent, the additional increase to top ordinary rates loses, rather than raises, revenue. Our preferred estimates suggest the opposite. Pairing rate increases with the elimination of loopholes that erode the capital gains tax base—like stepped-up basis and the tax preference for charitable gifts of appreciated assets—produces larger revenue estimates. We provide a simple calculation that abstracts from many important details. Our point is not to offer an official score, but instead to illustrate the magnitude of potential revenue and how sensitive capital gains revenue estimates are to various assumptions. We suspect that making scorekeeping procedures more transparent and the subject of external professional debate and review will lead to an upward revision in the estimated revenue potential from substantially increasing capital gains tax rates....."
Summer's back of envelope arithmetic, "... Suppose that doubling capital gains rates from 20% to 40% causes realizations to occur half as often: instead of realizing gains every year, individuals realize gains every two years. If assets grow at 10% annually, then in the low-tax regime, $100 of assets yield realizations of $10 in year 1 and $10.80 in year 2 (after paying two dollars of tax in year 1). In the high-tax regime, $100 of assets yield realizations of $0 in year 1 and $21 in year 2. Despite the appearance in year 1 of a large elasticity of realizations in response to the tax increase, total revenues over both years increase from $4.16 in the low-tax regime to $8.40 in the high-tax regime. In this simple example without other behavioral responses, the short-run revenue score is zero and the medium-run revenue score is double the baseline.Clearly, the latter revenue score is more relevant for policy purposes...."
Natasha Sarin, Lawrence H. Summers, Owen Zidar and Eric Zwick, "Rethinking How We Score Capital Gains Tax Reform," National Bureau Of Economic Research, January 2021, https://www.nber.org/papers/w28362
Ed Comment, “It could be overstated in both the short run and the long run. In the short run, I might wait for a political regime change that lowers the capital gains rate, which grows more likely as they raise the rate higher. And the value of the market might drop. He assumes high rates prevail for a long time (they haven’t) and that the market is unaffected (it might be but probably not). In the long run, talented people might take less risk, work less hard at the arduous and tedious tasks that produce wealth (i.e. they might become professors instead of business people), and get les valuable/more fun training e.g., art history instead of computer programing. I contend that, in the long run, Americans are doing exactly those things more than their European counterparts because the payoffs for doing them are higher here than there. They are higher for a variety of reasons, but higher nevertheless, and higher taxes lower those payoffs. Raising the cap gain rate from 20% to 40% lowers the payoff from 80 to 60 or 25% (=60/80), which is not insignificant. I don’t know how much lower the payoffs are in Europe (for a variety of reasons) but it seems to be enough to have had a substantially impact on their contribution to innovation, which is largely the only thing driving growth these days. So I don’ think it changes behavior in the short run, it changes behavior gradually in the long run. So the dems can always mortgage the future for higher taxes and more redistribution (to buy votes) in the short run. The cast the republican POV as having to generate more tax revenue in the short run for the tradeoff of lower taxes to be more valuable but it’s a complete red herring (i.e. lie), especially when you recognize the consumer is capturing virtually all the value from innovation, not the innovator who is getting taxed.”
Worth noting given pen. Summer's makes the case that JCT/CBO are lowballing revenue potential from raising capital gains rates. Aside Danny Yagan (Zidar/Zwick’s frequent coauthor) is going into administration as Chief Economist @ OMB.