Capital Gains Taxes Are Going Up

The top tax rate on long-term capital gains is currently 15%. That’s why Mitt Romney is spending so much time talking about his tax returns.

That revelation has set off a familiar debate about whether that low rate is appropriate. Often overlooked in these discussions, however, is the fact that the days of the 15% tax rate are numbered. As of this posting, it has only 342 left.

On January 1, 2013, capital gains taxes are scheduled to go up sharply:

First, the 2001 and 2003 tax cuts are scheduled to expire. If that happens, the regular top rate on capital gains will rise to 20%. In addition, an obscure provision of the tax code, the limitation on itemized deductions, will return in full force. That provision, known as Pease, increases effective tax rates on high-income taxpayers by reducing the value of their itemized deductions. On net, it will add another 1.2 percentage points to the effective capital gains tax rate for high-income taxpayers.

And that’s not all. The health reform legislation enacted in 2010 imposed a new tax on the net investment income of high-income taxpayers, including capital gains. That adds another 3.8 percentage points to the tax rate.

Put it all together, and the top tax rate on capital gains is scheduled to increase from 15% today to 25% on January 1. That’s a big jump. If taxpayers really believe this will happen, expect a torrent of asset selling in November and December as wealthy taxpayers take final advantage of the lower rate.

Of course, the tax cuts might get extended for all Americans, including high-income taxpayers. That’s what happened in 2010. In that case, the increase in the capital gains rate will be smaller. Because of the health reform tax, the top capital gains tax rate will increase from 15% to 18.8%. That’s still a notable increase, but would likely set off much less tax-oriented selling this year.

The only way that the top capital gains tax rate remains at 15% will be if the tax cuts are extended for high-income taxpayers and the new health reform tax gets repealed. That’s a key distinction in the election: President Barack Obama opposes those steps, while the GOP presidential candidates favor them (and some candidates would cut the capital gains tax rate even further).

4 thoughts on “Capital Gains Taxes Are Going Up”

  1. If you think about reasons for a difference between capital gains tax rates and “ordinary” income tax rates, there are a few that come to mind: Incentives, risk and time value of money/inflation.

    One could make a number of comments on incentives depending on situations, but if you consider a simple passive investor in equity, there is stronger incentive to invest (rather than sticking the money in a bank account) compared to a worker considering whether to work an incremental hour, so this shouldn’t dictate a lower capital gains rate.

    If you consider risk, investments have different risks, and the appropriate risk adjustment of return should occur at the asset level, not the task level.

    Which brings us to the time value of money/inflation, which are differentiating features. When capital gains rates were created in the dark ages, there was the concept of short and long term rates, which reflected this, but was a crude correcting tool. Now that we are in the computer age, has anyone considered updating this approach by charging ordinary income tax rates on the difference between sales price and purchase price (updated by a factor to reflect inflation/time value of money)?

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