Who said tax reform was a dead letter in the nation’s capital? With President Barack Obama’s State of the Union address still a day away, it’s already clear that the President will make income tax reform a major talking point. A preliminary description released to the media over the weekend gives the broad outlines of a tax plan that would take important steps towards eliminating the special capital gains tax breaks currently enjoyed by the best-off Americans, while imposing a new tax on the assets of the largest, “too big to fail” financial institutions. Initial indications are that Obama proposes to use most, but not all, of the resulting new revenues to cut income taxes for middle- and low-income families. While some additional details will likely emerge in the wake of tomorrow night’s speech, the emerging picture is of a tax plan that would take a moderate step toward deficit reduction, and a major and welcome move toward greater fairness in our federal tax system.
Twin Capital Gains Tax Reforms Would Mean Major Tax Fairness Gains
The centerpiece of Obama’s plan is a proposal to raise substantial new revenues by closing the long-lamented, and rarely defended, “stepped up basis” rule for capital gains. Stepped up basis means that when stocks and bonds (among other assets) are not sold during the owner’s lifetime, no income tax will ever be paid on the (unrealized) capital gains income created during the owner’s lifetime. When the heirs who are gifted these capital assets sell them, they will pay not a dime of tax on the often-huge capital gains that accrued prior to the time they inherit.
Obama’s proposal would treat the transfer of these untaxed capital assets to heirs as a potentially taxable event. This sensible step would remove what is called the “lock-in effect” of the current system, which encourages wealthy owners of capital assets to hold on to them until death to avoid paying tax on their (unrealized) capital gains. Notably, the proposal would actually leave stepped-up basis intact for many heirs of smaller estates, since it would allow capital gains of up to $200,000 to be passed on tax-free for a married couple (half that for a single taxpayer). On top of this, the proposal would allow a $500,000 exemption for the value of homes passed on to heirs. While complete elimination of stepped-up basis would be a more straightforward and welcome reform, the half-step toward reform taken in Obama’s draft plan would sharply curtail one of the least justified tax dodges in existence today.
Taken on its own, ending stepped-up basis is only a starting point toward the laudable goal of taxing wealth like work. This is because even repealing stepped up basis would leave intact the stark difference in the top income tax rate on wages (currently 39.6 percent) and capital gains (20 percent). Happily, Obama’s draft proposal would mitigate (but not eliminate) this tax break by increasing the top tax rate on capital gains and dividends to 28 percent.
Tax on “Too Big to Fail” Financial Institutions
The President’s plan includes one other substantial revenue raiser: a low-rate tax on the value of the assets of a handful of the biggest financial institutions. This idea, like a similar plan included in Obama’s budget proposal from last year, would serve the twofold purpose of recovering taxpayer money used by the Bush administration to bail out financial institutions and reducing the excessive risk-taking that necessitated the bailout.
Achieving Vital Anti-Poverty Goals
The President’s plan would use some of the new revenues from these tax hikes to fund needed expansions of two targeted tax credits for working families: the Earned Income Tax Credit and the $1,000-per-child tax credit (CTC). Both the EITC and CTC are set to be reduced at the end of 2017, as temporary expansions pushed through by President Obama will expire at that time. Obama proposes to make these tax cuts permanent, and reiterates his proposal to expand the EITC for the childless workers who currently benefit least from the credit. Each of these steps, which Congress has discussed ad nauseam in the past year but has refused to enact, would provide needed relief to working families below or near the poverty line: collectively, these changes would mean a real victory for those seeking to use the tax code to help end poverty.
Other Middle-Income Tax Cuts
Obama’s plan would also create a tax credit available only to two-earner couples in which both spouses work. The credit would equal 5 percent of the lower-paid spouse’s first $10,000 of earnings, for a total tax break of up to $500, and would be unavailable to those couples earning over $210,000. Obama would also increase tax credits for families with dependent care expenses, and would simplify the array of tax breaks available to offset families’ higher education expenses.
The President’s tax proposal, as outlined this weekend, appears less ambitious than some would have hoped– after a year in which shameless corporate tax avoidance was constantly in the headlines, loophole-closing corporate tax reforms should be a centerpiece of any tax reform plan–but in the current political context, it’s certainly more than many observers expected.