Our guest blogger is Seth Hanlon, Director of Fiscal Reform at the Center for American Progress Action Fund.
On January 24, 1963, exactly half a century ago, President John F. Kennedy called on Congress to enact a broad overhaul of the tax code. One of JFK’s boldest proposals was to close a giant tax loophole that allows wealthy people to escape taxes on capital gains — the appreciation in value of stocks, businesses, or other investments — by holding onto assets until death and passing them onto heirs.
Though JFK’s successor, Lyndon Johnson, pushed through much of the Kennedy tax program in 1964, the tax break on inherited capital gains survived. It exists to this day as one of the largest loopholes in the tax code.
The provision is sometimes called the “angel of death loophole” or, in tax-speak, the “stepup in basis at death.” Here is how it works: Let’s say an investor buys stock for $1,000 and over time it shoots up in value to $100,000. If the investor sells that stock, he’ll owe capital gains taxes on the amount it has gone up.
But if the investor holds onto the stock his whole life and bequeaths it to his heirs, the $99,000 of gain is never subject to capital gains tax. The heirs inherit the stock with what’s called a “stepped-up basis,” which means that if they sell the stock at some point, they’ll only owe capital gains tax on any gain above $100,000.
The inherited capital gains loophole has major effects on the budget, on the economy, and on tax fairness. It results in about half of all capital gains going permanently untaxed. It costs the U.S. Treasury an estimated $50 billion per year (perhaps more). It encourages people to hold onto assets even when they would otherwise want to sell them. And since capital gains are highly concentrated at the top end of the income scale, it undermines progressivity.
One of the arguments for maintaining the inherited capital gains tax break is that the estate tax provides a backstop, ensuring that large inheritances are taxed. But that argument holds less water now that the estate tax has been largely eviscerated.
In submitting his tax reform proposal to Congress, Kennedy emphasized that eliminating “the ability to avoid all capital gains taxed on assets held until death” would mean that more investors would choose “the most desirable investment[s],” not the most tax-favored ones. JFK’s proposal included a number of exceptions to address practical issues, including exempting the vast majority of people with only modest amounts of capital gains. Unfortunately, however, Congress left the loophole untouched, and subsequent efforts to address it have also come up short.
Fifty years later, Congress is again discussing tax reform, and though the inherited capital gains loophole is one of the largest tax breaks, it is rarely debated. But if Congress is committed to a balanced approach to our fiscal challenges, and serious about “base broadening” tax reform, it should revisit a half-century-old proposal that is more relevant than ever.