Under Biden’s Scheme, Taxes and Inflation Could Claim 100% of Some Capital Gains
Preston Brashers /
A common misconception is that the U.S. federal corporate tax rate of 21% means that business owners keep 79 cents on the dollar.
That, however, ignores the many layers of taxation they face. In fact, if President Joe Biden’s 5% to 8% “surcharge on high-income individuals” is enacted, after accounting for inflation, some investors could face a more than 100% marginal tax on the business profits their investments earn.
To demonstrate, let’s take an example involving a high-income individual with a regular stream of income of at least $25 million each year who is subject to Biden’s top rate 8% surtax.
In addition to this passive income, which includes rents, royalties, and certain dividends that don’t require active involvement, this individual also receives a high salary. On the salary income, the individual pays federal income tax, the 8% surtax, payroll taxes, and state and local income taxes. After all this, suppose the individual takes home a $10 million after-tax salary.
The individual may spend the $10 million salary or invest it. Assume he or she invests the after-tax salary in corporate stock, and that corporation uses the $10 million of capital to fund a 10-year project that ultimately earns a $20 million payout at the end of the decade. The business earns $10 million of income subject to corporate tax.
First, the federal government taxes the corporate income at a rate of 21%, then the median state tacks on an additional 6.5% corporate tax. After allowing for state and local tax deductions, governments claim about $2.58 million at the corporate level.
After paying the corporate taxes, suppose the corporation distributes a pre-tax dividend to the individual of $7.42 million, paid out 10 years after the original investment. The individual investor then pays a 20% federal capital gains tax, Biden’s 8% surtax (notice this is the second time the surtax shows up), a 3.8% net investment income tax, and a 5.2% average state and local capital gains tax.
Among the various taxes, governments claim $5.33 million in taxes on the $10 million of income earned on the investment. Only $4.67 million of investment profit is left by the time the individual has paid capital gains and related taxes. The total value after 10 years is $14.67 million, compared to the original investment of $10 million.
However, as 2021 has demonstrated, prices after 10 years will almost certainly be higher than they were when they started. Depending on inflation, $14.67 million in 10 years may be worth significantly less.
Even at the low 2% inflation rates of the past couple of decades, the investor in the example would only have 20% more purchasing power after 10 years of investing than if he or she had immediately spent the $10 million salary.
At 4% inflation over the 10-year period, the investor’s purchasing power would be lower than if he had immediately spent the salary.
At the current 5.4% inflation, the investor effectively would end up with a return on investment of negative 13%, because of the combination of taxes and inflation.
This underscores the importance of keeping inflation in check. The runaway federal spending attached to Biden’s new proposed taxes doesn’t help matters.
The example also illustrates why excessive taxation on investment income is counterproductive, not only for the economy, but also for federal tax receipts.
At some level of taxation, people stop investing in assets subject to the tax. Capital is notoriously mobile. In the face of high taxation, a large amount of capital moves into untaxed assets or into countries offering investments with higher after-tax returns.
Reports show that the Joint Committee on Taxation and the Treasury Department estimate the revenue-maximizing federal capital gains tax rate is between 28% and 32%. Both the Tax Foundation and the Tax Policy Center use estimates that imply that long-term capital gains are maximized when the top rate is set at about 28%.
The new surtax takes the top federal capital gains rate to 31.8%, likely high enough to start costing the federal government revenue.
In high-tax states, the situation would be worse. Consider California, where the top tax rate on capital gains is 13.3%. Biden’s new taxes would push combined capital gains tax rates in the Golden State to 45%. Such tax rates on the capital gains of high-income individuals will punish the wealthy, but won’t help fund Democrats’ extravagant spending proposals.
Regarding his plans to tax the rich, Biden has said, “I’m not out to punish anyone.” However, if he increases some individuals’ taxes beyond the point of raising additional revenues, what else is he achieving besides punishing the rich?
Exorbitant taxes on capital gains certainly don’t help the economy. Capital investments are a critical fuel for economic growth. If the government eliminates incentives for people to fund businesses’ operations, the obvious result is that some business operations will stop. Demand for labor will drop, and that will bring down the real wages of the lower- and middle-class Americans that the Build Back Better plan supposedly claims to help.
Instead of layering tax after tax on investments, Congress should work toward building a tax code that encourages investment and thereby encourages long-term growth.
Making the full expensing provisions of the 2017 Tax Cuts and Jobs Act permanent would be a positive step. Under full expensing rules, taxpayers can deduct capital investments in the year the costs are borne.
Unfortunately, in 2023, the U.S. tax code is set to revert to a system in which businesses must wait several years to deduct capital investments using a complicated depreciation schedule. A system that effectively requires taxpayers to pay taxes on investment profits before they are earned is especially problematic when businesses fear continued inflation.
With inflation, the tax code artificially devalues these deductions that are delayed for years after a taxpayer incurs an expense. As in the example above, taxpayers can end up paying taxes on phantom profits.
Investment drives long-term economic growth. The U.S. tax system is already biased against saving and investment. Biden’s tax plans exacerbate the problem.
Worse, Biden is resorting to inefficient and counterproductive taxes that are incapable of funding even half of his new social welfare spending that could amount to $4 trillion after factoring in budgetary gimmicks.
That will only lead to larger deficits, which will further crowd out investment and stunt economic growth.
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