In the tax debate now raging in Congress, lawmakers should address the double standard in taxation of investment income versus labor income.
Existing law gives substantial tax preferences to income from selling investment assets held for more than a year (long-term capital gains). The top tax rate on these gains stands at 20 percent, plus a 3.8 percent surtax on high earners. This is far lower than the top marginal tax rate of 37 percent on ordinary income.
Equalizing these rates could reduce wealth inequality while bringing in substantial revenue to fund major social priorities like renewing the expanded child tax credit that lifted nearly three million children out of poverty in 2021.
Moreover, contrary to conventional wisdom, recent analysis from our team at American University’s Institute for Macroeconomic and Policy Analysis (IMPA) suggests that equalizing tax rates on capital gains and ordinary income would not hamper the economy. Indeed, an earlier IMPA analysis projects that higher tax rates for capital gains would modestly increase economic growth. Conversely, cutting capital gains taxes would actually be detrimental to the economy.
Current capital gains tax policy benefits the wealthy
Investors “realize” a capital gain when they sell an asset that has increased in value. Recent data show that, in 2022, the top 1 percent of households by wealth (with net worth over $13.8 million) reported 39 percent of all realized capital gains (worth about $739 billion). The bottom 80 percent of households collectively got just 6 percent of realized capital gains.
The distribution of “unrealized” gains — gains that have accrued but haven’t been “realized” through sale or other event — is even more skewed to the very rich. In 2022, the top 1 percent held 44 percent of all unrealized gains (worth over $21 trillion). What’s more, the approximately 64,000 households with wealth exceeding $100 million held 18 percent of all unrealized gains.
The ability to put off paying capital gains taxes indefinitely is a powerful advantage for the ultra-wealthy. The current U.S. system lets them monetize appreciated assets by borrowing against their assets, effectively allowing them, but not taxpayers of more modest means, to escape income taxation on appreciation during their lifetimes.
Challenging the trickle-down narrative
Defenders of preferential capital gains taxation repeat a trickle-down tale: Lower rates encourage savings, which then flows to business investment, boosting productivity, wages, and economic growth. However, empirical evidence contradicts these claims on multiple fronts.
First, research on this issue has failed to find the expected big boost in household savings when after-tax rates of return rise. Studies have also failed to find that capital income tax breaks boost corporate investment, job creation, capital stock growth, or long-term economic expansion through the savings channel.
Finally, while defenders claim low taxes on capital, including capital gains, incentivize entrepreneurship through risk-taking, economic theory points to a countervailing “risk-sharing” effect where government absorption of a portion of investment risk through the tax system can decrease the costs associated with risky investments and actually encourage risk-taking when capital gains tax rates are higher.
How higher capital gains taxes could nudge growth up
Contrary to conventional wisdom, raising capital gains tax rates might modestly increase economic activity in two ways.
First, higher capital gains taxes could reduce federal deficits and debt. This makes more household savings available for business investment and helps maintain lower interest rates, which encourages firm investment, job creation, and wage growth. This mechanism operates by reversing the “crowding-out” effect of government debt described in economics textbooks.
Secondly, increasing taxes on capital gains could make investment cheaper. Research shows that such rate hikes reduce the price of stocks and privately held businesses, and so reduces returns demanded on equity. While this might initially sound like a bad thing, it actually allows firms to use more resources for productive investment and less for dividends and stock buybacks. Through this equity price channel, higher capital gains taxes would modestly increase investment, employment, and GDP. The macroeconomic policy model built at IMPA allows us to incorporate the impact of this channel in our assessments of policy.
Recently, we used our model to assess raising the capital gains tax from 20 percent to 39.6 percent for households earning over $1 million — equalizing it with the top ordinary income rate as it stood before the 2017 tax reform. This policy would be mildly pro-growth. In the long run, the capital stock would be approximately 0.8 percent higher and GDP approximately 0.5 percent higher annually.
Capital gains taxation and inequality
Wealth inequality in the United States has increased substantially in recent decades. The wealthiest 1 percent owned approximately 20 percent of total wealth in 1990. Today, they own approximately 27 percent. Their share of stock market wealth has risen even more dramatically, with the top 1 percent now owning nearly half of all U.S. households’ stock market wealth.
A significant driver of growth in inequality has been declining tax progressivity, culminating in the 2017 Tax Cuts and Jobs Act. These changes disproportionately benefited the wealthiest households with the most capital gains income.
Equalizing tax rates on capital gains and ordinary income would help reduce wealth inequality. The IMPA analysis projects that households at lower and middle wealth levels would experience higher income, employment, and government transfers, leading to increased savings and wealth. Conversely, the wealthiest 5 percent of households would see wealth declines from lower equity values and reduced after-tax income.
The distortions of realization-based taxation
While taxing capital gains only upon realization provides convenience in valuation and collection, it creates significant economic distortion. The ability to defer tax liability at no cost creates a “lock-in effect” by incentivizing investors to hold appreciated assets even when those assets underperform. This prevents optimal portfolio rebalancing and diversification, increasing overall economic risk. It also discourages successful entrepreneurs from selling their businesses to start new ventures, potentially limiting innovation and economic dynamism.
Another distortion occurs when investors strategically sell off depreciated assets for the sole purpose of paying lower taxes. This further reduces portfolio diversification and increases risk. Tax arbitrage strategies often involve complex financial maneuvers with substantial transaction costs, potentially outweighing their tax benefits.
These problems arise because our current system fails to tax economic income — the increase in capital asset values — until realization occurs. Economists have long considered appreciation to be income whether realized or not, since it increases the owner’s economic resources.
The mark-to-market alternative
Given these issues, many economists now support a progressive comprehensive income taxation system where capital gains are taxed annually as they accrue, even without asset sales. This “mark-to-market” approach could generate approximately $180 billion in annual tax revenue. The vast majority of this revenue would come from the wealthiest taxpayers.
Though implementing mark-to-market taxation faces some challenges, they are not insurmountable. For example, proposals recognize that some taxpayers may struggle to pay by allowing extended payment periods. These challenges highlight the need to carefully design taxes on unrealized capital gains — not to renounce them.
Lawmakers could also consider intermediate reforms that would improve the system even if they would not raise as much revenue. These could include eliminating the “step-up in basis” tax provision that currently allows inherited assets to be valued at their fair market value on the date of death, with all capital gains accrued over the years vanishing for income tax purposes.
Economic theory supports the mark-to-market approach
The economic theory underlying IMPA’s analysis of capital gains tax rates suggests that taxing unrealized gains would produce similar benefits to increasing rates on realized gains. Both would decrease share prices and returns on equity, making it cheaper for firms to fund productive investments. Through this channel, comprehensive reform of capital gains taxation can be expected to modestly increase economic activity rather than harm it.
The current system of capital gains taxation in the United States fails to deliver on its promise of increased investment and economic activity. IMPA’s analysis shows that removing tax preferences for capital gains income would not harm economic growth and might even modestly improve it. Additionally, by generating substantial revenue primarily from the wealthiest Americans, capital gains tax reform could fund critical social priorities while helping to address wealth inequality.