Treasury Notes

 The President’s Proposals to Cut Taxes for Over 44 Million Families

By: Adam Looney
1/29/2015

In last week's State of the Union address, the President announced new proposals to reduce taxes on working families and to offset the cost by eliminating inefficient tax breaks that primarily benefit high-income taxpayers. In the President's plan, individual tax cuts would help boost the paychecks of middle-class and working families, reduce the burden of child care costs while parents work, and help cover the cost of college and retirement. The plan would:

 

  • Boost child care tax incentives to give middle-class families with young children a tax cut of up to $3,000 per child. The President's proposal would streamline and dramatically expand child care tax benefits, helping 5.1 million families cover child care costs for 6.7 million children. Among all families ​with child care expenses, the proposal cuts taxes by an average of about $560. This proposal will com​plement new investments in the President's Budget to improve child care quality, access, and affordability for working families.

  • Provide a new, simple tax credit to two-earner families. The new $500 second earner credit would help cover the additional costs faced by families in which both spouses work and reduce tax-driven disincentives to working outside the home—benefiting nearly 24 million couples.

  • Simplify, consolidate, and expand education tax benefits to improve college affordability. The President's plan will consolidate overlapping education provisions and improve the American Opportunity Tax Credit. Students would be eligible for up to $2,500 each year over five years as they work toward a college degree – cutting taxes by an average of $750 for 8.5 million families and students and simplifying taxes for the more than 25 million families and students that claim education tax benefits.

  • Make it easy and automatic for workers to save for retirement, giving 30 million additional workers the opportunity to easily save for retirement through their employer.

  • Help low-income workers get ahead by doubling the EITC for workers without qualifying children, increasing the income level at which the credit phases out, and making it available to workers age 21 through 66. This expansion would reduce poverty and hardship for 13.2 million low-income workers struggling to make ends meet and promote employment.

 

All in all, these new policies will benefit over 44 million families, who would receive an average tax cut of nearly $600. As the table shows, on net these proposals would provide benefits to a range of working families, from a boost for minimum-wage workers from the increased EITC for childless workers to substantial tax benefits for middle-class parents with kids in daycare or students in college. (The increased access to employer retirement plans that would take effect in 2017 and which are not included in this table would expand the number of beneficiaries to 49.7 million families.)​


Table for Proposals to Improve the Tax System for Families 2016To help finance this reform, the President’s plan would target what is perhaps the single largest loophole in the income tax—“stepped-up basis.” Capital gains on appreciated assets held until death are never subject to capital gains tax. While most middle-class retirees pay capital gains tax when they spend down their savings to finance college or retirement, wealthier taxpayers can afford to hold on to their appreciated assets until death – which is what lets them use the stepped-up basis loophole to avoid ever having to pay tax on capital gains. Each year hundreds of billions of dollars of capital gains income avoid tax through this loophole. And most of the benefit accrues to the wealthiest taxpayers. 

The President's proposal would close the stepped-up basis loophole by treating bequests and gifts other than to charitable organizations as realization events, like other cases where assets change hands. It would also increase the total top capital gains and dividend rate to 28 percent. (The top rate applies to couples with incomes over about $500,000.)

 The proposal would almost exclusively affect individuals in the top 1 percent of the income distribution. In fact, 99 percent of the effect of the President's capital gains reform proposal (including eliminating stepped-up basis and raising the capital gains rate) would be on taxpayers with income over $500,000, and more than 80 percent on taxpayers with incomes over $2 million (the top 0.1 percent of the income distribution). Under the President's proposal, capital gains income would still get a preferential rate, but high-income taxpayers would no longer be able to avoid paying any tax whatsoever.

The proposal is designed to exclude the middle class and small businesses. To ensure that it imposes neither tax nor compliance burdens on surviving spouses the proposal exempts couples until the death of the second spouse. Further, the proposal excludes up to $500,000 of capital gains on their residences and other real estate and $200,000 of any other assets of a couple ($250,000 and $100,000 per person). It also excludes tangible personal property other than expensive art and similar collectibles. And it includes extra protections that ensure no small family-owned and family-operated business or farm would ever have to be sold for tax reasons.

As the table shows, the proposal is highly progressive, with 99 percent of the tax increase coming from the 0.8 percent of taxpayers with income over $500,000.


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Importantly, in examining the effect of this proposal on taxpayers at different income levels, it is necessary to take into account the capital gains income that is currently excluded from tax by the loophole. To do otherwise would count the taxes paid by individuals without counting the income, which would be misleading.

For instance, consider an individual who has accumulated a $10 million gain on shares of corporate stock but who was living off of $100,000 per year in other retirement income. Under the proposal, if that taxpayer sold the stock in retirement, his income would rise by $10 million and his tax bill would rise by at most $2.8 million. If, instead, that taxpayer held the stock until death, rather than having his tax bill of up to $2.8 million wiped out entirely, the taxpayer would still owe the tax (less the value of the exclusion). In other words, the two transfers are treated the same under the proposal and should be measured the same. In particular, it does not make sense to ignore the $10 million of income and to suggest that this taxpayer was paying $2.8 million of tax on only the $100,000 of income.

These aren't trivial differences. Each year about $200 billion of capital gains is wiped out by stepped-up basis, or about 30 percent of the average capital gains realized by taxpayers between 2005 and 2009. To continue to ignore those gains obscures the facts and isn't good tax policy.

 

Adam Looney is Deputy Assistant Secretary for Tax Analysis at the United States Department of the Treasury.​​

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Posted in:  Tax
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