Long-Term Capital Gains Tax Expectations

by: Steve Levitt September 17, 2008    

Steve Levitt

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Long-Term Capital Gains Tax [LTCGT] rates are likely to increase regardless of the outcome of this year’s presidential election. This tax hike will be driven by the widening public budget deficit and the expiration in December 2010 of certain legal tax exceptions.

Candidates’ Platforms on Taxes

Most Americans are worried about the economic situation and the measures required to restore stability and growth.  On this issue—particularly on taxes—analysts concur that American voters will pay attention to each candidate’s proposal.

Barack Obama has pledged to instill fiscal discipline by “repealing Bush tax cuts for the wealthiest Americans,” thereby restoring “fairness and efficiency” in the tax system.  He promises to eliminate special-interest loopholes and deductions, particularly those within the oil and gas industry, and to revoke Bush’s policies of offering tax breaks to the wealthy, which, he claims, will cost the nation over $2.3 trillion by 2010 − the year they expire.

In contrast, John McCain is an anti-tax zealot.  His plan is to maintain the capital gains rate at 15% by extending President Bush's income-tax cuts.  He has promised to enact new tax breaks, such as raising the exemption for dependents, even though this could increase the budget deficit.

Presidential candidates comparative platforms on Taxing Wealth

McCain

Obama

Preserve the 15% tax rate on carried interest - the cut private equity and hedge fund managers take when the funds they manage make a profit.

Tax carried interest as ordinary income rather than as an investment gain, thereby subjecting it to much higher tax rates than 15%.

Increase the amount of money exempt from the estate tax to $5 million.

Freeze the exemption amount of estate tax at $3.5 million -- where it will be in 2009.

Reduce the top estate tax rate to 15% from 55% - where it otherwise will be in 2011 under current law.

Freeze top estate tax rate at 45%.

Keep capital gains and dividend tax rates where they are.

Raise capital gains and dividend tax rates to at least 20% but under 28% for high-income investors.

Other sources of revenues to be reviewed i.e. Corporate Taxes, Oil, R&D, etc.

Other sources of revenues to be reviewed i.e. Corporate Taxes, Oil, R&D, etc.

Regardless of each candidate’s economic platform, tax rates will likely increase because of the simple, yet undeniable, fact that, all else equal, excessive public spending creates economic imbalances, which, sooner or later, obliges fiscal austerity.

In addition, tax exemptions created by the Economic Growth and Tax Relief Reconciliation Act [EGTRRA], as well as all its provisions and amendments to the tax code, are set to expire in December 2010.

Fiscal Imbalance: Taxes and Revenues

Under President Bush, the federal debt has increased from $5.7 trillion to $8.8 trillion —a greater than 50% increase.  The White House reported that total federal revenues declined in 2008, and that from 2008 to 2011 corporate income tax collections will be lower than the amount collected in 2007.

Also, the White House Budget Director Jim Nussle stated that the budgetary deficit could reach up to $482 billion in the 2009 fiscal year—the largest share of GDP since 2004—as total tax revenues continue their downward trend through 2011.  Such economic imbalance will challenge the next president to raise government savings by increasing taxes and curbing spending.

The LTCGT rate may possibly be the lowest of all corporate taxes. It is 5% for investors in the 10% and 15% income tax bracket and 15% for investors in the 25% to 35% bracket. Moreover, in 2001, President Bush cut the LTCGT rate to 15% when he signed EGTRRA, which was extended in 2006 through 2011.

Economic Growth and Tax Relief Reconciliation Act [EGTRRA]

According to the EGTRRA, the LTCGT exemptions will expire after 2010. If EGTRRA provisions are not extended before 2011, LTCGT rates will revert to those established originally by the Omnibus Budget Reconciliation Act of 1990 (HR 5835; PL 101-508), approximately 28%.

In any event, either to maintain or to change the LTCGT rate, the next president of the United States will have to submit his proposal to Congress. Once there, it shall follow the ordinary legislative procedure meaning it will be sanctioned and voted on by legislators, most of which prioritize constituents’ preferences over party affiliations.  The next US President will likely have to compromise with Congress.

Today, politicians who seek to reinstate the higher tax rate aim to make the wealthiest Americans contribute more tax dollars.  Those who strive to extend the current tax cuts claim it places an unfair burden on certain constituencies.

When the time comes for Americans to tighten their belts, increasing the LTCGT rate may well be parenthetically justified because it has been too low for too long and has been benefiting only the wealthiest Americans.

The LTCGT rate may climb simply as a consequence of the current economic situation and the official deadline of the EGTRRA provisions. This rise in taxes is an issue beyond political affiliation.

Conclusion

Today the US is facing increasing unemployment, declining equity and home mortgage markets, and upward pressure on interest rates. In its effort to stabilize a fragile and weakening financial system, the Federal Reserve has opted to cut interest rates aggressively, which undoubtedly is one major driving factor behind dollar depreciation and inflation. Yet despite such efforts job losses have continued and fiscal spending has not abated.

Worsening economic imbalances (a widening government deficit, dollar depreciation, rising inflation and inflation expectations, not to mention the country’s existing trade deficit and social security quandary) make fiscal discipline a paramount objective.  If McCain wins, Bush’s tax cuts are set to expire in 2010, unless Congress extends the EGTRRA provisions.  And in the event that Obama wins, he has pledged to raise the LTCGT rate.

The government has few options when it comes to addressing the budget deficit: increase taxes, increase debt, cut expenditures and/or a combination of the three. Being optimistic, we may hope for increasing taxes without cutting government expenditures. Being pessimistic, taxes will rise and public expenditures will decrease. In either case, to avoid major economic turmoil, taxes must increase.

For an organization contemplating a sale over the next few years, there could be a tax advantage to consummating a sale process sooner rather than later.  A seller is likely to face higher LTCGT rates after 2010.

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This article has 4 comments:

  •  
    Sep 17 08:54 AM
    I think this year a good part of the platform might be the elimination of the restrictions of capital losses for individuals - or at least raising the limit.
    Reply | Link to Comment
  •  
    Sep 17 09:26 AM
    The wealthy don't pay capital gains taxes. They just borrow and hold on to their shares. It is the small investor who pays the capital gains tax because they are credit constrained. Their borrowing power is limited so they must sell shares if they need cash.

    It is a common story that Warren Buffet has never sold a share of Berkshire stock. If true, he has never paid a dime of capital gains tax and never will. He can just borrow against his stock to raise cash.

    Not surprisingly when capital gains taxes are raised tax revenues actually fall. The truly rich don't care what about the capital gains tax rate because they don't pay it.
    Reply | Link to Comment
  •  
    Sep 17 01:01 PM
    Good point Brian--any Private Banker who has worked with the ultra high net worth community has made their living doing exactly what you described--lending people money at 5.00%. This 5% interest is an "above the line item" for the borrowing entity owned by the rich person in question. Therefore, the borrowing entity gets to deduct 100% of this interest expense. With a 40% all in tax rate in New York, the effective rate of borrowing is thus closer to 3%. The same logic applies to the interest deductibility of mortgages. Meanwhile, the government tells us that they are doing great things for Joe Six Pack and Joe MBA because the first $1,000,000 of mortgage interest is deductible. Great, but the reality is that for Joe Forbes 400 there is no $1,000,000 limit. He just borrows against his stock, or might even borrow unsecured, pledging no specific collateral at all. This is just more of the same old velvet rope treatment that ensures that the rich get richer and the poor get poorer.
    Reply | Link to Comment
  •  
    Sep 19 10:48 AM
    Biden is exactly right. It is time for the rich to be patriotic and pay their fair share of taxes... especially hedge fund managers!!

    These 5 guys made BILLIONS in the hedge-fund industry in 2007 and paid a low, low tax rate due to the carried interest tax loophole of only 15%... lower than middle class Americans!

    John McCain wants to continue this tax break to the billionaires that have got us into this financial crisis that taxpayers are going to pay HUNDREDS OF BILLIONS to try to fix.

    Obama would make these BILLIONAIRES pay their fair share.
    seekingalpha.com/artic...

    www.bloomberg.com/apps...
    1 $3.7 billion, John Paulson, Paulson & Co.
    2 $2.9 billion, George Soros, Soros Fund Management
    3 $2.8 billion, James Simons, Renaissance Technologies
    Corp.
    4 $1.7 billion, Philip Falcone, Harbinger Capital
    Partners
    5 $1.5 billion, Kenneth Griffin, Citadel Investment
    Reply | Link to Comment
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