The President’s budget is out and, as we have in the past, we will start with a disclaimer.  Congress requires the President to issue a budget every year, and every year the President (regardless of party) complies with a ridiculously long and labored set of phone book-like documents outlining the budget.  And every year Congress yawns and says it’s dead on arrival.  So take our commentary below with a grain of salt, as most of the provisions in this budget are going nowhere, fast.

That said, the budget includes a couple tax proposals that caught the attention of our members, including:

  • A higher, 28 percent tax rate on capital gains and dividends;
  • A mandatory 28 percent tax on appreciated assets when the owner dies;
  • A new 30-percent minimum tax (Buffett tax) on high-income individuals; and
  • Applying self-employment taxes to the business income of professional services businesses.

We addressed the so-called Buffett tax and Gingrich-Edwards loophole when they were first proposed in prior budgets.  The capital gains proposals, on the other hand, are new.  The President first talked about them in his State of the Union Address this year.  You can read the White House explanation here and a more detailed Treasury Department summary here.

The basic premise is that wealthy people don’t pay their fair share and need to pay more in taxes.  This, of course, is nonsense.  The federal tax code has many faults, but the lack of progressivity is not one of them.  According to the Congressional Budget Office, the tax code is remarkably progressive and has been for a long time.

The CBO’s estimates on who pays what are from 2010, so they don’t include the recent hike in capital gains and individual tax rates enacted as part of the 2013 fiscal cliff deal.  Combined with the Affordable Care Act taxes put in place that year, capital gains rates increased from 15 to nearly 24 percent.  The new proposal would raise them again to 28 percent, or nearly double their level from just three years ago.

These higher rates work against the Administration’s 2012 framework to reduce corporate tax rates.  What’s the point of reducing the corporate tax rate from 35 to 28 percent if you’re just going to hike the tax paid by corporate shareholders at the same time?  As the CBO pointed out back in December, the marginal effective tax rate on corporate investments includes both layers of the corporate tax.

In 2012, the combined marginal rate on corporate investment was 45 percent (the 35 percent corporate tax plus the 15 percent shareholder tax times the remaining corporate income).  After health care reform and the fiscal cliff, today’s marginal tax on C corporation investment is 50 percent.  If Congress agreed with the President and cut C corporation rates while also hiking capital gains and dividend rates, the net result would be a 48 percent marginal tax.  You’ll notice that’s higher than when we started, which begs the question of how all this is supposed to make the U.S. a more attractive place to invest?

The capital gains tax hike is bad for pass-through businesses too.  For many business owners, selling the business is their retirement plan.  One of the advantages of S corps and partnerships is that their owners get capital gains treatment when they sell the business.  The President’s proposal would raise the tax on those sales to 28 percent.

For owners who choose to pass their business on to their children or employees, the proposal would force them (their estates, really) to pay the capital gains tax at the time of their death, along with any estate tax that is owed.  The Administration used this example:

The largest capital gains loophole – perhaps the largest single loophole in the entire individual income tax code – is a provision known as “stepped-up basis.” Stepped-up basis refers to the fact that capital gains on assets held until death are never subject to income taxes. Not only do bequests to heirs go untaxed, but the “tax basis” of inherited assets used to compute the gain if they are later sold is immediately increased (“stepped-up”) to the value at the date of death – making the capital gain income forever exempt from taxes. For example, suppose an individual leaves stock worth $50 million to an heir, who immediately sells it. When purchased, the stock was worth $10 million, so the capital gain is $40 million. However, the heir’s basis in the stock is “stepped up” to the $50 million gain when he inherited it – so no income tax is due on the sale, or ever due on the $40 million of gain. Each year, hundreds of billions in capital gains avoid tax as a result of stepped-up basis.

Let’s take a step back.  There are two reasons for stepped-up basis.  The secondary reason is to ease record keeping.  Ask the American Farm Bureau how hard it is to keep track of basis from one generation to the next.  The Administration “solves” the record keeping challenge by forcing the estate (heir, really) to recognize any capital gain when the owner dies.

So if the stock left to an heir in the Administration’s example is a pass-through business, the estate is going to need to raise around $10 million to pay the capital gains tax.  For most estates, coming up with that sort of cash without selling or liquidating the business is simply out of the question, so the proposal will result in an increase in the number of private businesses sold at the death of the owner or, most likely, when the owner is still alive and able to plan the transaction.  Warren Buffett will love this proposal.

But record keeping is the secondary reason for stepped up basis.  The primary reason is the existence of the estate tax.  That $10 million owed by the estate is in addition to the estate tax already owed on the business.  Since the resolution of the fiscal cliff in 2013, the estate tax owed in the Administration’s example is 40 percent on the value of the estate over $5 million, or $18 million.  The tax code recognizes this liability by giving the heir of the estate a step-up in the basis of the assets they just inherited (and the estate just paid tax on).  The Administration ignores this dynamic in their write up and proposal.

So under the President’s plan, the heir inherits a $50 million business but also (in effect) inherits a $28 million tax bill.  What business could survive that sort of tax hit?

The Administration claims their proposal includes protections to ensure that no “small” business would have to be sold to pay the tax, but we’re skeptical.  Congress tried to protect family businesses from the estate tax back in the 1990s, and it was your basic disaster.  Almost no businesses were able to jump through the necessary hoops to gain the protection, and the qualified family-owned business provision was scrapped.

But those are just minor details and quibbles compared to the scale of the tax envisioned by the President – over 50 percent in the example above!  Thomas Piketty would be proud.  The new Republican Congress will never go along with these ideas, of course, so they only serve to remind us of just how far apart Congress and the Administration are on tax policy.  It’s just one more reason to be skeptical of tax reform or any other broad tax policy being enacted this year.