This year marks the 100th year since the Revenue Act of 1921 introduced the first preferential rate for capital gains into the U.S. federal income tax system. In recent years, no single tax issue has been as contentious and divisive as the capital gains preference. Just four years after the enactment of the 2017 Tax Cuts and Job Act, the federal tax system may be on the cusp of yet another major overhaul. The capital gains rate increase has been one of the most scrutinized tax proposals in President Biden’s Build Back Better plan, which has been continuously slimmed down in ongoing negotiations from the initial $3.5 trillion price tag over a decade (which, though high, is far less than would be the ten-year cost of the annual military budget just passed by the House and Senate).1 While the federal tax code has undergone numerous reforms, however, the capital gains preference has weathered the shifting political winds with remarkable durability, perhaps reflecting the fact that it is most readily available to the nation’s wealthiest and most powerful individuals.
This article addresses notable aspects of the 100-year-old history and policy debate about the preferential treatment of capital gains. Part I provides the general contours of the Build Back Better Act as proposed by President Biden and the significance of President Biden’s capital gains proposals as compared to those in the Tax Reform Act of 1986 (the 1986 Act), under which capital gains and ordinary income were subject to the same rate for the first time in the U.S. income tax history. Part II provides historical background on the origins of the capital gains preference. Part III explores the policy arguments, repeated throughout the 100-year period, for and against the capital gains tax preference.
I. The Build Back Better Act and the Tax Reform Act of 1986
In late fall 2021, the Build Back Better Act2 was considered under congressional budget reconciliation rules which would allow the bill to pass in the Senate with a simple majority, though that majority is in serious question given W.Va. Senator Joe Manchin’s recent “stuck on coal” positions against various provisions in the bill, including its support for renewable energy sources.3 Known to be the centerpiece of President Biden’s domestic agenda, the initial $3.5 trillion reconciliation package included a paid-family leave program, free universal preschool services, an extended child tax credit, and renewable energy tax breaks, among others.4 To pay for these social programs, the House reconciliation bill originally proposed higher taxes, tax enforcement,5 and other major tax law changes, such as further limitations on section 1031 like-kind exchanges and carried interest, introduction of graduated corporate rates, a country-by-country application of the global intangible low-taxed income (GILTI) rules, and limitations on the 20 percent deduction under section 199A.6 The House reconciliation bill prior to passage included an increase in the top tax rate on long-term capital gains to 25 percent. That rate fell well short of President Biden’s previous ambitious goal to tax capital gains at the maximum ordinary income rate of 39.6 percent for wealthy taxpayers earning more than $1 million annually.7 The capital gains rate increase was ultimately withdrawn from the bill as passed in the House, however, and is unlikely to be added back if and when the Senate passes the bill.
Eliminating the capital gains preference has been politically popular among Democrats and progressives for some time. All three of the 2020 democratic presidential front-runners—then former-Vice President Biden, Senator Elizabeth Warren, and Senator Bernie Sanders—campaigned on taxing capital gains as ordinary income to certain wealthy taxpayers.8 In contrast, Republican lawmakers have steadfastly resisted the idea of raising capital gains rates; in fact, former President Donald Trump floated the idea of further reducing the top capital gains rate to 15 percent.9
The only time in the U.S. income tax history when the statute provided for capital gains to be taxed at the same rate as ordinary income was for the brief period after Republican Senator Bob Packwood, chair of the Senate Finance Committee, and Democratic Representative Dan Rostenkowski, chair of the House Ways and Means Committee, joined to become a dynamic tax-writing team pushing through the most significant tax reform bill in history.10 The Tax Reform Act of 1986 increased the highest rate on capital gains from 20 percent to the ordinary income rate. At the same time, it reduced the top marginal individual income tax rate from 50 percent to 28 percent. As a result, both ordinary income and capital gains were to be taxed at a 28 percent rate. In 1986, as in the case of the Biden proposal, fairness seems to have been the central goal. President Reagan called the 1986 Act “a sweeping victory for fairness.”11 The Treasury Department Report to the President further explained:
A tax that places significantly different burdens on taxpayers in similar economic circumstances is not fair. For example, if two similar families have the same income, they should ordinarily pay roughly the same amount of income tax, regardless of the sources or uses of that income.12
Critics, however, viewed the 40 percent increase in the capital gains rate as a “detrimental fallout from tax reform.”13 The change was short-lived, lasting only from 1988 to 1990, when ordinary rates were increased without parallel increases in capital gains rates. Nevertheless, today’s ever widening economic inequality, exacerbated by the COVID-19 pandemic and public outcry against the wealthy who pay little or no federal income taxes,14 has given some new political momentum to the elimination of one of the most expensive tax expenditures in the Code that has played a key role in exacerbating that inequality through its preferential taxation of a significant source of income for an elite group of carried interest recipients, corporate founders, and dynastic families with inherited capital.
II. The Origin of the Capital Gains Preference
Capital gains are gains from the sale or exchange of capital assets such as stocks and bonds, real estate, and artworks. Under the current tax law, long-term capital gains, which are gains from capital assets held for more than one year, are taxed at 20 percent.15 Short-term capital gains, which are gains from capital assets held for less than one year, are taxed at ordinary income rates. Special categories of capital gains enjoy even lower rates, such as gains on certain small business stock under section 1202. Gains on collectibles such as antiques and art, however, are taxed at a slightly higher 28% rate.
Neither the first income tax adopted during the Civil War nor the income tax adopted after the ratification of the Sixteenth Amendment in 1913 “took  notice of capital gains.”16 As academic commentators noted, although the idea of progressive rates and different classifications of income had existed well before these income taxes were introduced in the United States, the 1913 income tax was designed to be simple, for taxpayers to “become acquainted with the proposed law and for it to become adjusted to the country.”17 With the initial high exemption and low rates topping out at 7 percent, about 2 percent of the households paid income tax at the marginal rate of only 1 percent.18
The first preferential rate for capital gains was introduced in the Revenue Act of 1921. Under the 1921 Act, capital gains on assets held for at least two years were taxed at 12.5 percent, while ordinary income was subject to the top marginal rate of 65 percent.19 By that time, the Code had become more complex, largely due to the growing need for revenue to finance the country’s World War I efforts. The Revenue Act of 1916 and the War Revenue Act of 1917 greatly increased income tax rates while simultaneously lowering exemptions.20 The top marginal rate on individuals had climbed from 7 percent to 77 percent by 1918,21 and nearly 20 percent of American households were then subject to income taxes.22 At the same time, more Americans started participating in financial markets, with ownership of stocks and bonds becoming more common. Almost one-third of the American population owned some form of federal war bond during World War I, compared to less than 1 percent before the war.23
After World War I, the country’s need for revenue remained high, but it also faced an economic recession, unemployment, and “growing labor and racial unrest.”24 The income tax system developed in wartime was viewed by commentators as “a prime cause of the depression.”25 Pressure mounted on Congress to cut taxes to stimulate the economy.26 This set the stage for the policy debate on preferential treatment of capital gains—a debate repeated through the next hundred years. As the country now emerges from a global pandemic—which many have analogized to a war27—it is faced with similar questions about vastly unequal wealth, opportunity and economic growth that it faced in the aftermath of World War I.
III. Policy Debate Then and Now
Preferential rates for capital gains are thus the U.S. historical norm, as well as in many developed countries around the world.28 This norm has been challenged, especially in times of significant social, political, and economic turmoil. The capital gains debate is part of the larger debate about how to best organize (or reorganize) our social, political, and economic lives. Yet, “[t]here is hardly anything natural, neutral, or necessary about the capital gains tax preference.”29 The main arguments can be cast in terms of the familiar tax policy goalposts of efficiency, fairness, and simplicity.
The dominant rationale, expressed by various lawmakers and business leaders in the 1921 tax act debates in favor of the capital gains preference, is the claim that it removes barriers to economic growth and entrepreneurship by encouraging savings and unlocking the free flow of capital. Because capital gains are generally taxed only when realized through a sale or other disposition of capital assets, economists see a “lock-in” effect, whereby taxation discourages investors from realizing accumulated capital gains and thus from allocating capital to more productive uses. For instance, a congressman noted that a taxpayer “would refrain from making a sale of land or other property constituting capital assets because he would have to pay so large a proportion to the Government.”30 Then-Treasury Secretary Andrew Mellon argued that high tax rates cause investment to move from private enterprises into tax-exempt municipal and state bonds, which “allowed subnational governments to indulge in extravagant public projects,” resulting in economic inefficiency.31
These arguments are echoed by those political and business leaders today who oppose the proposed capital gains rate increase in the Build Back Better bill. For example, Senate Finance Committee Ranking Member Mike Crapo (R-Idaho) raised similar concerns about the capital gains rate increase, quoting a recent Wall Street Journal article on the subject.32
The most important reason to tax capital investment at low rates is to encourage saving and investment. Consumption—buying a car or yacht—faces a sales tax but not a federal tax. But if someone saves income and invests in the family business or in stock, he is smacked with another round of tax. Tax something more and you get less of it. Tax capital income more, and you get less investment, which means less investment to improve worker productivity and thus smaller income gains over time.33
Similarly, the U.S. Chamber of Commerce emphasized that capital gains “are a critical element as businesses seek to form and expand operations,” and the proposed capital gains rate increase would “deliberately harm U.S. economic competitiveness and job creation.”34
Critics of the capital gains preference have questioned whether empirical data support that purported efficiency argument. Scholars have pointed out that the arguments made during the 1921 debate in favor of the capital gains preference were based on minimal “objective, empirical evidence to support the theory that the lower tax rate on capital gains led to greater tax revenue from the increased sale of capital assets.”35 Recent Congressional Research Service and economist studies have confirmed that there is “essentially no correlation between economic growth and capital gains tax rates.”36 Armed with these findings, organizations opposing the capital gains preference, such as the Center for American Progress, have actively challenged the idea that cutting capital gains taxation helps the economy.37
Another argument of opponents of capital gains taxation is that taxing capital gains is unfair. The first claim is that preferential treatment of income from capital is a necessary remedy for the bunching of income. If taxed under ordinary income’s progressive rates only upon realization, income from capital gains would be “bunched” into one year and therefore taxed substantially more than would the same total income earned incrementally over twenty or thirty years: the one-time sale pushes the taxpayer into a higher income tax bracket. An increase in tax rates on capital gains would therefore lead rational taxpayers to hold onto assets longer rather than selling.38 At the 1921 hearing, Frederick R. Kellogg, an established corporate lawyer of the day, shared stories of this presumed “injustice” manifest across classes: an inventor who could not sell his invention because he could not afford the tax liability; a farmer who could not sell his land despite an increase in the land’s value; and a homeowner who had to suffer a loss from selling his appreciated home before relocating to a different city.39 Echoing Kellogg’s point in July 2021, the entire Senate Republican Caucus came out in opposition to a capital gains tax increase, arguing that it would “hit family-owned businesses, farms, and ranches hard, particularly in rural communities” whose businesses “consist largely of illiquid assets.”40
A second fairness claim of proponents of the preference is that it relieves taxpayers from multiple levels of taxation on the same income. If an individual taxpayer uses her income to buy shares in a corporation, the corporation is taxed on its profits and the taxpayer is also taxed on dividends paid out of those profits (currently, at the preferential capital gains rate). If and when the taxpayer eventually sells her stock at a gain, she is also taxed on that increased value. The claim is that the taxpayer pays more total tax than another who had the same amount of income in the form of wages.41 Worse, according to this argument, capital gains and capital losses are treated asymmetrically, with net capital losses allowed to offset only up to $3,000 of ordinary income per year.42
Critics of the capital gains preference also argue fairness, but from a different angle. The capital gains preference functions as an unnecessary giveaway to uber-wealthy taxpayers whose wealth disproportionately consists of capital assets as compared to middle- and lower-class taxpayers. For instance, before the Tax Cuts and Job Act was enacted, “the top 10 percent of earners reported 82.6 percent of taxable interest, dividends, capital gains, schedules C and F income, and flow-through business income.”43 In justifying its proposal to raise the capital gains rate in September 2021, the Biden administration released an analysis showing that the “400 wealthiest American families paid an average federal income tax rate of only 8.2 percent on $1.8 trillion of income from 2010 to 2018.”44 Based on these statistics, there would clearly be no significant increased tax cost because of bunching income for high-wealth taxpayers.45 Furthermore, critics note that preference proponents overlook the substantial tax benefits conferred by deferral (potentially indefinitely) of capital gains on top of the preferential rate. If a taxpayer holds a capital asset that appreciates in value over time, the taxpayer effectively receives “an interest-free loan from the Treasury” equal to the amount of tax she would owe on the appreciation until she sells the asset.46 Even the eventual sting of deferred income recognition from bunching is hardly felt, since it can be avoided if the taxpayer borrows against her wealth rather than selling assets (leaving the intact wealth to an heir, who can sell to pay off the debt with no taxable gain because of the step-up in basis). The gains may, using borrowing and deferral until death, escape taxation altogether. On balance, the benefit of deferral may well outweigh any higher future taxes. If this sounds theoretical, look no farther than to billionaire Warren Buffett, who pays a lower effective income tax rate than his secretary.47
The final arguments against a capital gains preference relate to tax simplicity. A tax preference for capital gains necessarily opens the door for tax planning opportunities to reduce tax liability by recasting what would be ordinary income as a capital gain. If a taxpayer in the 37 percent income tax bracket can recharacterize ordinary income as capital gains—e.g., recharacterizing cancellation of debt income as a section 1231 gain in a debt discharge situation—then she would lower her tax rate on that income to 20 percent. Many sophisticated tax shelters have successfully combined this capital gains alchemy with tax deferral and taxpayer-friendly depreciation schedules to produce gold-plated tax results. Even worse, such tax shelter strategies encourage wasteful investments and may “actually retard economic growth.”48 For instance, during the surge in real estate tax shelters in the early 1980s, the capital gains tax preference encouraged “churning of residential rental real estate”—the selling and buying of depreciable assets for no other purpose than to save taxes.49 Resources that could otherwise have been put to more productive purposes are wasted on designing and managing such tax shelters. In response to the proliferation of abusive tax shelters, the IRS keeps and regularly updates a “bad boy” list of transactions that taxpayers are required to disclose.50 The endless game of tax shelter “Whack-a-Mole” between the IRS and clever tax advisers (mostly for ultra-wealthy taxpayers) has resulted in more rules and regulations and less tax simplicity in the federal income tax system.
Capital gains rates have fluctuated up and down with shifting political winds and very briefly merged with ordinary rates under the 1986 Act. The low rates of the capital gains preference are only one part of what makes capital gains a powerful tax planning tool—the realization requirement and related opportunity for significant deferral, combined with the step up in basis at death, go a long way in the continuation of wealthy dynasties. A number of amendments to the Build Back Better bill have been introduced over the short period of writing this article, but the capital gains preference is highly unlikely to be eliminated. The Republicans are unwilling to tax the ultra-wealthy, and even some Democrats find changing the rules on likely campaign donors hard to do.