Here's how Obama's capital gains tax plan hits the 1% where they live

Obama's capital gains plan would close the biggest loophole in the tax law--so guess who's against it

With President Obama placing tax reform on the table in his State of the Union address, scheduled for delivery to Congress on Tuesday, we can expect weeks or months of Washington debate about the vices and virtues of the tax breaks held dear by many segments of the taxpaying public.

In the past, the most prominent tax breaks have generally been treated as equals--the mortgage deduction is pretty much the same as, say, the capital gains preference or the charitable contributions write-off.

But they're not equal. Aiming his fire at the capital gains tax by proposing that the top rate be raised to 28% from 23.8%, Obama essentially has exposed what the 1% really value. They really love the capital gains preference, which applies to profits from the sale of stocks, bonds and other capital assets. (The top marginal rate on ordinary income is 39.6%--for married couples, that's on income in excess of $457,600.) This provides a clue to how the tax reform debate is likely to play out in Washington.

Most itemized deductions such as mortgage debt benefit the wealthy more than the middle or working class because the rich pay a higher marginal income tax rate. If you earn more than about $500,000 and your top rate is 39.6%, then for every dollar you contribute to charity or spend on a home mortgage you reduce your tax liability by as much as 39.6 cents (actually it can be somewhat less, as itemized deductions are reduced for high-income taxpayers). If your family earns $100,000 (top rate: 25%), every deductible dollar you spend gains you only 25 cents.

Some of these deductions are further capped for the wealthy. The mortgage deduction, for instance, applies to a maximum mortgage debt of $1 million, including the debt on both a first and second home.  

As a result, even the wealthiest Americans have relatively modest mortgage deductions. According to IRS statistics for 2011, the most recent available, the average mortgage deduction for taxpayers reporting $10 million or more in income was $13,898. For those with income of $1 million to $1.5 million, the average was about $17,266; for those in the $75,000-to-$100,000 income range, it was $4,982. These figures aren't surprising, since the first year's interest on a million-dollar home loan even at 6% is a hair less than $60,000.

The capital gains preference, however, is uncapped. The larger the gain one reports, the greater the tax break--that differential between the 23.8% top cap gains rate and the 39.6% top marginal rate is gold, pure gold. In 2011, according to the IRS, the average net capital gain reported by those in the $75,000-to-$100,000 income range was $761. For those just at the millionaire level, it was $137,755. For those earning $5 million to $10 million, it was $1.8 million. And for those with income of $10 million or more, the average reported taxable capital gain was $12.6 million. That's the income club, remember, that claimed an average of only $13,898 in average annual mortgage deductions.

Which tax preference do you think the 1% will fight hardest to preserve? 

There's another aspect that makes the capital gains preference entirely too profitable. As USC tax expert Edward Kleinbard has observed, the capital gains tax is our only truly voluntary tax. Taxpayers can defer it indefinitely simply by deferring the sale of taxable assets. If you're rich enough to hang on to your stocks and bonds, or can employ financial strategies enabling you to exploit their value without actually selling them, you can put off your capital gains liability for your entire life.

Then comes the biggest loophole of all, the so-called trust fund loophole. This allows capital assets to be passed on to one's heirs at their appreciated value: if you bought a share of stock for $100 decades ago and it's now worth $1,000, it's valued at the higher figure when your heirs inherit it. In other words, the accumulated capital gains tax liability is utterly extinguished. That's virtually unique in the tax world, where taxes typically can be deferred, but not eliminated.

"Hundreds of billions of dollars escape capital gains taxation each year because of the 'stepped-up' basis loophole that lets the wealthy pass appreciated assets onto their heirs tax-free," says a White House fact sheet on the tax proposals. Closing that loophole would make the cap gains tax much less voluntary--someone would have to pay the liability at some point--either the deceased owners' estates, or their kids. 

The beauty part of this proposal is that it's aimed surgically at the wealthiest taxpayers. Obama's opponents will try to paint the plan as an attack on middle-class taxpayers and small-business owners. Here's Sen. Orrin Hatch, R-Utah: "Slapping American small businesses, savers and investors with more tax hikes only negates the benefits of the tax policies that have been successful in helping to expand the economy, promote savings and create jobs."

The numbers contradict him.

"Only a very small percentage of people--essentially those who are quite wealthy--would owe any tax on unrealized capital gains when they die," observes Robert Greenstein of the Center on Budget and Policy Priorities.  As he points out, the Treasury estimates that 99% of the revenue raised by boosting the capital gains tax rate and closing the inheritance loophole would be paid by the top 1%--and four-fifths of it would come from the richest tenth of 1%.

Representatives of the 1%--and that's a distressingly large component of Congress--have staved off tax reforms oriented toward the middle- and working class by painting tax increases on the wealthy as attacks on the middle. The State of the Union address gives Obama a chance to make the true stakes crystal clear. 

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