Incorrectly Ruling Out “Step-Up”

The authors also made a considerable error in ruling one policy out of bounds. They assume that the Romney plan would not change the step-up in basis of capital gains at death. This critical error significantly biases the report’s results.

All proper tax reform plans should eliminate the death tax, as the Romney plan does. Under current law, heirs of taxable estates inherit assets after paying the death tax. When they sell those assets later, they calculate their capital gains tax by subtracting the asset’s value at the time they inherited it rather than the price that the original owner paid. This is known as “step-up” basis. This makes sense because the heir already paid the death tax on the asset. Using the initial owner’s basis would make the double taxation of the death tax even worse than it already is.

However, keeping step-up in place after eliminating the death tax would mean that some of the value of inherited assets escapes taxation. There is no economic justification for keeping it in place after death tax repeal. Plans that properly repeal the death tax typically employ a system, after repeal, whereby heirs pay capital gains tax when they sell inherited assets using as the basis the price paid by the person from whom they inherited the asset. This is called “carry-over” basis.

Different Assumptions, Different Results

The authors assume that Governor Romney’s plan would raise taxes on middle-income and low-income taxpayers by $86 billion, which would result from closing certain tax preferences on these taxpayers. However, if they had instead eliminated certain tax preferences that tilt toward high incomes that they originally ruled off the table, such as the exclusions of interest on life insurance savings and municipal bond interest, a minimum of $45 billion of the $86 billion would fall on high-income taxpayers, according to their follow-up analysis.

If they fixed their step-up error, a large portion of the remaining $41 billion would also shift from middle-income and low-income taxpayers to high-income taxpayers, moving the Romney plan even closer to distributional neutrality.

The Office of Management and Budget estimates that step-up will reduce tax revenue by $24 billion in 2013.[9] Assuming that assets inherited after death follow the same distribution as long-term capital gains as reported by the IRS in 2009, 78 percent of that $24 billion, or $19 billion, would count as offsets for incomes over $200,000.[10]

In total, fixing the step-up error and putting the exclusions of interest on life insurance savings and municipal bond interest back on the table would shift at least $64 billion of the $86 billion tax increase (about 75 percent) that the report assumes would fall on middle-income and low-income taxpayers to high-income taxpayers.

In addition, this amount is decidedly conservative. Strong evidence suggests that the authors significantly underestimated the $45 billion that would be transferred up from middle-income and low-income taxpayers by eliminating the exclusions of interest on life insurance savings and municipal bond interest.[11] Furthermore, the $19 billion tax reduction for step-up in 2013 would likely be even higher in 2015, the year the report uses for its analysis.

Even assuming the $45 billion estimate is accurate and assuming step-up would not grow in value, there are several ways to close that remaining gap of $22 billion. For example, choosing tax preferences other than the ones the authors chose and combining them with other policy changes that they did not consider in their analysis could close the gap. These could include phasing out personal exemptions for high-income taxpayers or capping their itemized deductions. Some of these options might not be sound policy, but they would easily raise enough revenue from taxpayers earning more than $200,000 to close the $22 billion gap. In fact, President Obama’s fiscal year 2013 budget includes a cap on itemized deductions for incomes over $250,000 that would raise considerably more than $22 billion.[12]

Making these changes in the authors’ assumptions would undo their headline-grabbing conclusion that Governor Romney’s tax reform plan would cut taxes on the rich and raise taxes on middle-income and low-income taxpayers. Instead, with these changes in place, their analysis would show that the Romney plan makes growth-promoting policy changes in a revenue-neutral manner and does not raise taxes on middle-income and low-income taxpayers.

Step-up arises because of the interaction of two taxes—the tax on capital gains and the death tax—and the need to avoid yet another instance of double taxation. When someone dies, an estate is created. Typically, the estate contains appreciated assets on which capital gains tax would have been owed had they been sold prior to the decedent’s passing.

The death tax levies tax on the total value of the estate less an exemption amount. In contrast, the capital gains tax is levied on the increase in value of the asset, which is the difference between the current value and the purchase price, or “basis.”

Taxing the capital gain when an inheritor sells an asset using the basis of the original owner would be taxing the same wealth twice. Thus, after death tax is paid, the basis of the asset is “stepped up” to the current value so the recipient of the asset will owe capital gains tax only on appreciation occurring after receipt.

On the other hand, if the death tax were repealed, then step-up basis would be inappropriate as long as the capital gains tax remains. The appropriate policy is for the new owner to retain the basis of the original owner and thus receive the asset along with its accrued capital gain. This is called “carry-over,” as the tax basis carries over from one owner to the next.