Capital Gains Tax: Overview
Capital Gains Tax (CGT) refers to the tax imposed on the profit realized from the sale of capital assets, such as real estate, stocks, and bonds. When an asset is sold for more than its purchase price, the profit is classified as a capital gain and is subject to taxation. The tax rate varies depending on how long the asset was held; gains from assets held for less than one year are treated as short-term capital gains and taxed at the seller's ordinary income tax rate, while long-term capital gains, from assets held for over a year, benefit from a lower tax rate established by tax laws.
The historical context of the capital gains tax reveals fluctuations in rates influenced by economic conditions and fiscal policies, with significant changes occurring through various tax reform acts over the decades. Recent discussions around CGT have centered on its implications for economic growth, wealth inequality, and investment behaviors. Supporters of lower rates argue that high capital gains taxes hinder investment and may disproportionately affect wealth accumulation among higher-income individuals. Conversely, advocates for higher rates highlight concerns about fairness and the potential for widening income disparity. Overall, capital gains tax remains a complex and often debated element of the U.S. tax system, with ongoing discussions reflecting differing economic philosophies and social priorities.
Capital Gains Tax: Overview
Introduction
According to the United States Internal Revenue Service (IRS), “Almost everything you own and use for personal or investment purposes is a capital asset.” Capital assets include real estate, stocks, bonds, and other investments. When a capital asset is sold at a profit, that profit is considered a capital gain and is subject to taxation. Profits from capital assets that were held for less than one year before being sold are considered short-term capital gains and are taxed at the same rate as the seller’s personal income tax rate. However, if the capital asset is held for more than one year, any profit from its sale is considered a long-term capital gain and is taxed separately. After changes in US tax law in 1997, the capital gains tax rate in most cases became significantly lower than personal income tax rates, which are applied to wages and salaries.
Proponents of lowering the capital gains tax argue that the tax represents a double taxation on savings and investments, emphasizing that the tax is not indexed for the effects of inflation. Those who support lowering the tax rate further argue that a high capital gains tax discourages investment and economic growth. On the other hand, those who support raising the capital gains tax point to evidence that indicates the capital gains tax has little correlation with economic growth and that a low capital gains tax rate disproportionately benefits the wealthy.
Understanding the Discussion
Capital gain: The profit generated from the sale of an asset such as stock or real estate that is subject to the capital gains tax rate.
Capital loss: The financial loss incurred by selling an asset for less than its original purchase price. Capital losses may be deducted on tax returns if they exceed capital gains and may be used to reduce other sources of income.
Laffer curve: A graphical representation of the relationship between tax rates and tax revenue, which demonstrates that raising tax rates above a certain point will result in lower revenues.
Long-term gains: The profits generated from the sale of assets held for more than one year before being sold; subject to the capital gains tax rate.
Short-term gains: The profits generated from the sale of assets held for less than one year before being sold; subject to the personal income tax rate.
History
The US tax code was established in 1913 with the ratification of the Sixteenth Amendment, which eliminated restrictions on income taxation and granted Congress the “power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” From 1913 through 1921, capital gains were taxed at the same rate as income, fluctuating from 15 percent in 1916 to 77 percent in 1918 at the height of World War I. Beginning in 1922, with top income tax rates set at 58 percent, capital gains were made distinct from other forms of personal income with the enactment of the Revenue Act of 1921; the 1921 law created a separate tax rate for capital gains with a maximum of 12.5 percent for assets held for more than two years.
During the Great Depression, President Franklin D. Roosevelt responded to the economic crisis in part by raising tax rates on income and capital gains, more than doubling the maximum capital gains tax rate to 31.5 percent in 1934. Also beginning in 1934, taxpayers could exclude percentages of gains based on how long the assets had been held—allowing exclusions of up to 70 percent on assets that had been held for more than ten years. Following the entry of the United States into World War II, taxpayers were allowed to exclude 50 percent of capital gains on assets held for longer than six months or to elect to pay an alternative rate of 25 percent; these provisions remained largely unchanged through 1960s. With the Tax Reform Act of 1969, personal income tax rates were lowered significantly, while the maximum tax rate on long-term capital gains totaling more than fifty thousand dollars was steadily increased over several years, reaching 36.5 percent in 1972. Under the 1969 act, capital gains totaling less than fifty thousand dollars remained eligible for the 25 percent tax rate. The Tax Reform Act of 1976 again raised the capital gains tax rate—to nearly 40 percent.
In 1978, several changes were made to the tax code, lowering capital gains tax rates to 28 percent; rates were lowered again in 1981 to a maximum of 20 percent. In 1986, President Ronald Reagan signed a tax reform law that would tax personal income and capital gains at the same rates, bringing maximum rates for capital gains up to 28 percent. Despite the increase in the tax rate, revenues from the capital gains tax dropped, prompting some economists to speculate that the new rate was set on the “wrong side” of the Laffer curve, a graph that demonstrates the point at which raising tax rates actually leads to decreased revenue. Nevertheless, despite the increase in capital gains taxation, the economy grew by 3 to 4 percent each year from 1988 through 1990. In 1991, capital gains were again subject to a separate tax rate from personal income, with a maximum rate of approximately 29 percent through 1996. In 1997, the capital gains tax rate was dropped to 20 percent. Despite reducing the capital gains tax rate by nearly 30 percent, the reduction generated a 25 percent increase in tax revenue the following year. While the US Treasury had collected approximately $60 billion in capital gains revenues in 1996, it collected $75 billion in 1997.
In 2003, in response to the economic downturn that had begun in 2001, President George W. Bush signed the Jobs and Growth Tax Relief and Reconciliation Act, which temporarily reduced the maximum rate on capital gains to 15 percent. In 2005, the Tax Increase Prevention and Reconciliation Act extended the 2003 tax rates—which would have otherwise expired in 2008—through 2010. In 2010, the 15 percent rate on capital gains was extended again through 2012 with the passage of the Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act.
The temporary reductions made to the capital gains tax rate during Bush’s presidency expired on December 31, 2012. The American Taxpayer Relief Act of 2012 added the 20 percent rate in the 39.6 percent tax bracket, but it locked in qualified dividends to the tax code.
Capital Gains Tax Today
US tax law continued to evolve through the late 2010s and into the 2020s, influenced by numerous complex economic, political, and social factors. The capital gains tax remained relatively stable despite some changing details, but the issue continued to be a frequent point of debate. According to the Tax Policy Center, beginning in 2018, long-term gains in the brackets under 25 percent were taxed at a 0 percent rate, those in the 25–35 percent brackets were taxed at 15 percent, and those in the brackets above 35 percent were taxed 20 percent. The maximum capital gains tax rates were also higher for the sales of arts and collectibles (28 percent), certain small business stocks (28 percent), and certain developed real property (25 percent). For high-income earners, there was a further net investment income tax (NIIT) of 3.8 percent.
Under the Tax Cuts and Jobs Act of 2017, the income levels used to determine long-term capital gains were severed from the higher-income tax brackets. Around that time, President Donald Trump reportedly considered whether to index capital gains to inflation, a move widely favored by conservatives. Conservatives tend to see the higher capital gains taxes as harmful to global competitiveness and investment, a deterrent to entrepreneurship, and a double tax, as both individual investors and a corporation pay tax on the same profits. Indeed, the idea of abolishing the capital gains tax altogether gained traction among some Republicans in the 2010s.
Many liberals and progressives, on the other hand, tended to favor increasing or otherwise radically reforming the capital gains tax. They often asserted that existing capital gains tax policies more than accounted for inflation, and also potentially exacerbated income inequality and the racial wealth gap through loopholes for inheritance, charitable donations, and like-kind exchanges. Critics of lowering capital gains taxes fear growing the government budget deficit and creating possible tax shelters. Some capital gains reformists have argued for an accrual tax, meaning unrealized gains in asset value would be taxed each year.
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