5 Reasons Why Terminating Stepped-Up Basis Would Be Very, Very Bad for Family Businesses, Entrepreneurship and the Economy

By at 9 August, 2021, 12:53 pm


by Raymond J. Keating –

If one thinks that class warfare and increasing government spending are essentially all that truly matter regarding the impact of taxes, then why wouldn’t you favor all kinds of tax increases? That is the case with the Biden administration and many in Congress, including plans to increase the burden of capital gains taxes at death. That’s obviously problematic for investment and entrepreneurship, which happen to be key drivers of economic growth.

President Joe Biden and assorted Members of Congress (such as through the so-called Sensible Taxation and Equity Promotion (STEP) Act) have proposed a drastic change in the capital gains tax applied at death, which, in turn, would dramatically increase the overall tax rate faced at death.

A Deadlier Death Tax

The Biden plan would impose both the estate tax and the capital gains tax at death. Currently, and what has been the case since 1921, imposing both taxes at death has been avoided. Tax law typically has allowed for a “stepped-up basis” for assets transferred at death, so that they were not hit by the capital gains tax and the death tax. The stepped-up (or step-up) basis means that the capital gains basis for an inherited asset is stepped up to the fair market value at the time of the original owner’s death. So, if an heir sold the asset in the future, then capital gains tax would apply to the gain in value since, or after, the bequeathal.

Specifically, the Biden plan and related proposals would retroactively tax capital gains on income and property passed on to heirs after the owner’s death. Therefore, a person who inherits an asset would be taxed on the full appreciation of an asset, including before they took ownership or control. And by the way, then total assets inherited would be subject to the estate tax, or death tax.

For good measure, President Biden has proposed a dramatic increase in the capital gains tax – from 20 percent plus the 3.8 percent Obama Medicare tax for a total of 23.8 percent to an increased top personal income tax rate of 43.4 percent on gains worth more than $1 million.

Let’s consider 5 key reasons why this effort to eliminate the stepped-up basis makes for tax policy that undermines entrepreneurship, small business and the economy.

#1  Tax increases are negatives for the economy 

Quite simply, tax increases undermine the economy by draining resources from the private sector – where resource allocation decisions are guided and disciplined by prices, profits, losses, consumers, competition and private ownership – and handed over to elected officials and their appointees in government – where political and special interest preferences prevail and failure generally is subsidized.

This is the overarching problem with all tax increases – most certainly including higher capital gains taxes – that is missed entirely by those who advocate for bigger government and higher taxes.

#2  Higher capital gains taxes are particularly damaging to the economy

When one recognizes that entrepreneurship and private investment are the engines or fuel of economic growth, it becomes clear that taxing the returns on entrepreneurship and investment via the capital gains tax is particularly damaging to economic, income and employment growth.

By reducing the potential returns on such risk taking, the incentives for undertaking such activities are reduced. And make no mistake, starting up, building and investing in a business are endeavors fraught with risk and uncertainty. Increasing the tax burden on capital gains – such as via killing the stepped-up basis and/or increasing the tax rate – ranks as one of the most economically destructive tax measures government can inflict.

#3  Increased taxes at death

When talking about a small business, the death of an owner obviously can be a devastating blow. How many businesses, and the jobs they produce and support, go under at such times? And as a business reels under such grim circumstances, it’s always been unwise for government to show up via the death tax to grab a big chunk of total assets.

The death tax ranks as a pure class warfare undertaking, given that basic economics go completely ignored. In an SBE Council brief, it was explained that the death tax fails to provide any net revenue to the federal government; “reduces incentives for investing and entrepreneurship, and increases the likelihood of businesses being closed or sold”; imposes broad economic costs; is an unfair levy, being imposed at death on total assets after a lifetime of paying taxes and fees; and again, is rooted in class warfare and envy.

Given all of these problems, President Biden and various members of Congress are looking to make matters even worse by adding the capital gains tax to this grave mix of death and taxes.

#4  The combined tax rate at death would be destructively high

While noting the ills of capital gains and death taxes, those negatives grow ever worse the higher tax rates climb.

In a recent SBE Council analysis, we took a look at how the death tax would combine with the removal of the stepped-up basis for capital gains. It was noted:

“Let’s consider the example of a small business valued at $52 million at the owner’s death after an initial investment of $12 million. The $40 million capital gain would be taxed at 43.4 percent, for a liability of $17.36 million. The remaining $34.64 million in assets, after the $11.7 million [death tax] exemption, would be taxed at 40 percent, for an additional tax bill of $9.18 million. That’s a total tax bill of $26.54 million, or a total tax rate of 51 percent. For good measure, factor state taxes and inflation into the equation (capital gains are not adjusted for inflation), and the real total tax rate would be pushed even higher.”

If we add in a 5.2 percent state capital gains tax (the approximate state average), the total tax rate climbs to 53.4 percent under the above scenario.

Let’s take a moment to further consider a possible inflation scenario. If we assume that the business is 20 years old and that inflation over that period was the same as what prevailed from 1999 to 2019, then the inflation-adjusted total tax rate – that is, combined capital gains and death taxes – would come in at almost 80 percent.

The disincentive for starting up, building and investing in businesses should be obvious at such an absurd level of taxation.

#5  Estimating economic losses

Basic economic principles and history tell us that eliminating the stepped-up basis in capital gains at death will be a negative for the economy. The only real question is: how significant would this negative be?

A recent study conducted by Regional Economic Models for the Committee to Unleash Prosperity found the negatives to be quite significant:

● Sustained annual job losses ranging from over 500,000 to almost 1 million;

● 10-year losses in economic output and GDP of about $2 trillion and $1 trillion, respectively, with a $600 billion loss in private investment, and a $6 billion loss in R&D spending;

● 10-year loss in personal income of about $1 trillion, which translates to $8,000 – 10,000 per household.

Another study for the Family Business Estate Tax Coalition also estimated the macroeconomic effects of eliminating the stepped-up basis and found:

● “A significant portion of the burden of repeal of step-up of basis would fall on workers through reduced labor productivity, wages, and employment. Repealing step-up of basis via tax at death is estimated to decrease job equivalents” by an estimated 80,000 jobs annually in the first ten years and 100,000 jobs per year thereafter.

● Also, “for every $100 of revenue raised by repeal via tax at death the wages of workers would decline $32. That is, the burden of the tax is such that nearly one-third of every dollar of revenue raised comes out of the paychecks of US workers.”

● “Repeal of step-up of basis via tax at death is estimated to decrease US GDP” by $10 billion each year.

This study went on to look at the negative effects via a series of family business case studies, including for family-owned manufacturers, a farm, and a beer distributor.

The Wrong Debate and the Wrong Time

In the end, the U.S. is having the wrong debate about capital gains and death taxes. And most certainly at the wrong period in time – as the economy works to recover and sputter in the pandemic economy.

The Biden administration and congressional allies are focused on how to raise these taxes, and the debate is focused on how to do so and by how much. They are engaged in the politics of government spending and class warfare. However, revitalizing entrepreneurship, spurring investment, and driving economic growth forward demand a very different discussion, that is, one focused on actual economics, and therefore on whether to reduce or completely eliminate capital gains and death taxes.

Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.


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