President Joe Biden came into office planning to tax intergenerational wealth more heavily. He had several policy ideas to do this, and the most intellectually defensible of these was to change a capital gains tax provision called “step-up basis.”
Under current law, when you sell an asset, you pay capital gains tax on the amount the asset appreciated. The appreciation is calculated by subtracting the acquisition price—known as the basis—from the sale price. However, there is an exception when you inherit an asset: the basis is the value of the asset at the time you inherited it, not the value at the time it was originally acquired. The capital gains between acquisition and inheritance are lost to the income tax system, as the Treasury Department explained in a recent report supporting Biden’s plan.
Biden had hoped to address this issue in upcoming legislation. But that plan is now in shambles after a public revolt and a decisive push from lobbyists like former senator Heidi Heitkamp. Step-up repeal has been entirely removed from the latest plans released by House Ways and Means Chair Richard Neal.
“Frankly this is a humiliating climbdown from the administration’s posture,” Capital Alpha Partners’ James Lucier told the Financial Times.
It was inevitable that Biden’s tax plans would face some headwinds: a razor-thin margin in both House and Senate, an organized lobbying force, and sincere public sentiments against them. But the Biden administration overreached by coupling this reform with a more aggressive provision that would have forced people to pay capital gains tax immediately upon inheritance, rather than at sale.
Repealing step-up should be important to Democrats
The step-up fight is a big deal. It’s not just an isolated, one-off item on a checklist. Rather, it is interconnected with a variety of Democratic priorities. A Center for American Progress column by Seth Hanlon and Galen Hendricks casts it urgently: “Congress can’t miss this chance to close the biggest tax loophole for the ultrawealthy.”
Step-up basis reform is critical for raising effective tax rates on the dynastic wealth of billionaires and their families, as Hanlon and Hendricks note. One strategy for those families, often known as “Buy-Borrow-Die,” leans heavily on the step-up provision. Here’s how it works.
First, someone founds a successful company—maybe even one worth hundreds of billions of dollars. As a founder, they own shares of the company worth billions of dollars. While they have a lot of wealth on paper, they do not owe tax until they sell their shares.
In principle this could be unobjectionable: money reinvested in the business is productive, and taxing people on what they take out of the business is more efficient. However, there’s a loophole here that lets the family extract spending money without selling the shares: they borrow against the value of the shares, and use that to finance their lifestyle.
Finally, upon the death of the founder, the value of the family’s shares steps up in basis from nearly nothing (its price when it was founded) to billions of dollars. Then the heirs can freely sell their shares without paying any capital gains tax on appreciation that happened during the founder’s lifetime.
This is not merely an academic curiosity: the Wall Street Journal reports that Tesla’s Elon Musk and FedEx’s Fred Smith have pledged their stock as collateral for personal loans. They may be able to live on the appreciation of their stock without selling shares or triggering income realization by the IRS. And if they die, that appreciation will never go taxed.
This violates some notions of fairness. There is an inequity in that capital gains taxes don’t end up applying to all capital gains. Additionally, there is a sentiment, especially on the left side of the aisle, that inherited wealth is inherently unfair.
This priority is also important to budget math enthusiasts like Progressive Policy Institute’s Ben Ritz. Ritz sees a multiplication problem. Every tax’s revenue is a product of two things: the base (what you pay tax on) and the rate (the percentage of that amount you owe.) If you let some capital gains—like the gains earned between acquisition and death—slip through the base by stepping up the basis, you make the capital gains tax less powerful.
This might already be undesirable for revenue-raisers in normal times, but Ritz sees that this as especially undesirable in 2021, as it will diminish the effectiveness of Biden's planned increase in capital gains tax rates. “Failure to close the step-up basis loophole would not only require lawmakers to find another offset to replace the lost revenue, it would also limit what they can raise from Biden’s other tax proposals,” writes Ritz.
Furthermore, the higher the rate, the more people will attempt to evade it by funneling money through loopholes like stepped-up basis. In practical terms, raising the capital gains tax without reforming stepped-up basis will give billionaires even stronger incentives to hold onto their shares until they die, reducing the revenue generated by the higher tax rate. And this will all be apparent in the scores that get assigned to the legislation by the Congressional Budget Office, making it harder for Democrats to meet their revenue goals.
All in all, step-up reform is valuable to Democrats and the urgency from think tanks makes sense. Even centrist or right-of-center tax wonks are looking on at the failure to repeal step-up with a bit of pity for their left-of-center counterparts. “If I were in their shoes, I wouldn't be happy with this, because it doesn't go after the gains that go untaxed,” Tax Foundation’s Erica York tells me.
So where did Biden’s effort go wrong?
A strong lobbying blitz
Biden’s campaign for step-up repeal has faced intense opposition from former farm-state Democratic senators Heidi Heitkamp and Max Baucus. Heitkamp is employed by a group called Save America’s Family Enterprises, and has been fighting to save step-up in recent weeks. Baucus wrote an op-ed in the Wall Street Journal on similar themes.
Both have relied heavily on an tactic that has historically been employed by Republicans seeking repeal of the estate tax: focusing on small family businesses or farms. “The disruption that it would create for small family business and farmers and family assets is not worth the pain,” Heitkamp told CNBC’s Squawk Box.
Liberals like Jonathan Chait have questioned Heitkamp’s motives. The American Prospect’s Alex Sammon notes that just six months ago, she was singing a different tune on step-up. “This is one of the biggest scams in the history of forever on income redistribution,” she argued on ABC’s This Week. “If you have a stock, you can pass it on to your kids with stepped-up basis, and it’s never taxed. You know that there needs to be reform on unearned income.”
Liberals are skeptical of Baucus’s motives as well, though it is unclear whether Baucus’s own lobbying firm took money to place his op-ed. Liberals also argue that with an exemption for smaller inheritances, this won’t be an issue for many businesses.
But Heitkamp and Baucus, despite being relatively marginal figures in today’s Democratic party, have forced a capitulation, at least for now.
Though few avid Democratic partisans are looking to these former senators for policy views, the senators can still influence the process by threatening to generate a persistent stream of negative stories. (“Nice bill you have there, it would be a shame if someone were to lower its favorability numbers.”) There’s an implicit bargain: leave their clients alone, and they’ll be quiet again.
And attempting to fight their arguments on the merits is not a winning proposition. Agriculture Secretary Tom Vilsack tried, with a dueling op-ed titled “Biden’s Tax Changes Won’t Hurt Family Farmers.” But just in the title, you can already see how this works to Biden’s disadvantage. Now the main topic of discussion is whether or not Biden is going to harm family farmers. This triggers more letters responding to Vilsack, reaffirming that Biden will indeed harm family farmers, and so on. At some point, Biden benefits more from changing the subject than winning the argument.
This lobbying blitz forced a total retreat. The retreat seems hasty to me; a sufficiently moderate version of step-up repeal with a high exemption could probably evade most criticism. But a moderate provision might still have drawn ire without adding much revenue. “They were gonna get attacked no matter what they did, and the higher the exemption was, the less it was worth enduring those attacks,” Ritz tells me. “It’s a damn shame.”
Biden walked into a trap
Progressives who blame this loss entirely on lobbying and a duo of former senators are letting themselves off too easily. Biden and his team misread the public’s feelings and preference intensity. They overreached and allowed the step-up issue to get blurred with other issues where their footing isn’t as strong.
The key problem with the reform was that Biden got greedy. Biden wanted not only to eliminate step-up in basis, but also to treat death as a capital gains realization. In other words, when you die, your heir will have to immediately pay capital gains tax—even for assets you don’t sell.
This played into the hands of Republicans in the Senate, who pounced immediately and unanimously:
These businesses consist largely of illiquid assets that will in many cases need to be sold or leveraged in order to pay the new tax burden. Making these changes could force business operators to sell property, lay off employees, or close their doors just to cover these new tax obligations.
This is a compelling narrative and it caught on pretty quickly. The farm-state Democratic lobbyists would be echoing it just a month later.
One reason the Democratic effort here failed is because it blurred the line between income taxes under current law (in which tax is only paid on appreciated assets after they are sold) and estate taxes.
Rather than getting a news cycle about a genuine loophole in the income tax, Democrats instead allowed Republicans to run their estate tax playbook. If it’s a tax at death, it looks like an estate tax (or, as Republican strategists would typically call it, a “death tax.”)
Misreading public opinion
The public actually doesn’t love estate taxes as much as Democrats would like them to.
I will inevitably get responses from young Democratic partisans with a variety of polls showing that—under the right framing—raising the estate tax polls well. This is true—under the right framing. But the Heitkamp and Baucus experience shows that you don’t get the framing you want in real life, and opposition is far more organized and intense than support.
Older tax policy specialists are more realistic about this. In many polls, not to mention actual votes in Congress, estate taxes tend to fare poorly. Tax historians like Joe Thorndike and pro-estate tax academics like Michael Graetz have put a great deal of thought into why this is, and why Republican strategies have been so successful, even writing academic papers on the subject. For a more comedic (if historically inaccurate) rendition of the same material, there’s an estate tax strategy scene in the Adam McKay film Vice.
Tax Notes’ Lee Sheppard puts it most bluntly: “There’s no popular demand for taxing capital gains at death,” she wrote. “Demand stops at the exit from the faculty lounge.“
The older hands in tax policy have this one right. Those who oppose estate or inheritance taxes tend to oppose them viscerally. Members of the public are not always engaged or sophisticated in their tax policy views, but they can get surprisingly animated about particular issues of fairness, even as they ignore others.
And there is a fairness issue to be found here: they see that estate taxes introduce an additional layer of taxation on the same family earnings, relative to wealth earned and spent in a single generation. They really don’t like this. As Graetz and his co-authors note in their study of popular opinion: “Speaking about double- or triple- taxation has been particularly effective. The rhetoric portrays the estate tax in moral rather than financial terms: as an unfair double tax, versus as a fair means of preventing extraordinary wealth from altogether escaping tax.”
Biden could have fought on the latter ground if he had been less ambitious. Loopholes are unpopular. But he made a big push for taxing inheritances, and taxing assets on death. This tied his legitimate and wonkish patch to the income tax together with more familiar targets of opposition, allowing opponents and lobbyists to muddy the waters.
A better approach on step-up might have been the “long game” played by Republicans in 2017 against provisions they opposed, like the state and local tax deduction or the mortgage interest deduction. Republicans made decisive cuts at the least defensible parts of those provisions, leaving smaller coalitions of beneficiaries to take on in the next round of reforms.
For Biden, a reform to step-up without any forced realization would have been a good start. He may have tried to do too much on this subject, and now he is at risk of getting too little.