In his State of the Union speech Tuesday night, President Barack Obama plans to put forth a plan to try to slow the widening gap between the richest and poorest Americans.
Widely seen as a nonstarter among the Republicans who now control Congress, the proposal targets the lingering financial setbacks inflicted by the Great Recession on all but the wealthiest American households. Even as the unemployment rate has fallen and the overall economy picked up steam, the wage gap between the richest and poorest continues to widen.
That disparity in wealth distribution was underway long before the financial crisis of 2008 sparked a global downturn. Between 1979 and 2011, the average after-tax income for the bottom 20 percent of U.S. households rose by 48 percent, according to Congressional Budget Office data. The top 1 percent saw their incomes rise by 200 percent during the same period.
The White House is proposing to use changes in the U.S. tax code to slow or reverse that trend. A key provision would close an inheritance tax loophole that benefits the wealthiest Americans the most. After raising those taxes, the plan would use the money to give middle-class families a tax break for expenses such as education and child care.
Here's how the overall plan would work:
How does that inheritance tax loophole work, exactly?
If you buy a stock for $10 and it increases in value to $100, you have to pay tax on that increased value—known as a capital gain—when you sell it. But if you hang on to it until you die and leave it to your kids or grandkids, Uncle Sam gets cut out of your will. The capital gains meter gets reset at $100 for your heirs and they only pay capital gains on any value above $100.
While anyone can leave money to their kids, the wealthiest have a lot more capital gains to shelter from taxes. Of those who got an inheritance, the average amount among the top 5 percent was $1.1 million, according to the latest Federal Reserve data. The average amount for heirs in the next 45 percent of the wealth ladder was $183,000. For those in the bottom half of households, the average inheritance was just $68,000.
But doesn't raising the capital gains tax discourage investment and hurt the economy?
That's clearly one of the strongest arguments from advocates of low capital gains tax rates, but there's little evidence of a link between the two. President Obama wants to increase the top rate on couples with incomes above $500,000 to 28 percent—where it was during the Reagan administration. (The top rate has already been raised from 15 percent to 23.8 percent during the Obama administration.)
That means a couple that generates $100,000 in capital gains from an investment would pay another $4,200 in taxes—and still make $72,000 on their investment. It's hard to see why they would sit out the chance to make $72,000 because of the extra $4,200 it will cost them.
More broadly, opponents of the increase argue it would act as a headwind to the overall economy. But looking back over the last 60 years, some of the biggest advances in real gross domestic product have come in years when the capital gains tax was highest. So the "growth killer" argument is a tough one to make.
Some proponents of closing the inheritance loophole argue that the tax dodge itself is a significant economic damper because it encourages wealthy households to hang on to their appreciated assets until they die—just so they can escape the inheritance tax. That "lock-in" effect, these analysts contend, keeps capital from flowing where it could be more productive and help spur economic growth.