The United States entered the COVID-19 crisis with an unusually large budget deficit for an economy at or close to full employment. Even if employment, output, and growth were to recover quickly to where they were at the end of 2019 (something that is far from certain), the deficit, under current law, will remain large.
The good news is that interest rates are likely to remain well below the rate of GDP growth for the foreseeable future, as they have since the beginning of the century. As long as that remains the case, there is no danger of an “exploding debt” scenario in which a large but constant federal deficit causes debt to grow without limit as a share of GDP. At this point, the greatest danger to the recovery is premature austerity. Still, as the recovery proceeds, we are sure to hear it argued on both economic and political grounds that the deficit should be reduced.
At that point, the search will be on for ways to close the budget gap. Although everyone will roll out their favorite spending cuts, much of the heavy lifting is going to have to come on the revenue side of the budget. As former Trump adviser Gary Cohn put it recently, talking to CNN’s Fareed Zakaria,
Our next Congress, the Congress that sits down in 2021, almost has to sit down and look at our spending and our revenue side. … How we spend money? There are a lot of places where we could cut back. In addition to that, I think they have to look at our tax system and think of ways that we raise revenue.
No area of the tax code is more ripe for reform than the preferential treatment given to capital gains. While incomes from wages and salaries face a maximum tax rate of 37 percent, capital gains on assets held for more than a year, in most cases, are taxed at a maximum rate of just 20 percent.
The benefits of the capital gains tax preference flow predominantly to the rich. Some 70 percent of the benefits go to taxpayers with annual incomes of $1 million or more, who enjoy annual benefits of $145,000 each. Benefits for households with incomes of $50,000 or less average about $10. For years, backers have tried to find broader justifications for this tax break, contending that benefits to the few somehow trickle down to the rest, but their efforts are less than convincing.
Here are some of the many issues raised by the capital gains tax preference, and the many reasons why its elimination should be at the top of the list in the search for additional sources of federal revenue.