The thing to understand about capital gains and taxes is that most capital gains have not been taxed yet, and may never be taxed, unless the tax code is changed. Consider the case of mutual funds:
From 1997-2012 households had a total of $1.75 trillion in taxable net capital gains on mutual fund assets — meaning that this the amount of income they would be taxed on if they realized the capital gains during this period. But how much of this was actually taxed? It turns out, almost none. The total amount of net gains reported on tax returns was $-100 billion, for an overall negative tax rate.
The explanation is, of course, that capital gains are taxed only on realization. And for most mutual fund holders it never made sense to realize their gains, but instead to only realize their losses, a process known as tax loss harvesting.
This is a particularly extreme example of the general principle that the capital gains tax is a particularly leaky sieve, and it is unclear the extent to which the massive capital gains we’ve seen over the past forty years will ever show up on tax returns.
To look over longer time periods, we can use my estimates of aggregate capital gains, compiled from the Financial Accounts, to capital gains reported on tax returns, estimated from the Treasury. The data is below, and again shows that most capital gains have not yet showed up on tax returns:
From 1954-2020 aggregate taxable capital gains in the Financial Accounts totaled $70 trillion. The total reported on tax returns over the same period was $22 trillion, significantly less than a third of the total.
The low levels of taxes paid on capital gains compared with the massive aggregates means that the effective average tax rates on capital gains are vanishingly small.
Will they ever show up on tax returns?
There are a number of reasons why capital gains haven’t shown up yet on tax returns, and research remains to be done on the relative importance of the different causes.
- Many wealth taxpayers can avoid realizing capital gains indefinitely by borrowing against their assets rather than selling them.
- Unrealized capital gains at death are forgiven entirely, a massive loop-hole known as step-up basis at death.
- In a growing economy (or, similarly, in an economy where capital gains are growing rapidly), if only a small percentage of capital gains are realized each year, then even in a steady state the amount realized relative to the aggregate amount will be low.
- There are a variety of other loopholes, legal and otherwise, that have allowed wealthy Americans to avoid paying capital gains taxes.