ANALYSIS — The late, great Jessica Walter once said in her “Arrested Development” role as matriarch of the fallen-from-grace Bluth family: “I’d rather be dead in California than alive in Arizona.”
President Joe Biden’s tax proposals are about to put Lucille Bluth’s maxim to the test, as the White House pushes the biggest tax increases since President Lyndon B. Johnson was waging dual wars in Vietnam and on domestic poverty. It’s happening amid the thinnest of partisan margins for Democratic leaders and a midterm cycle some say is the GOP’s to lose, given redistricting and historical headwinds facing a president’s party.
There’s little institutional memory of the last tax increase anywhere near this size that Democrats carried alone, in 1993, and the midterm wipeout that followed; only 32 Democrats out of 268 currently serving in Congress were around for that experience.
“My very strong preference would be to do as much of this as possible in a bipartisan way, and one of the reasons you do that is so the blame game doesn’t happen as severely in 2022,” said former Sen. Mark Pryor, D-Ark., who lost in 2014 to Republican Tom Cotton.
Biden and top Democrats appear to be giving bipartisanship a go, for now. But they’re already laying plans for another filibuster-proof reconciliation bill to ram through their package on a party-line vote, as in 1993.
The pain would be concentrated in Democratic strongholds. Biden’s average margin of victory was almost 29 points in the 50 richest House districts by 2018 adjusted gross income, according to IRS data. Connecticut, New York, Massachusetts, California and New Jersey had the most millionaires per capita, and accounted for nearly 40 percent of U.S. millionaires’ total capital gains.
For those earning over $1 million, the top rate on capital gains and dividends would nearly double to 43.4 percent, the highest since the 1920s. In California, the rate would hit nearly 57 percent, the Tax Foundation estimates; in New York City, 58 percent.
Nearly a quarter of California’s individual income tax burden is already shouldered by those earning more than $5 million, with almost half of that group’s income coming from capital gains. California and New York households making more than $1 million account for roughly 40 percent of state individual tax receipts. In New York City, the figure is closer to 50 percent, even before Albany’s recent tax increase deal.
“If you have just 50 of the highest-earning people leave, it will have an effect,” said E.J. McMahon of the Empire Center for Public Policy in Albany. “And this is a policy basically telling people, ‘If you’re on the curb, jump off – get lost.’”
It’s not just coastal areas that will get hit, said the S Corporation Association’s Brian Reardon, who represents privately held firms.
For the first time, profits earned by owners of “pass through” businesses structured as S corporations would be subject to the 2010 health care law’s 3.8 percent investment income tax, if they make more than $400,000. Combined with higher ordinary income rates, pass-through businesses could face a 6-point marginal tax rate increase.
That’s on top of other tax increases already scheduled to take effect next year, including tighter limits on interest expense deductions from the GOP tax law in 2017.
“We’re going to a place we’ve never gone before, and I think for private companies, they’re going to have a really hard time surviving this environment,” said Reardon, who thinks the Fortune 500 will benefit at their expense. “Flyover country is just going to get screwed.”
Biden’s picked a head-spinning number of lobbying fights, any one of which would make headlines — and he’s doing it all at once.
He’d revoke the century-old deferral of capital gains tax on “like-kind” real estate exchanges of similar properties, ranging from office buildings to grazing land. After a $500,000 annual exclusion — half of what President Barack Obama proposed when he tried to kill the tax break — gains would be taxed immediately.
That’s going to affect the big commercial real estate deals where most of the economic activity occurs, said Chicago Deferred Exchange Company’s Mary Cunningham, who helps arrange like-kind transactions. “It becomes a major disincentive for investment, which is desperately needed in the wake of the pandemic as we have to reimagine and reinvent how commercial real estate is going to be used," Cunningham said.
A who’s who of influential lobbies is fighting the proposal, including the American Farm Bureau Federation, American Hotel & Lodging Association, National Association of Realtors and The Nature Conservancy, which supports like-kind exchanges between landowners to protect environmentally sensitive areas.
Taxing gains at death
In another major shift, heirs would have to pay capital gains tax on the appreciation in value of inherited property from the date the deceased originally purchased it, above a $1 million per spouse exemption with up to $500,000 more allowed for gains on primary residences.
Once the estate tax captures whatever’s left, the Tax Foundation says the combined effect is a 61 percent tax on large inheritances. The take would total nearly 70 percent in California and New York City after state and local taxes. If heirs decide to keep running the farm or family business, they can defer paying capital gains tax until they eventually sell. But they’d be on the hook for tax on the entire gain going back to the deceased’s original cost basis.
Groups like the Farm Bureau, National Association of Manufacturers, National Multifamily Housing Council, National Federation of Independent Business and other powerful stakeholders are opposing the change. NFIB is already putting small businesses out there to try to sway lawmakers, like Steve Ferree, a Portland, Ore., plumbing business owner and constituent of Senate Finance Chairman Ron Wyden.
“You have all these ups and downs as a business owner, and the payoff at the end, your exit strategy basically, is when you go to finally retire and pass it on, or sell it to somebody else,” Ferree said at a recent NFIB panel discussion. “And by having additional death taxes or capital gains … you take away all that, where that payback finally comes, from all those years of reinvesting in your business.”
NFIB has traditionally been a GOP-leaning group. Silicon Valley, which contributes plenty to Democratic campaigns, is concerned as well.
Under Biden’s plan, startup founders who put in years of “sweat equity” before the big payoff would be rewarded with the same tax rates as those who didn’t take such risks. Venture capitalists argue that’s a recipe for less risk-taking, and therefore less innovation of the kind that led to lifesaving drugs like Moderna’s COVID-19 vaccine.
But in the pandemic era, the sweat equity argument may be wearing thin with otherwise sympathetic lawmakers as the income gap widens between front-line workers and wealthy investors cashing in stock market gains from the comforts of home.
Arshi Siddiqui, a former top aide to Speaker Nancy Pelosi, now a lobbyist with Akin Gump Strauss Hauer & Feld, said at a National Venture Capital Association briefing that stakeholders need to “come out swinging” to head off a steep capital gains rate hike.
The House districts most affected by Biden’s proposals — those at the very top in terms of average income, capital gains and state and local taxes — are mostly safe Democratic seats representing places like Manhattan; Silicon Valley; posh Los Angeles ZIP codes like Bel Air and Beverly Hills; San Francisco; and Greenwich, Conn., and its environs, playfully known as “Hedgefundistan.”
Of the 32 “Frontline” House Democrats designated for special help in the midterm campaign, eight want to repeal the $10,000 limit on state and local tax deductions Republicans imposed in 2017, which would disproportionately help the richest households. Others, representing less well-off districts or states without an income tax, have less interest. Still, Democratic insiders say some relief from the “SALT” cap will likely be included.
But anything short of full repeal may not keep the uber-rich from fleeing states like California and New York, a factor of which Pelosi and Senate Majority Leader Charles E. Schumer are undoubtedly aware. At the same time, Schumer has to cultivate West Virginia’s Joe Manchin III, representing the fewest millionaires per capita in a state where residents on average deducted less than $10,000 in state and local taxes to begin with.
The early betting line among Democratic insiders is on a smaller package of infrastructure and other spending, paid for with smaller tax increases. But public polling shows a large appetite for taxing the rich to pay for Biden’s programs.
“This is a big test of the power of entrepreneurs and business owners,” said veteran Democratic aide Russ Sullivan, now head of tax policy at Brownstein Hyatt Farber Schreck. “It’s a test of capitalism.”
Peter Cohn edits CQ Roll Call’s tax policy coverage.