Death and Taxes: Does the Lock-in Effect Fade when Gains must be Taxed at Death?

• In Event: Wealth and Estate Taxation

Abstract

Income from capital gains is typically taxed only when assets are sold, and the gains are realized. This results in such taxpayer discretion over timing and amount of realized gains that is unlike the discretion afforded by other forms of income. The “lock-in effect” of capital gains tax predicts that higher tax rates on capital gains income result in low levels of realization and loss of revenue. Contrary to existing estimates, this paper provides empirical evidence that in a system with mandatory tax on unrealized gains at death, the lock-in effect is very low. I study a reform in Canada in the year 2000 that reduced tax rates on capital gains income, to find that the medium-term response of capital gains realization to changes in tax rates is null – in contrast to existing evidence primarily documented in systems that allow forgiveness or deferral of tax on unrealized gains at death. Canada’s mandatory tax on unrealized gains at death creates an opportunity to measure behavioral response to tax changes using a novel comparison group, namely deceased realizers. Using a 20% random sample of administrative tax records, this paper employs a matching strategy to match living realizers to deceased realizers on observable characteristics. A difference-in-difference methodology helps identify dynamic response of realizations to the tax change, which is null in the medium to long term. When taxpayers expect that their unrealized gains will inevitably be taxed at death, their incentive to defer realizations is dampened.

Author

• Sobia Jafry, University of Toronto