The trouble with unrealized capital gains taxes

No one knows what will come out of the sausage making now going on up on Capitol Hill, but let’s take a look at one proposal to raise money to pay for some of the cost of the reconciliation bill.

At the moment, capital gains are taxed only when the asset is sold or the owner dies. (The estate tax is just a tax on capital that is triggered by death rather than by sale.) Oregon senator Ron Wyden proposes that they be taxed every year whether sold or not.

Unrealized capital gains are certainly a tempting target. After all, for people like Bill Gates and Jeff Bezos, practically their whole, vast fortunes are capital gains, the cost basis of their stock in Microsoft and Amazon is, at most, a few cents a share.

Under Senator Wyden’s plan, this tax would only apply to those people who had a net worth of more than $1 billion, or had had annual incomes in excess of $100 million for three years straight. While the exact details are still unknown, it is said that the tax would raise about $250 billion over ten years.

Speaker Nancy Pelosi flatly called it a wealth tax on a Sunday morning talk show last week. But Treasury secretary Janet Yellen demurred, saying, “It’s not a wealth tax, but a tax on unrealized capital gains of exceptionally wealthy individuals.” That’s a frankly ludicrous statement for someone with a PhD in economics to make. It’s a wealth tax, plain and simple, but laid only on a portion of a person’s wealth, not his whole net worth.

There are several things to note here.

First, wealth taxes have been tried in many other countries, including France, Sweden, and Germany, and they were all repealed. One reason was the difficulty of determining what the net worth of individuals is. Financial assets are easy: just look online. But real estate, jewelry, fine art and intangible assets, such as a movie star’s “likeness and image,” are much more difficult.

To get around this problem, Senator Wyden has announced that only financial assets and real estate would be subject to the tax. That, of course, would be an incentive to concentrate wealth in assets not subject to the tax, such as art, rare books, antique cars, and other collectibles. These sorts of assets have been appreciating rapidly thanks to the wealth explosion of recent decades. A wealth tax would supercharge that appreciation.

The second reason wealth taxes have failed elsewhere was that the very rich simply decamped to other countries to escape them. France estimated that 10,000 people with a collective net worth of €35 billion had left the country in the 15 years prior to the wealth tax’s repeal in 2018. France was losing more money from not being able to tax the incomes of those 10,000 than the government would have gotten from the wealth tax itself.

The United States, uniquely, taxes its citizens regardless of where they live. So a wealth tax would be an incentive to renounce American citizenship.

Second, if unrealized capital gains are to be taxed, would unrealized capital losses be refunded? In 2008-09 there was a 30 percent reduction in stock prices as the Great Recession hit the economy. If unrealized capital losses had been refundable then, thanks to the Wyden wealth tax, far from adding to government revenues, the wealth tax would have been a huge drain on government revenues, already diminished by the recession.

In the early years after Amazon went public, the stock was very volatile, with yearly gains and losses in excess of 20 percent.

But if unrealized capital losses are not refundable while unrealized capital gains are taxable, then it’s a heads I win, tails you lose situation. Right now while realized capital losses can offset capital gains, only $3,000 in realized capital losses can be deducted from regular income.

Third, while this proposed tax would only affect the super rich, we’ve heard that one before. The 1913 income tax was tucked into the tariff bill of that year after the ratification of the 16th Amendment.

It was aimed only at the rich. There was a personal deduction of $3,000 and a marital deduction of $1000. In 1913, $4000 was an upper-middle-class income and 98 percent of American families were exempt. The tax act of 1942 converted the income tax into one that hit just about every family.

The alternative minimum tax was enacted in 1969 after it was learned that 155 people with very high incomes had paid no federal taxes thanks to such things as tax-free municipal bonds. Today its latest iteration affects at least 1.5 million taxpayers every year.

Fourth, if billionaires are required to pay taxes on unrealized capital gains, they would be forced to liquidate stock every year to pay it. That would cause downward pressure on stock prices, adversely affecting the tens of millions of non-billionaires who also own the stock, either directly in such vehicles as 401(k) accounts, or as beneficiaries of pension and insurance plans.

If the date for determining capital gains for the year is December 31, those who would be subject to the tax would sell stock before the deadline to drive down the price and lower their tax liability. Speculators, knowing there will be large sales of such stocks as Microsoft, Tesla and Amazon, would be tempted to sell those stocks short, further depressing their prices. The Wyden wealth tax, therefore, would make December a bad month for stocks.

Fifth, a tax on unrealized capital gains is flatly unconstitutional. The Constitution forbids “direct taxes” unless they are apportioned among the states according to population. That would be impossible with Wyden’s wealth tax for the simple reason that there are many more billionaires in New York and California than in Mississippi.

The 16th Amendment allows taxes on income, “from whatever source derived.” But unrealized capital gains are not income. Income is money you can spend, and you cannot spend a capital gain until you realize it.

Further, the Constitution forbids bills of attainder, in other words, laws that are aimed at particular individuals. There are about 700 billionaires in the United States, and Bloomberg regularly lists them, their net worth updated daily.

Senator Wyden’s proposed wealth tax would not raise as much revenue as predicted and would have many unintended consequences, all of them bad for the country, the economy and millions of ordinary investors.