The Many Problems With Taxing Unrealized Capital Gains

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As part of its push to raise taxes on affluent Americans, the White House released a report late in September that purported to show the real estimate of the “average federal income tax rate on the wealthiest Americans.” Now, the last I checked, the income tax rate was, you know, the tax rate paid on income—like the salary I make writing articles for Fisher Investments. This is the gist of the entirety of the US tax code. But economists from the Office for Management and Budget (OMB) see it differently, apparently. Their report redefined income as the increase in wealth from one year to the next—a bizarre methodology that introduces a lot of oddities, in my view. This would be a mere academic curiosity if Congressional Democrats weren’t jawboning about taxing wealthy individuals’ unrealized capital gains as they scramble to rewrite the reconciliation budget bill. While it is far from certain that this becomes law—and probably isn’t inherently bearish for stocks if it does—it is worth exploring the problems such an effort could create.

Much of the current push stems from the notion that wealthy people aren’t paying their “fair share,” which the OMB’s analysis aimed to demonstrate. It estimated “the average Federal individual income tax rate paid by America’s 400 wealthiest families, using a relatively comprehensive measure of their income that includes income from unsold stock.” (Italics mine.) Lest you think that means dividends, they go on: “An important feature of our analysis that is less common in existing estimates of tax rates is that we include untaxed (‘unrealized’) capital gains income in our more comprehensive income measure as they accrue.” As they explain it, “The wealthy pay low income tax rates, year after year, for two primary reasons. First, much of their income is taxed at preferred rates. In particular, income from dividends and from stock sales is taxed at a maximum of 20 percent (23.8 percent including the net investment income tax), which is much lower than the maximum 37 percent (40.8 percent) ordinary rate that applies to other income.” Hence, the OMB’s staffers claim the wealthy paid, “an average Federal individual income tax rate of 8.2 percent for the period 2010-2018.” Getting to that figure, though, requires redefining income altogether—and changing how they approach capital gains, too. Taxing unrealized gains as they accrue—which Congressional Democrats have said is on the table for America’s billionaires—or removing the tax code provision allowing heirs to inherit investments without inheriting the original cost basis (known as the cost basis step-up at death), are the purported solutions to this alleged conundrum.

Thing is, these families are not sitting on mountains of gold coins like Scrooge McDuck. Their wealth is predominantly assets—illiquid (businesses, art) and liquid (stocks, bonds). Increases to that wealth exist on paper only. The current proposal to tax unrealized gains would include real estate, which is also quite illiquid—you can’t sell it in a minute and expect to get fair value. Nor is there a way of tracking its market value day by day. Like all illiquid assets, rising property values are one step away from imaginary. Every asset, liquid or illiquid, is worth only what someone will pay for it. Taxing the transaction, in my view, is the only logical and objective way to do it. This is doubly true for illiquid assets. Someone will have to guesstimate the value of these potentially unique pieces of property. (Does anyone actually think that couldn’t be gamed?)

Plus, there are two simple reasons capital gains taxes have preferred rates. One is incentivizing long-term investment, which drives job creation. The other is to account for inflation, which can offset a large chunk of long-term returns. Preferential rates help people avoid taking inflation-adjusted losses on their investments, which would skew the risk/reward calculation.

Congressional Democrats have said their proposed tax would apply only to billionaires or people with $100 million in income (defined the standard way, we presume) for three straight years. So at least on paper, it would exclude family farmers, dentists and pediatricians with private practices, shop owners and other people who might be independently wealthy on paper but have little actual liquid net worth. Yet applying the tax only to billionaires and mega-high earners would be impossible and probably illegal. For one, people would ensure they never earned $100 million three years in a row, which would leave net worth as the determinant. That could very well fail the apportionment test by targeting individuals directly. It would also be rife for legal challenge if someone thought their real estate holdings were worth only $998 million but government assessors disagreed. More likely, if experience is a reasonable guide, any passable tax would have an income threshold that would ensnare far more people.

Now, not everyone subject to a tax on unrealized gains has illiquid assets only—it would also apply to those with large holdings of publicly traded stocks. That it is theoretically easier for them to raise the cash needed to pay the tax doesn’t make it any more sensible. When you own stock, you own a company’s future earnings. Those earnings are—wait for it—post-tax. They are already diminished by corporate taxes. Some economists already argue paying capital gains taxes on realized gains amounts to double taxation. (Ditto for dividends.) But forcing people to sell stocks in order to pay Uncle Sam for their unrealized gains forces them to make moves that run counter to their long-term investment goals and preferred portfolio strategy. It is basically a giveaway to overseas institutional investors, who would be the logical buyers.

Ending the cost basis step up, which remains a topic of discussion among progressives, doesn’t make much more sense. If it applies to all assets—liquid and illiquid—we come back to the difficult issue of calculating the actual cost basis. Pretend a dentist named Dr. Driller paid $10,000 for his dental practice in 1970 and was still filling cavities as the owner-operator of that practice when he passed away last month, leaving the practice to his dentist daughter, Dr. Crown. The practice is now worth about $1 million. If the stepped-up basis goes away, what is her actual cost basis? The $10,000 her father paid? That doesn’t include the tens of thousands of dollars he spent on improvements over the years. Does she even have access to all the handwritten ledgers that would track those expenses?

One reason the stepped-up basis exists is to account for the lack of recordkeeping on all these items, including the initial purchase. That applies to stocks as well. Many of us know someone whose stock holdings’ cost basis is an utter mystery thanks to the technology and record-keeping in use at the time of purchase. Loads of investors hold on to stocks simply because calculating the tax bill would require digging up ancient paper trade confirmations and then adjusting prices for splits and mergers over many years. If you can leave such assets to your heirs at market value on the date you die, at least you can be confident that they won’t need a forensic accountant just to pay their taxes whenever they sell.

Proponents of removing the cost basis step up argue it would raise needed government revenue. Well, maybe, depending on your definition of the word “needed” and your views on how incentives affect behavior. But one thing that does seem painfully obvious is that the huge compliance burden would funnel mountains of money and energy to accountants. Is that really the best use of productive capital? What businesses and opportunities would miss out? Folks, this is the Broken Window Fallacy at work.

Then too, incentives do matter. If you tax long-term wealth creation, it stands to reason you will get less of it. If you tax entrepreneurship, you will get less of it. Most of all, if you make an heir pay taxes on a deceased individual’s long-term gains, you are taxing that deceased person’s discipline, patience, careful planning and faith in the American capitalist system. Considering many of these same politicians decry investors’ alleged short-termism, discouraging long-term investing is a very odd position to take.

Now, anyone who has been watching the “progress” of the bipartisan infrastructure bill and the associated reconciliation bill in Congress is probably pretty well aware that changes to the US tax code—particularly those redefining long-standing principles of taxation—are unlikely to simply sail through Congress into law. Even if we limit the measures to those targeting billionaires (which are, again, of questionable constitutionality), it may be a challenge to get all 50 Democratic senators and near-unanimity in the House to pass it. Still, should they do so, the measures are small—with most of the bigger tax moves like corporate tax hikes diluted or ditched as talks drag on. Given the fear of such moves early this year, that seems like gridlock delivering a pretty bullish treat for investors as Halloween draws near.