The Debate on Taxing Unrealized Gains
Exploring the implications of taxing unrealized gains to address government spending.
Amidst the growing desire to find methods to increase taxes on a country's citizens to alleviate the burden of excessive government spending, it is an opportune moment to consider the contentious idea of taxing unrealized gains.
What are Unrealized Gains?
Unrealized gains are the increases in value of assets that you own but have not yet sold. Essentially, they represent the potential profit that could be realized if the assets were sold at the current market price. This concept applies to various assets, including stocks, capital property, and other business or investment holdings.
Provide me an example.
If you purchase a stock for $100 and its value rises to $150, you have an unrealized gain of $50. If it is sold at that price, then that $50 gain becomes a realized gain.
Vice President of the United States of America, Kamala Harris, in August endorsed the tax increases proposed by President Joe Biden in his fiscal year 2025 budget. One of the proposals is a 25% minimum tax on total income, including so-called “unrealized gains,” or asset growth, exceeding $100 million. This is known as the billionaire minimum tax.
Before delving into the opinionated segment, let's consider the 'book' aspect of the argument.
Pros of Taxing Unrealized Gains
Increased Revenue: Generation of significant revenue for governments, which can be used to fund public services and reduce deficits.
Tax Fairness: It ensures that wealthy individuals pay their fair share of taxes (if you believe this rhetoric), as they often hold substantial wealth in assets that appreciate over time.
Reduction of Tax Avoidance: This approach could reduce the ability of the wealthy to defer taxes indefinitely by holding onto appreciating assets.
Economic Redistribution: It could help address income inequality by redistributing wealth more effectively.
Encouragement of Asset Sales: It might encourage the sale of assets, potentially increasing market liquidity.
Cons of Taxing Unrealized Gains
Valuation Challenges: Accurately valuing assets annually can be complex, especially for illiquid assets like real estate or private businesses.
Market Volatility: Forced sales to pay taxes could lead to market disruptions and increased volatility.
Economic Impact: It might discourage investment and innovation, as investors could be less willing to take risks if they face annual taxes on paper gains.
Legal and Constitutional Issues: There are concerns about the constitutionality of taxing unrealized gains, as it represents a significant shift from current tax practices.
Administrative Burden: Implementing and enforcing such a tax would require substantial administrative resources and could be costly.
Solely from a ‘book’ perspective, I think the cons far outweigh the pros in this debate. But let’s take a step back, and actually consider what taxing unrealized gains may at a level that everyone can understand.
Current State
Staying away from the exceptions of foreign held assets or those held by non-citizens, the taxing of unrealized gains is highly uncommon. Instead, capital gains are taxed (at a certain percentage) when they are realized, period.
It's also important to distance ourselves from the notion that such a tax, specifically in the United States, would solely affect the "top 1%." Over time, any newly introduced tax is likely to cascade down to the lower income brackets.
The modern federal income tax system of the United States, as we know it today, was established with the ratification of the 16th Amendment in 1913. The tax primarily targeted the wealthiest individuals, ensuring that the burden of the new tax system fell on those with the greatest ability to pay.
Departure from Reality
The proposal to tax unrealized gains would mark a significant shift from existing global tax policies. The United States, surprisingly, is considering this approach. The Democrat party, that is. Should it be implemented, it could influence other Western nations, given the U.S.'s role as a pioneer in policy changes.
Imagine being taxed on paper value, an amount you don't have the liquid funds to settle. Indeed, how would one pay such a tax? If your profit is linked to assets you've not yet liquidated, what are your options for payment? You'd require a significant cash reserve, the capacity for secured loans, or be forced to liquidate assets to meet the tax obligation. This scenario seems unproductive and unappealing across all income brackets, regardless of your wealth or net worth.
There is also no offsetting or balancing rule in place. It is not possible to capture unrealized losses in order to receive a tax refund. Does that sound fair to you?
The creation of new taxes seems to be a mechanism employed to extract money from citizens, which only serves to enable the government to continue its excessive spending and further inflate the deficit. Yes, inflate, I said it.
This isn't merely a matter of targeting wealthy individuals. Who controls the movement of goods and services in the financial markets? Who lobby’s the government for increased 'investment' spending? It's the ultra-rich. Believing that the government is on your side may require a second thought. Any tax levied on the wealthy could ultimately be placed on the average citizen or lead to more severe repercussions.
Let’s take a note of some of these possible ‘unintended’ consequences:
Return of investment in countries that adopt measures like these would decline resulting in economic stagnation as wealth moves to greener pastures.
The liquidation of investments to facilitate payments can lead to business closures, job losses, and increased volatility in equity markets due to forced selling, which in turn can negatively impact individual portfolios, retirement, and pension funds.
Individuals may seek out tax avoidance strategies. Since loan interest payments are deductible, the wealthy might opt to take out loans against their assets to offset taxes. This could potentially lead to reduced government revenues. Not to mention the additional debt in the economy.
The imposition of an annual tax could lead to a significant decline in startup companies, as any equity accrued could be rapidly depleted. This may result in slower rates of innovation and growth.
The intricate nature of assets and the extensive effort required to manage such a tax would be burdensome. Assessing the value of stocks at a specific moment, given their fluctuation throughout the year, appears impractical. Moreover, appraising illiquid assets poses significant valuation challenges. Additionally, there is skepticism about the government's ability to administer this efficiently while also managing costs.
The precedent will be set for their next idea. What will they choose to tax next?
Food for Thought
In one interesting post on X, formerly Twitter, Bill Ackman - an American billionaire hedge fund manager, proposed the following idea:
Wealthy individuals frequently utilize their assets to strategically borrow money. They can secure loans against their investment portfolios, including stocks and bonds, or other forms of capital. This approach enables them to obtain cash without liquidating their investments, which may continue to appreciate in value.
A step-up in basis would generally apply to avoid double taxation; however, this is hard to fathom as the loan still bears risk. Loan proceeds do not constitute income since they do not result in a gain for the borrower. Indeed, the borrower receives cash, but this is counterbalanced by the liability to repay the borrowed amount, along with interest. Consequently, there is no income subject to taxation.
Conclusion
One may hold any opinion about the ultra-wealthy and their tax contributions or lack thereof. Nonetheless, it's unnecessary to concoct extravagant theories. It's important to recognize that the wealthy establish and invest in businesses that generate countless jobs for the economy. Should they be compelled to relocate to countries with more favourable tax conditions and invest their resources there, they likely will as they have the means to do so. Consequently, jobs and the economy may suffer, impacting the average person more severely than the affluent. Other avenues that should be considered include simplifying the existing tax code, such as revising the step-up in basis on inheritance that the United States employs, or curbing government spending to address the massive deficit, a common problem among many Western countries. Politicians often engage in politics rather than insisting on substantial changes that would enhance the lives of their citizens and the prospects of their economy.