Here are three possible answers to this question:
1. No, they are not income and should not be taxed.
2. Yes, they are income and should be taxed.
3. Yes, they are income, but they should not be taxed. We should tax consumption, not income.
I favor the third view.
People often say that you haven’t really earned income on an appreciating asset until the asset is sold. I understand their intuition, but I think they are conflating two issues, income and consumption.
Consider two investors that have identical big gains on Nvidia stock. One holds onto the stock, and the other sells the stock and then buys it all back just one minute later at roughly the same price. One guy has no income tax liability while the other faces a huge capital gains tax bill. But their underlying financial situations are essentially identical.
I suspect that the intuitive belief that income is only real when the asset has been sold is based on the perception that until it is sold there is a risk that the price goes back down. But if you sell an asset and put the money into a different investment, that new investment also might go back down. Even cash is slightly risky due to inflation. The only way of being 100% sure that you’ve realized your gain is by spending the profits on consumption.
To an economist, the person that holds the Nvidia stock has earned income every bit as much as the person who sells it and puts the funds into an alternative asset. Both hold portfolios that have appreciated. Both hold portfolios that might go back down.
And yet I understand why people are reflexively hostile to the idea of paying taxes on assets that haven’t yet been sold. The real problem is that basic tax theory suggests that taxes should apply to consumption, not income. Under a consumption tax, it makes no difference whether you hold the asset or sell it and buy an alternative investment. There’s no tax until the funds are spent on consumption. This reduces lock in effect of capital gains taxes.
Of course the real world is very complex, and it’s possible to argue for the taxation of capital as a second best policy. In my view the real problem is not which capital gains to tax, rather it is the entire concept of income. It is very difficult to define income in a way that is both logical and useful for real world tax systems. You either give up on logic and consistency, or you impose a true income tax system (including unrealized gains) that many people will think makes no sense.
READER COMMENTS
Market Fiscalist
Sep 4 2024 at 11:43pm
I agree that it is better to tax consumption that to tax income but I disagree that capital gains should count as income
If I own a machine that is used to produce goodX and I can rent out that machine then that rent is clearly income.
If people start to value goodX more for some reason then my rental income will go up as a result and this will likely lead to an increase in the value of my machine to reflect the expected increase in my future income stream. The increased rent is clearly an increase in income in the present period. The “capital gains” as a result of the increased expected value of future income whether realized or not is clearly not additional income in the present period.
Scott Sumner
Sep 5 2024 at 12:56pm
Your intuition is right in the sense that taxing capital gains would be a form of double taxation. But that’s just another way of saying that income is the wrong entity to focus on. All forms of capital income taxation (not just cap gains taxes) effectively double tax income consumed at a future date.
RohanV
Sep 5 2024 at 12:03am
To be fair, this is only because the tax authorities say it works this way. If you do the opposite, sell at a loss and then immediately buy it back, it’s called a “wash sale” and the capital loss doesn’t count for tax purposes. It would be pretty trivial to extend wash sales to gains.
Scott Sumner
Sep 5 2024 at 12:58pm
Yes, but that doesn’t solve the broader problem. It’s also not clear why the gains should be taxed if put into a entirely different financial asset.
nobody.really
Sep 5 2024 at 1:44am
Disagree: The guy who sold and re-purchased the stock will face a high capital gains tax NOW, but will have a higher basis—and thus will likely face a lower capital gains tax when he sells in the future. The guy who simply kept the stock will face no capital gain tax NOW, but will likely face a higher capital gains tax in the future.
(Side point: Economists poo-poo the idea of making decisions based on sunk costs. But accountant know that another word for sunk cost is “basis,” which is a valuable asset. Indeed, profitable firms sometimes look to acquire firms that have lost a lot of money simply to offset the profitable firm’s gains, thereby reducing the two firm’s combined tax liability. The sunk costs ARE the relevant asset being acquired.)
I say that the people owning stock will LIKELY face future taxes. But I don’t know that they actually will. Contra Mark Twain, death may be certain, but not taxes, due to the loopholes in the income tax code. Consider:
Larry, Moe, and Curly each buy identical houses. Larry rents his house to Moe. Moe rents his house to Larry. Curly lives in his house. Though they each consume identical housing services, Larry and Moe have to pay income tax on the rent they receive from each other (though they can also deduct home maintenance costs and depreciation). Curly ‘s situation does not differ from Larry and Moe’s—Curly-the-occupant implicitly pays market rent to Curly-the-owner—but the income tax code fails to recognize this dynamic.
Larry needs money so he sells his house and, due to massive appreciation, pays capital gains tax reflecting the difference between the selling price and the acquisition price minus depreciation. Moe also needs money, but he merely borrows against his house. When Moe dies, his estate does NOT have to pay capital gains because the estate benefits from a “stepped-up basis”—in effect, the tax code treats the asset as if Moe had bought the house for the prevailing market price on the day he died.
I suspect the drive to tax unrealized capital gains is driven in part to clamp down on these massive unjustified subsidies to owners—especially the “buy/borrow/die” subsidy. Admittedly, these are second-best solutions, but are arguably more politically viable than the first-best solutions.
(Note: Many jurisdictions waive or cap capital gains taxes on homes, so maybe I should have picked a different asset to illustrate my point. But the larger point about income tax loopholes remains.)
Economist David Bradford (one of the architects of Reagan’s tax reform) favored a progressive consumption tax. He attempted to calculate how much such a tax might benefit society—but struggled with how to recognize the value of “basis” that property owners have in their property under the current income tax system. In transitioning from an income tax system to a consumption tax system, would government simply wipe out/appropriate all the value embedded in “basis”? I think he died before he solved that problem.
anonymous
Sep 5 2024 at 11:58am
The estate tax is 40% so if they are above the threshold, they will pay 40% on the full amount, not just any capital gain. If they are below the threshold, then we have decided there should be no estate tax, so there isn’t any, including stealth “capital gains” taxes.
Scott Sumner
Sep 5 2024 at 1:00pm
You misunderstood me. I meant the underlying situations are identical apart from capital gains tax considerations.
Kevin
Sep 5 2024 at 4:21am
Should we consider the appreciation of any asset to be income? Real estate, jewelry, cars, musical instruments, etc.?
nobody.really
Sep 5 2024 at 5:30am
Conceptually, yes. Indeed, each time the post office raises the price of a standard first-class stamp, the value of my “Forever” stamps climbs as well. More unrealized gains!
The relevant constraint is not conceptual, but administrative: I don’t expect the IRS would add another line item to the 1040 form just to address every microscopic gain. I expect the tax code could simply say “Annual aggregate capital gains of less than $X may be omitted from the calculation of adjusted gross income.”
Scott Sumner
Sep 5 2024 at 1:02pm
It depends what you mean by “should we”. Are they income. Yes. Should we tax any capital gains? I’d prefer to tax consumption.
Kevin
Sep 5 2024 at 3:37pm
If only it were politically feasible. It seems difficult, if not impossible to get politicians to understand even basic economic concepts with 90%+ agreement from economists (free trade, price controls, and the like).
Mark Brophy
Sep 5 2024 at 4:45pm
Capital gains and income shouldn’t be taxed because it’s immoral to punish people for working and investing. Taxes should be levied for vices such as alcohol and cigarettes. Taxes should be levied as a fee for a government service so that when they protect your property, they levy a property tax. Taxes shouldn’t be used to steal from one group to benefit another group.
Jason
Sep 5 2024 at 4:53pm
I would consider local Property Tax a bit (or exactly) like an unrealized capital gains tax. Every year an assessor determines a value for my house and applies a proportional tax rate to the assessed value.
The assessed value almost never decreases, but it’s not really a ‘market price’.The actual realized capital gains against the ‘market price’ of the house after a sale aren’t even taxed by anyone. (at least the first $250k, I think)
**Thresholds matter (wealth above the $100 million… in the Harris ‘plan’*). In all of these argu-memes that I see, there’s the “coming after your life savings” boogey-man. They may be, but they’re not coming after the other 99.9% of us.
Kevin
Sep 5 2024 at 6:58pm
I agree, property taxes are much like an unrealized capital gains tax.
And while you are correct, few would be directly affected by a wealth tax, in the long run, wouldn’t we expect growth to increase by less, wages to increase by less, and people to be working longer hours?
At least that’s what this study suggests:
https://budgetmodel.wharton.upenn.edu/issues/2019/12/12/senator-elizabeth-warrens-wealth-tax-projected-budgetary-and-economic-effects
Granted, this is Elizabeth Warren’s proposal being put on trial (before she decided that 6% was the ‘right’ proportion to tax billionaires annually), but I would think that taxing capital is even less efficient then taxing income.
Kevin
Sep 5 2024 at 7:00pm
*earned income
Jose Pablo
Sep 6 2024 at 4:44pm
property taxes are much like an unrealized capital gains tax.
No, nothing to do. Property taxes tax your capital, not your capital gains. Property taxes are like a wealth tax, not like an income tax.
Proof: if the value of your property (as capriciously stated by your county property appraiser) goes down in a given year you will still have to pay property taxes. But you will get a credit for this fictitious (it only exists in the mind of the county appraiser) unrealized capital loss.
Knut P. Heen
Sep 5 2024 at 5:41am
Alternative 3
It is a measurement problem combined with a liquidity problem. It is easy to measure realizations. Once you have realized a gain, you also have the money to pay the tax.
How should Zuckerberg have paid the capital gains tax on his Facebook-holdings before he realized some of it? Personal debt with Facebook-stock as collateral or selling Facebook-stock are the only alternatives. Actually, postponing the tax until realization is just a debt to the treasury anyway.
Scott Sumner
Sep 5 2024 at 1:03pm
Yes, there are practical considerations that caused the system to be set up this way. But every adjustment creates new problems. The problem of taxing income will never be “solved”, because it’s a fundamentally problematic concept.
rick shapiro
Sep 5 2024 at 9:35am
What this discussion fails to address is power. Capital gains enable financial oligarchs to dominate political discourse, which is why, for example, basis is stepped up at inheritance; so that accumulated capital gain is never taxed, while the accumulator lives off loans with the asset as collateral. Even aside from the power associated with great wealth, anyone who has ever heard of Random Walk With Absorbing Walls will understand why society needs to mitigate inequality.
anonymous
Sep 5 2024 at 12:00pm
The estate tax is 40%.
Jim Glass
Sep 5 2024 at 3:07pm
After receiving a tax-exempt $13.61 million per person.
Jim Glass
Sep 6 2024 at 2:02am
The “oligarchs” who run the tax system are the upper middle class — the people who collect the great bulk of the biggest tax breaks in the tax code: tax favored pensions, retirement savings, employee medical benefits, home sale $250k exemption, mortgage interest deduction, child care credit, etc., Strangely enough, the oligarchs you seem to be thinking of are all knocked out of using these by income limitations. That’s a pretty inept use of “power” by them!
‘Living off loans against capital gain assets so accumulated gains are never taxed’ is neither cheap nor safe. The maximum capital gain tax on the gain portion of an asset’s value is a one-time 20% — while borrowing cost against financial assets today is 5% annually, forever. How many years are you planning to live? Also, assets can go down in value. See my other comment about my client who lost $200,000 using this borrowing strategy when his “safe” capital gains collapsed.
Another example of how the Upper Middle Class rules: The estate tax exemption is $13.61 million per individual. For upper-middle-classers that’s plenty to cover the house, vacation home, boat, cars, investment accounts, life insurance proceeds … everything they’ve got.
For Elon, Jeff, Bill, Warren and your other “financial oligarchs”, that’s < 1% of what they’ve got. With all their “power”, how’d they get themselves so left out?
Robert EV
Sep 8 2024 at 4:57pm
https://www.statista.com/statistics/318079/average-tax-rate-in-the-us-by-income-percentile/
The top 0.001% seem to be better off than the remaining top 3% on a solely income tax basis.
I don’t know. But the Waltons seemed to do okay with some advanced planning. https://www.businessinsider.com/walton-family-sam-walmart-stock-billionaires-estate-planning-inheritance-wealth-2024-8
J Mann
Sep 9 2024 at 12:16pm
The article is paywalled – are the definitions and analysis concise enough for you to print them?
The section I could see said:
… which would seem to support Jim Glass’s point that the tax code favors the upper middle class.
I guess you could argue it’s a conspiracy by the upper 3-10% and the upper 0.0001% against the .0002%-2.99%, but again, I’d want to see how the authors reached their conclusions.
Robert EV
Sep 9 2024 at 2:07pm
Yeah, an annoying thing I’ve noticed about Statista is that you can view the full page from a search engine link, but not from a direct link.
Even so they paywall the sources, so I can’t validate the accuracy of their data, or what they consider an “average” to be (per taxpayer, per dollar, ?)
This is for 2020. Income taxes paid as a percent of income (average).
Top 0.001% = 23.73%
Top 0.01% = 25.17%
Top 0.1% = 26.55% (this is the peak)
Top 1% = 25.99%
Top 2% = 24.76%
Top 3% = 23.79%
Top 4% = 23.05%
Top 5% = 22.44%
So somewhere in the top 2 – 3% range is the equality point. Though of course it’s also possible that the top 0.0001% has an even lower effective income tax rate.
J Mann
Sep 10 2024 at 12:08pm
Thanks!
Andre
Sep 5 2024 at 10:45am
I don’t think the relevant issue is taxation of income (a flow) vs. consumption.
The issue is taxation of capital vs. flow.
Capital is stock and income is flow. Taxing stock of any kind opens up all kinds of problems.
The fact that mechanisms exist to pretend that asset price changes are flows doesn’t make them flows.
We don’t tax stock for a reason.
AFAIK the only exception is property taxes, which is a workable exception: property can’t move, requires government regulated services, and isn’t valued at market rates anyway, because if it were, half of all building owners would be in dispute with the government at any given time.
Robert EV
Sep 9 2024 at 12:03pm
Securities require government regulated services as well. And before you say “remove all regulations and let it be a free market!”, this sort of happened with cryptocurrency exchanges, and not you have a lot of people suing and otherwise asking the government to be made whole.
Jim Glass
Sep 5 2024 at 2:28pm
Unrealized capital gains aren’t included as income in the national accounts. BEA. “Enrichment through increase in value of capital investment is not income in any proper meaning of the term,” US Supreme Court, Eisner v. Macomber, 252 U.S. 189, 1920. (Case involving unrealized gains in the form of stock dividends.)
As noted in comments above, in the tax world the main argument against taxing such gains is “double taxation.” Capital value is expected future income earned by an asset discounted to current value. If you tax the increase in this value at time 1, then later tax the full capital value of the asset at time 2 (when sold) the income is taxed twice.
In real-world practice…
(1) Congress can tax whatever it wants, apply a “cattle tax” to fish by defining fish as cattle, and in cases has pretty near done that. It does tax capital gains even though they aren’t income in the national accounts, as per the above.
(2) There will never be a serious tax on “unrealized capital gains”. It’s pure political posing. The idea has been tried many times and always failed utterly for reasons which, if you think about it for a moment, you could list down your arm. (The Europeans wouldn’t be doing it already if they could?)
(3) The only way to turn the US into a consumption tax system it by expanding tax-deferred saving accounts (IRAs, Keoghs, 401(k)s, etc.) to enable them to take unlimited contributions from anybody. That could easily be implemented and would preserve the existing progressivity in the tax system — two killer problems for sales taxes, VATs and the like. And this idea has been proposed in the tax literature for decades — while getting exactly nowhere in politics. “Unlimited tax-favored savings for Musk, Bezos, Gates…!!!” Good luck getting that through Congress.
Craig
Sep 5 2024 at 7:54pm
Jim, I’m sorry I am not grasping this point, “The only way to turn the US into a consumption tax system it by expanding tax-deferred saving accounts (IRAs, Keoghs, 401(k)s, etc.) to enable them to take unlimited contributions from anybody. ”
The way I see it is that if the US went to solely consumption based taxes there wouldn’t be IRAs, 401k etc because there wouldn’t be income tax to defer at all and I guess capital gains on the back end of Roth wouldn’t need to be avoided either. The only way I could see them making any sense would be to allow contributions and then let people make sales tax free purchases if the funds came from that account?
Jim Glass
Sep 6 2024 at 12:19am
All income is either consumed or saved/invested. The idea of a consumption tax is to tax consumption expenditures — income spent on consumption — leaving all funds that are saved/invested, and income earned thereon that is reinvested, untaxed.
An individual receives income. All income that he spends on consumption is taxable as under current rules. All income that he doesn’t consume is saved in the MegaUltraIRA, which can hold all investments that exist today, from one’s bank card account to S&P stocks to real estate, whatever. Contributions to the MegaUltra IRA are deductible, making the income that funds them tax-free. (Of course, everybody will contribute every dollar they can into it — *all* they don’t consume — to maximize their deduction and tax-free gains.) Investment gains are tax free (unlike today) if reinvested, and reinvested, forever. There are no capital gain rules or capital gain tax rates. Funds that come out of the MegaUltarIRA are taxable income.
The result is consumption is taxed, all savings/investment isn’t: a consumption tax.
The great practical advantage is that this is just how traditional IRAs and other tax-deferred savings work today, all the rules and procedures are already in place and operating. There’s no need to create a new system, just to expand the current one as to the amounts that accounts can receive (unlimited) and investments they can hold (everything). There’s potentially a huge amount of tax simplification as to investments, because the only tax accounting required is counting money going into/out of the account. Also, the consumption tax is progressive, increasing with amount consumed (income minus savings/investment) on the politically acceptable current schedule. And there is no more favorable long-term capital gain tax rate, a revenue booster progressives will like, to offset the revenue lost to bigger deductions for contributions.
This idea has been kicked around in the tax literature as long as I can remember. There’s all kinds if analysis covering all kinds of imaginable complications and contingencies. But it is never going to get enacted. Not even considered. Fun to theorize, though.
And no conventional consumption tax is going to get enacted to replace the current income tax system either. No. Way. Even a European-scale VAT would produce nowhere near enough revenue, so it would have to be an addition to the income tax system, as it is across Europe. And there is no room for a European-scale federal VAT in the USA, because state and local sales taxes already take most of that space. Maybe a carbon-consumption tax is the best shot, but that will be in addition to the income tax too.
Jim Glass
Sep 6 2024 at 1:23am
To clarify, BEA doesn’t include realized capital gains in national income because it would be double counting. Income is counted when received. Capital gain includes expected future income discounted to current value. To count income both when it is expected to be received, and then again when it is actually received, is to count it twice.
Also, to tax unrealized capital gains results on its face in multiple counting … Time 1, pay unrealized gain tax on expected future income discounted to current value …. During the following year receive some of that income and pay tax on it, again … Time 2, sell and pay capital gain tax on … I’m not sure … over multiple years of this there’s going to be a lot of new calculations going into basis adjustments. Full employment for IRS regulation writers and tax accountants.
Richard W. Fulmer
Sep 5 2024 at 3:20pm
I don’t think that unrealized capital gains are income. The gains aren’t fungible and the assets must be sold to make them so. Moreover, the sale of the assets may reduce their value or entail the sale of the business that has generated the gains.
Robert EV
Sep 8 2024 at 5:10pm
Barter has the same basic issues and is taxable as income under the current IRS code.
Craig
Sep 5 2024 at 7:50pm
Be curious if the law will allow for clawbacks if an unrealized gain flips and turns into an unrealized loss.
“Consider two investors that have identical big gains on Nvidia stock. One holds onto the stock, and the other sells the stock and then buys it all back just one minute later at roughly the same price. One guy has no income tax liability while the other faces a huge capital gains tax bill. But their underlying financial situations are essentially identical.”
If Harris elected I actually would expect many to sell, lock in the capital gains today, and repurchase their positions. Nevertheless whether the asset you hold has an unrealized gain and whether it should be called ‘income’ really is a function as to how much that can be attributed to the actual income generated by the corporation that would be attributed to you but for the fact of the legal fiction of separate corporate personhood. To the extent that the value of the asset is based on the income of the corporation on a look through basis, calling that income to the shareholder is fair, but to the extent that the value of the stock is based on the net present value of future expected earnings that haven’t happened and may not happen, is wrong. That is a wealth tax and if called a wealth tax that would make it a direct tax subject to apportionment and likely making it constitutionally suspect.
Look at it this way if the government were to tax ALL unrealized gain in Nvidia stock the government would likely collect more in capital gain than Nvidia has even earned yet. https://companiesmarketcap.com/nvidia/earnings/
Robert EV
Sep 8 2024 at 5:17pm
Does tax law allow “clawbacks” of sales tax if I break the item a minute after purchasing it?
I presume a best case scenario of this being treated like gambling losses. They can only be used to offset gambling gains for tax purposes. If you lose everything on unrealized losses then this is a lesson that you should have been paying more attention to the market.
Matthias
Sep 5 2024 at 9:11pm
What about alternative 4: tax land?
Well, at least tax land rents as much as possible, and only then consider taxing consumption.
Lowering taxes on income and capital increases land rents anyway.
Craig
Sep 6 2024 at 9:23am
Property is taxed at state level but taxing property at federal level would be a ‘direct tax’ which is constitutionally problematic. [Income tax is a direct tax but specifically permitted by amendment]
Jose Pablo
Sep 5 2024 at 9:19pm
The difference between realized capital gains vs unrealized capital is very significant both from a conceptual and (even more so) practical point of view.
Realized capital gains are “certain”, can be precisely calculated and, once realized, are the same today, tomorrow, in 100 days. Once “realized” I, you, Peter, Paul … everybody will come up with the same figure for “capital gains”. They will be capital gains or capital losses forever.
This is not the case with “unrealized capital gains”. Quite the contrary, they change all the time. They are different today, tomorrow in a week. Can even switch from unrealized capital gains to unrealized capital losses in the blink of an eye.
And, even worse, most assets don’t have permanently quoted “market” prices. For these unquoted unsold assets, market prices, and so “capital gains”, don’t even “exist” in any meaningful way. They are just a “theoretical” concept different for different people for the most different reasons (market prices to be paid with my money are known, for instance, to differ substantially from market prices to be paid with other people’s money. Even for the very same assets at the very same moment).
The estimation of unrealized capital gains will vary hugely for me, you, Peter, Paul … they are all over the place, which is normally accepted as a probe of non-existence.
Unrealized capital gains for most assets (if not for all) simply don’t exist. Realized capital gains do exist. A huge conceptual (and practical) difference.
Scott Sumner
Sep 5 2024 at 10:49pm
You haven’t addressed any of the arguments that I made in the post. You’ve just ignored them. I’m afraid almost everything you say in this comment is completely wrong.
A note to all commenters. If you ignore my arguments, don’t expect to convince me of your point of view.
Jose Pablo
Sep 6 2024 at 11:34am
I haven’t addressed any of your comments because I don’t necessarily disagree with any of them. What I do think is that you are understating the difference between realized and unrealized capital gains and that this is dangerous in the context of modifying taxation on capital markets.
Taxing consumption is, no doubt, much better. It is way simpler and doesn’t distort capital allocation (very likely the worst consequence of taxing capital gains as income either in their actual form or, even worse, following the proposed modifications)
What my comment was trying to point out is a very significant “conceptual” difference between realized and unrealized gains (between “real transaction prices” and the “illusion of quotes”). This (in my point of view) significant difference is not even mentioned in your post.
And this conceptual difference, if it creeps somehow into the tax code, will no doubt result in further and significant distortions in price formation, in thousands of useless pages in the tax code, and in the conditioning, for the worse, of the size and functioning of all relevant capital markets. This already happens with the actual taxing of realized capital gains, that’s why taxing consumption is better. These effects would be made far worse with unrealized capital gains.
And, by the way, nothing in the comment is wrong. Prices that have not been used in an actual closing are nothing but an illusion. Doesn’t really “exist”. Even for Nvidia. You can not trade your Nvidia shares at the price you see on your broker screen. That is the price of the last trade. No guarantee (at all) that it will hold for the next trade you want to make.
Matthias
Sep 5 2024 at 11:38pm
Your reasoning suggests that, if instead of selling my stocks to get cash to buy a house, if I were to swap some for other assets (like a house) or goods and services in kind, I shouldn’t pay capital gains taxes, either?
Jose Pablo
Sep 6 2024 at 7:32am
Not really.
My point is that “prices” (and so capital gains) are brought into existence only when money and property rights over an asset change hands in a closing.
Before that, “prices” for an asset don’t exist. They are but an irrelevant, not-bidding estimate, an illusion that can disappear, different for different people.
That is clear for all non-listed assets. But even for listed assets (like Nvidia) what you “see” is the last price at which shares changed hands. That price is irrelevant for the next transaction. Doesn’t mean you can buy or sell at that price. There is a buying price for a fixed number of shares and a selling price for another number. And if you want to sell (or buy) more shares, you have to look further down the order book (different average prices for different quantities of shares). There is no price but the “realized” price. So, there are only realized capital gains. Unrealized capital gains are just a matter of convention. An illusion. Not a reality.
Now, leaving “a matter of convention” to generate very real tax liabilities is a slippery slope. Rules will have to be created to “invent” a non-existing price (remember price only comes into existence in a closing). The government will decree the conventions that define how much money you owe to the government. It is easy to see what happens next.
Thanks, but no thanks.
Craig
Sep 8 2024 at 12:35am
US tax law has this btw Matthias, its called a 1031 exchange. There are conditions on it of course: https://en.wikipedia.org/wiki/Internal_Revenue_Code_section_1031
Jim Glass
Sep 6 2024 at 1:01am
nobody.really wrote:
The motivation is the unrealized gains of the likes of Elon and Jeff, not homeowners. Congress hands homeowners tax-free $250k gains to begin with. It loves to make homeowners happy. Homeowners have a lot more votes than the top 1%.
Also, “buy-borrow-die” is no free lunch.
I’ve seen it pushed all over YouTube by the expert financiers there: Invest in a stock, take a big capital gain, never pay tax on it, instead spend its full value by borrowing against it, which is tax-free! Then get stepped up basis when you die, tax free again!
OK. Invest $100k, make a 100% gain. Yippee! Instead of cashing it in and paying tax, borrow against it and spend that money tax-free. The top federal capital gain tax rate is 20%, or $20k on the entire gain. Google tells me today’s interest rate for stock-secured borrowing is ~5%, or $10,000 on $200,000. That’s $20k once versus $10k annually. How many years do you expect to live? Of course you don’t have to borrow against the entire $200k this year, but if you borrow some amount annually the same principle applies. You’d better have a limited life expectancy.
Then there’s the problem that stocks go down in value too! I had a client who lost over $200,000 when his fully leveraged portfolio crashed in 2020. Those stocks were can’t miss! Of course if was safe to borrow against them! Borrow against stock’s full value, have the value plunge, leave your heirs no stock and a big debt. No stepped up basis for that.
Jose Pablo
Sep 6 2024 at 1:22pm
Yes Jim,
the “buy/borrow/die” subsidy that Nobody mentions was, in fact, invented for homeowners. And its practice by these voters (sorry, I meant homeowners) has been strongly supported by government policies. From different tax subsidies on mortgages to the very creation of the GSEs.
But obviously, it is very different when done by shareholders!
I have also observed that this nonsensical unrealized capital gains tax talking only takes place after long bull markets. Nobody was considering this back in 2009 after an almost 60% drawdown in the S&P from the 2000 heights (in nominal terms, even worse in real terms!). In this period something around 20 tr was lost in asset valuation (and that is only equity and housing market). That would easily translate into a 5 tr accumulated liability for the Treasury.
I hope government officials are ready to embrace this increase in tax income volatility (and volatility is not really their “thing”). Or, maybe, when (because it is not “if”) they have to face the next recession of this kind, they will come up with a way of getting away with these liabilities. You can never really trust the government when money is involved. They have the guns.
Jim Glass
Sep 6 2024 at 10:21pm
A true-life “unrealized income buy-borrow-die” horror story:
Start-up tech firm goes public at a huge price at the start of the year. Top exec rewards himself with very fat pile of stock shares. These are taxable compensation at their market value, and he should redeem enough of them to pay the tax bill right then. But under his brilliant leadership the stock price can only go up, so the smart thing is to wait until April 15 of the next year. Even better, he max-borrows against the shares to buy more shares. What’s smarter than getting exponential stock gains? You guessed correctly, the business crashes, its stock craters and he’s left bust — still owing both the unpaid tax bill *and* unpaid borrowing debt. But there’s more…
His wife is now poor too and angry about it, so … she claims “innocent spouse” status with the IRS to get off their joint return … divorces him to take everything he has left … files malpractice cases against the family tax accountant, lawyer and financial advisor, for not warning her about the downside to her in hubby’s financial “plan” … and sues what’s left of the business over SEC violations that enabled the whole mess. A tsunami of legal disaster.
So be cautious with the “buy-and-borrow against unrealized income” strategy, or you may end up wanting to die.
Bonus off-topic life lesson: This case is taught to professionals to highlight not the risk of leveraging volatile assets (which any dummy should know) but of malpractice when representing married couples. They typically hire pros to represent them jointly. The pro has fiduciary and confidentiality duties to each spouse individually. So if their interests start conflicting, you can see the conundrum. (Especially if they are deceiving each other, and the pro is oblivious at first.) The result can be really nasty for everybody. So if you are married and starting to have differences with the spouse, maybe step out to get an independent third-party opinion for just you.
Craig
Sep 8 2024 at 10:47am
“So if you are married and starting to have differences with the spouse, maybe step out to get an independent third-party opinion for just you.”
Thanks for that btw, personally I needed to read that, not that I am getting divorced, I am not, not that I am getting divorced or contemplating divorce, I am not, BUT I CAN foresee an empty-nest divergence. (My kids are 13)
Robert EV
Sep 8 2024 at 5:33pm
So you appear to be arguing that “buy/borrow/die” is an economic bad. Wouldn’t you want a tax policy that reduces the incentives for it then?
Though in your horror story the “top exec” seems to have saved many shareholders from the financial catastrophe that was the stock crashing. Very nice of him and his spouse to take one for the team. So does that make it a good?
Jim Glass
Sep 8 2024 at 10:37pm
Not at all. I’m saying plainly that borrowing against a volatile asset is a risky gamble. If you want to, and are aware of the risk, fine for you.
Personally, I’d go to a casino to make my risky gambles and enjoy a show and the buffet.
What? How do you imagine that? The business crashed and the stock plunged. Nobody was saved from that.
The entire “team” got wiped out together. He got more than wiped out. The point is that if you buy an asset for $100 and its price falls to zero, your loss is limited to $100. But if you borrow against the $100 value, you can lose a lot more than $100 … and a lot more than just money.
Robert EV
Sep 9 2024 at 11:45am
Except those who got out ahead of the crash when they sold their stock to the “top exec”.
Jim Glass
Sep 9 2024 at 6:12pm
Um, no…
Top execs commonly collect their pay from the company in shares. See Elon’s historic example of earlier this year. If he’d bought the shares from somebody else he’d have owed no tax bill on them to get stuck with. One doesn’t incur income tax on buying.
Robert EV
Sep 10 2024 at 11:48am
Okay. I had presumed he was leveraging to buy more shares in the open market. Not leveraging just to buy new shares from the company (exercising options?).
Jose Pablo
Sep 6 2024 at 6:03pm
Here are three possible answers to this question:1. No, they are not income and should not be taxed.2. Yes, they are income and should be taxed.3. Yes, they are income, but they should not be taxed. We should tax consumption, not income.I favor the third view.
The right answer is “it is complicated”. But it is definitely closer to 1 than to 3 (since 3 still includes the “they are income” part), at least with a little rephrasing.
1. No, any cash flow from my investment is not “additional” income (much less so a non-income from my investment like unrealized capital gains). The stream of future cash flows is the same income that has already been taxed, so they should not be taxed again.
Income from capital, in any form (dividends, realized capital gains, whatever …) has already been taxed. Here is why:
Scenario a). No taxes of any kind.
In this scenario, when you earn $100 you have two options:
a1) you spend $100 today
a2) you invest $100 and spend whatever returns this investment produces in the future (in any form).
You should be indifferent in front of these two scenarios: if $100 is the fair price (whatever that means) of the expected future cash-flows of your investment, the utility you get from spending your $100 today and spending the expected stream of future cash flows should be the same.
You are not getting, ex-ante, any additional utility by deferring and making your consumption more volatile. Both utilities are the same ex-ante (by the definition of the price of an asset).
Scenario b). 40% taxes on earned income.
In this scenario, when you earn $100 you have again two options:
b1) you spend $60 today (send $40 to the government)
b2) you invest $60 today (send $40 to the government) and spend the expected future cash flows that investing this $60 will produce (in any form).
In scenario b the tax has reduced the level of utility you get from your $100 of earnings by 40%. No matter what you do, b1 or b2. Any additional tax on your future cash-flows in b2 will be taxing again the same already taxed earnings that you got in year 0 (well, to be precise, will be taxing again earnings equivalent to the already taxed earnings you got in year 0).
But the government can say: “yes, very well, but actual future cash-flows from your investment can significantly differ from what you expect ex-ante. Can, for instance, be significantly higher like with this uber-rich I do hate. I want a cut on that difference”
And your answer to this should be: “Very well, sir, then invest this $40 you take from my $100 earned in year 0, and invest it alongside my $60. Do exactly as I do. Cash dividends when I do, sell when I do … actually, you know what, don’t even bother. Let me invest your $40 with my $60, I will do it for free, no management fee required, and I will send you 40% of whatever cash flows I get from investing the full $100 on year 0 …
… but, sir, what would be an obvious abuse is that you take $40 of my initial $100 and, on top of that another x% of my future cash flows. Make up your mind, dear government, you have a choice when I earn $100 and want to invest:
a) take $40 and spend them today
b) spend $0 now and get 40% of whatever future cash flows I get
I know you are not very good at this, but let me tell you that you should be indifferent to both options (well, I am assuming here that the government ex-ante expected cash flows for the asset and their opportunity cost are the same as mine. But for the sake of argument).
What amounts to a robbery, dear sir, is pretending to spend $40 today (of my $100) and still have 40% (of whatever %) of all the future cash flows, I get from investing the $60 you have left me with today”
Jose Pablo
Sep 6 2024 at 6:29pm
This (exhausting) example illustrates why taxing unrealized capital gains is different from taxing realized capital gains. And the very significant risk of introducing double taxation if you are not careful when considering cash flows from investment as “income”.
Looking at the government as a co-investor (the right mind-frame to avoid unfair taxing schemes), the selling of an asset will generate a cash flow that entitles the government to take its 40% share of all the selling procedures, (the concept of “capital gains” would be irrelevant as indeed it is, cash is cash). An unrealized capital gain doesn’t trigger any right of your government co-investor.
If you sell and buy again (your example) your government fair co-investor will be entitled to his fair share of the selling procedures but should immediately send it back to you in a capital call.
The example also illustrates your point that a “fair” treatment of investment cash flows of any kind will be totally equivalent to taxing consumption. And this latter option would be way simpler. Unfortunately, this option is not in any of the wannabe Presidents’ minds. Double taxing cash-flows from investment (even more than now) is.
Robert EV
Sep 8 2024 at 5:44pm
IMO, in a system such as ours which has an income tax, no one should bring up “double taxation” as an evil unless they are arguing against all other post-income taxes! There’s nothing special about a capital investment compared to investing in one’s self by buying groceries, textiles, books, or what have you. The most important single piece of ‘capital’ which people employ to generate income is their own willingness and ability to earn income.
Unless you’re saying that it’s okay for a government entity to single tax income/wealth that a separate government entity has already single taxed, but not for the same entity to tax twice. In which case I guess I can see the rationale, but it’s all the same to the taxpayer in the end, especially if the taxpayer is limited in their ability to move to another taxing jurisdiction.
Jose Pablo
Sep 6 2024 at 8:29pm
In fact, there is an extremely simple way of defining “income” that will make taxing income pretty similar to taxing consumption. Only three very simple rules:
* Consider any cash flow from your investments as “income” (dividends, selling of assets, capital reduction …)
* Consider any amount invested as “negative income” (buying of assets, capital increases, dividend reinvestments …)
* Add negative and positive incomes and consider this “net income” as “ordinary income”. Add it to any other taxable income.
Now, addressing, the arguments in your post:
Consider two investors that have identical big gains on Nvidia stock. One holds onto the stock, and the other sells the stock and then buys it all back
With the proposed definition, both will have the same “income”, roughly zero in both cases. Consistent with the zero consumption that will follow from this scenario.
But if you sell an asset and put the money into a different investment, that new investment also might go back down
With the proposed definition, this investor will still have zero income. He will also have zero consumption.
To an economist, the person that holds the Nvidia stock has earned income every bit as much as the person who sells it and puts the funds into an alternative asset
With that definition, both persons have the same income, zero. They also will have zero consumption.
It is very difficult to define income in a way that is both logical and useful for real-world tax systems.
No, it is very simple: cash flows from investment = income, cash flows invested in assets = negative income
Defining positive cash flows as “income” and negative cash flows as “negative income” is pretty logical to me (it is a criterion used for asset valuation all over the world and all over all asset classes). The usefulness of the definition to real-world tax systems is also pretty obvious.
Now, with this (very simple) definition of income the answer to your initial question becomes crystal clear and it is number 1:
1.- Unrealized capital gains are not “income” and should not be taxed
This (very simple) definition of income also has additional advantages (pretty much the same as taxing consumption):
1.- The distinction between capital gains and “basis” disappears for tax purposes. All the cash flow that you get in a sale (basis + capital gains) is “income” and will be taxed. Same as taxing consumption. Anyway, this “capital gains” mindset was always an irrelevant idea coming from the accounting department that never got that $1 is $1 is $1 is $1 …
2.- Double taxation on income from investments will be avoided.
3.- All the cash flows you get (either from investment or labor) would be taxed the same way
4.- The impact of taxing capital gains in capital allocation will disappear. Moving your capital from one asset to a more productive one will be tax-free and so, done more frequently.
5.- The tax code will be greatly simplified.
[Sure, politicians will find a way of messing up with, for instance, the “perimeter of the investments that qualified for this treatment”. But they will also find a way of messing around with the definition of spending: is buying an RV spending like buying a car or is it an investment like buying a house?]
Jose Pablo
Sep 6 2024 at 8:46pm
6.- the “stepped-up basis” provision will lose any meaning and will disappear.
It never had any meaning to start with. If an heir sells an asset inherited from his parents he gets “income”. By all means. Exactly the same “income” independently of how much his father invested originally or what the value of his parents’ investment was at the time of his death.
Jose Pablo
Sep 7 2024 at 1:03pm
7.- All the hype and nonsense around inheritance will disappear (finally!). Under the “fair co-investor model”, “inheritance” will become just a change of the fund manager (by no means a “taxable event”).
The government was the “owner” of X% of the father’s basket of assets (meaning the government had the right to take X% of every cash outflow from the basket of assets and the obligación to chip in, in the form of tax credits, X% of any cash inflow to the basket of assets). The basket of assets was managed by the father.
The father dies, and now the basket of assets is managed by the son. Apart from that, nothing changes, the government is still the owner of X% of that basket of assets (same meaning for “ownership”).
Under the proposed definition of “income”, “inheritance” can be seen as the son receiving “income” equivalent to the value of the father’s basket of assets (the value is irrelevant) and having a negative income equivalent to this very same value, because he/she reinvests in the very same basket of assets. Zero “income”, and zero consumption.
There is a Ricardian elegance in this.
Robert EV
Sep 9 2024 at 2:28pm
How do you feel about a ‘poll tax’ as a percent of the market value of one’s voting ownership stake in a corporation? Since one’s voting rights are proportional to ownership, and not “one person, one vote”, the equal protection grounds under which poll taxes were declared illegal in the US would not apply.
Suddenly everyone would love B stocks, hate A stocks, and Mark Zuckerberg would be screwed.
Robert EV
Sep 9 2024 at 2:33pm
I propose this because the most fundamental issue I think most of the hoi polloi (of which I am a member) have with disproportionate wealth is its effects on democracy, and most importantly the ability of individual humans to determine the direction of their lives, environment, and milieu.
Power should be constrained through checks and balances, or at the very least through taxation of that power.
Robert EV
Sep 8 2024 at 4:31pm
I agree with your general point, though am still uncertain as to income versus consumption or wealth taxes.
One of the complaints about wealth taxes that wealthier people have made is that “what if the value of the asset goes down”? But this is a complaint about literally everything, including income. An income tax taxes people based on the income they have made over the course of a particular fiscal year. But what happens if they lose their job on December 31st and their income flatlines? They will still be taxed at the full marginal rate for that year come April the 15th of next year despite being in a much more difficult financial situation the next year.
If income taxes don’t adjust for income changes in a future fiscal year, then why should any tax? It’s all the same hardship.
VJ Colvin
Sep 9 2024 at 10:39am
Scott, I have to side with Walter Williams on this. Government spending is the problem, not taxes per se. If the government was only 4-5% of GDP instead of 20+%, then the income taxes needed to support that would be quite low and not really an issue for the country as a whole.
I know talking about spending is a bit of a sideswipe to your subject but I also believe that constantly talking about taxes is a distraction to the real issue. Thanks.
J Mann
Sep 9 2024 at 12:25pm
I think we have to decide whether unrealized capital gains are income and whether we want to tax them.
We definitely don’t consider unrealized human capital gains to be income. If I get a medical degree but then retire or get a job as a school teacher, most people wouldn’t consider the increased potential value of my future services to be “income.”
There are a lot of other things that are income, but probably aren’t practicable to tax, like the guy who gets to work in an office with a nice view.
J Mann
Sep 9 2024 at 12:27pm
(Sorry, can’t edit my post!)As Scott says, this requires that we surrender some amount of “logic and consistency” when we tax income.
nobody.really
Sep 10 2024 at 12:49pm
If you quit your job as a physician to become a school teacher, I suspect the family court judge will continue to calculate the magitude of your alimony and child support payments based on the value of your potential earnings as a physican.
Robert EV
Sep 10 2024 at 1:13pm
So you’re saying that the thing to do is to commit such horrific malpractice that your license to practice medicine is permanently yanked, or at the very least such that you’re uninsurable, and then to become a school teacher.
Thomas L Hutcheson
Sep 11 2024 at 10:26am
The foundation of taxation should be the progressive consumption tax with business income imputed to owners’ personal income from which non consumption — investments, savings, reinvestment of dividends and capital gains, debt repayments, SALT, and charitable contributions — are deducted. The rates of taxation (including the negative rates corresponding to a more generous EITC) should be enough to make deficits < Σ(expenditures with NPV>zero)
In parallel there should be a tax on net emissions of CO2 with revenues rebated pro-rata.
In parallel there should be a VAT to fully fund (no net surplus or deficit over time) social insurance transfers like old age and disability pensions, health insurance, child allowance, more generous unemployment insurance.
Warren Platts
Sep 12 2024 at 1:05pm
Well, here’s a type of capital gains that should be taxed: capital gains made by the foreign investors who own 40% of the U.S. stock market. Currently they pay zero tax; if they were taxed at the same rate as American investors, that could potentially raise a half trillion in revenue per year. And the beauty part is Americans wouldn’t be paying that tax bill.
As for consumption taxes, isn’t a tariff a consumption tax? Then why are tariffs to economists like sunshine is to vampires?