A new report from ProPublica argues that wealthy taxpayers face low effective tax rates as a portion of their wealth and mentions taxing unrealized capital gains or imposing a wealth tax. However, a better approach to raising the tax burden on the wealthy would be to pursue progressive consumption taxes as they have fewer administrative and economic costs.
Under the current tax system, individuals are taxed on their income, which consists of wages and salaries; investment income like dividends and capital gains; business income, such as farms, partnerships, and LLCs; and retirement income. If an individual owns an asset like a stock or a small business, they do not pay taxes on the increased value of that asset until they realize the gain through a sale. Until they sell, any gain in the value of a stock or a business is a “paper gain,” meaning they have not received proceeds on which to be taxed.
One implication is that individuals can have large amounts of wealth tied up in paper gains while earning smaller amounts of taxable income, as the ProPublica report details. Individuals may also take deductions for charitable contributions, past business losses, and interest, which may reduce taxable income in any given year. Many provisions, like the deduction for past losses, are normal, important components of the tax system that help accurately measure income over time—and that would also exist under a wealth tax or taxing unrealized gains annually.
The report compares taxes paid on income to the amount of gains individual taxpayers have on paper, but that hypothetical measurement does not reflect how the income tax is structured—the true tax rate is taxes paid as a share of income. Data from the Internal Revenue Service indicates that the top 1 percent of taxpayers paid an average federal income tax rate of 25.4 percent in 2018—seven times higher than the 3.4 percent average rate paid by the bottom half of taxpayers.
Proposals to tax unrealized capital gains on a regular basis, also known as a “mark-to-market” tax system, would tax gains accrued on assets each year. For example, if the value of a stock increases by 5 percent each year, tax would be owed on that gain during each tax year. If the stock loses value, a taxpayer could carry forward that loss to offset future income, deduct the loss from current taxable income, or receive a refund from the government.
Moving to a mark-to-market system would bring the tax code closer to a Haig-Simons definition of income, which applies tax to a taxpayer’s consumption plus their change in net worth each year. However, moving toward a purer Haig-Simons tax system would come with large trade-offs.
A mark-to-market system would face significant administrative challenges—for instance, how to properly value closely held and illiquid assets such as businesses and artwork. Further, some taxpayers may not have the cash on hand to pay the tax without liquidating (selling off) certain assets. Taxpayers with a high net worth would be encouraged to consume their wealth instead of using it productively, depriving the federal government of revenue and reducing economic growth.
Instead, the U.S. could learn from the experience of other countries in the Organisation for Economic Co-operation and Development (OECD), which have tended to abandon complicated tax structures like wealth taxes due to their administrative and economic challenges. A mark-to-market system for capital gains is not the norm in OECD countries (the Netherlands has a limited version). Instead, most OECD countries tax capital gains on a realization basis and at lower rates than the U.S., and tax capital income overall at lower average tax rates.
As an alternative to wealth taxes or a mark-to-market system for capital gains, lawmakers could explore ways to ensure the tax code is progressive and address certain tax strategies the report highlights, like the ability to borrow against existing wealth to fund personal consumption. OECD countries rely more heavily on consumption taxes than the U.S. does—U.S. policymakers could tax the consumption of higher earners progressively and without the administrative complexity associated with pursuing a Haig-Simons system that taxes changes in net worth.
For example, take one strategy the ProPublica article highlights to avoid paying tax, called “buy, borrow, die.” Using that strategy, wealthy households purchase assets that appreciate (increase in value), and then borrow money against their assets to consume their wealth without paying tax. When the household passes away, the assets with unrealized gains escape taxation due to step-up in basis, which removes the unrealized gain and associated tax liability for the heirs.
While the “buy, borrow, die” strategy is a challenge under an income tax system, wealthy households could not employ it under a consumption tax that includes financial activity. That is because the household would be subject to tax on consumption, including consumption with borrowed funds, all without having to track basis or determine the value of illiquid assets.
Consumption taxes would also be a more economically efficient way to raise revenue, as they avoid the double taxation of saving and investment, so they do not distort decisions about whether to invest or consume.
Moving the federal tax code closer to a Haig-Simons system would come with many conceptual and administrative problems. Policymakers concerned about the current tax treatment of unrealized capital gains would be better off exploring policy solutions like consumption taxes rather than tried-and-failed strategies.
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