How many unrealized children may I include on my tax return? If this question sounds ridiculous, then you’ll understand exactly why a proposal to tax unrealized capital gains is equally absurd.
Sen. Ron Wyden (D-Ore.) announced last week that he wants to tax the unrealized investment gains of billionaires each year. The plan could help fund President Biden’s $1.85 trillion social spending bill that’s bogged down in Congress.
Unrealized investment gains are the increase in the value of your stocks and other investments that you have not sold. They exist only on paper and are not taxed under current tax law until you sell the investment and cash in the capital gains. For example, imagine buying a painting for $1,000 and after one year the market value of the painting increases to $1,500. You’re not taxed on that $500 gain because you haven’t sold the painting—the $500 is an unrealized gain.
Billionaires are good at avoiding taxes, and if the Wyden plan were implemented, they would likely cut back on stock holdings and move their money to assets that wouldn’t be subject to the new tax. This would hurt investment in U.S. companies and limit employment opportunities and wages for workers. Some billionaires would renounce their U.S. citizenship to escape the tax.
Government Checks for Billionaires?
Then, for billionaires who end up being subject to the tax, there’s the issue of capital losses. In years when the stock market collapses 22% or 37%, as it did in 2002 and 2008, does the Internal Revenue Service plan to send multimillion-dollar refund checks to billionaires for their unrealized losses? I can’t imagine this would be a politically popular move. The entrepreneurs, investors and other rich taxpayers subject to this tax would be able to carry forward losses and, in some circumstances, carry back losses for three years, but that’s unlikely to make up for all the losses in years when markets crash.
But first the IRS would have to figure out who is a billionaire. Forbes magazine says there were 724 as of March. Would the IRS use the Forbes list or attempt to tote up the value of different assets and identify this group on its own? But it might not get that far: The plan would face a big legal obstacle, namely the U.S. Constitution.
Previous Democratic administrations openly acknowledged the high cost of traditional capital gains taxes. In the 1960s, President John F. Kennedy noted how such taxes hold back investment and growth. Similarly, a Joint Economic Committee report in 1997 concluded that the capital gains tax “is systematically biased against savings, investment and work effort.” The Clinton administration agreed with that assessment.
But aside from the Wyden plan, one idea to help fund the social spending bill is the Biden administration’s proposal for a big jump in the capital gains tax rate for high earners. This would not only lead to less growth and fewer jobs but also less federal tax revenue because more investors would delay selling their shares and incurring the tax.
The Sorry Record of Wealth Taxes
Unrealized gains are different from regular capital gains because they represent an increase in wealth rather than income. So, the Wyden plan is a wealth tax rather than an income tax. And if the history of wealth taxes teaches us anything, it’s that they never work as intended and are often abandoned to end the economic destruction that accompanies them. Over the past century, 15 European countries have implemented a tax on wealth. Today only three still levy a wealth tax.
France repealed its wealth tax in 2017 after the prime minister admitted that it had led to an exodus of 10,000 to 12,000 millionaires every year. The French wealth tax (and the subsequent exodus of the rich) slowed economic growth and made up only little more than 1% of total tax revenue—hardly a worthwhile trade-off.
Sweden, often held up as a model by progressive policymakers, had a wealth tax for almost a century before abandoning it in 2007. The tax had “virtually no effect” on government finances while being blamed for massive capital flight. Germany, too, had a tax on wealth, but the country eliminated it in 1996 after it was ruled unconstitutional. Wealth taxes may not have worked around the world, but in the U.S., more importantly, it’s unclear whether the Constitution grants Congress the authority to impose such a tax.
That Pesky Constitution
The 16th Amendment says “taxes on income” do not need to be apportioned among the states. This likely means that other federal taxes, such as a tax on unrealized capital gains and other wealth taxes, must be applied equally to all 50 states, according to population. Alabama, which makes up roughly 1.5% of the nation’s population, would have to produce roughly 1.5% of the revenue raised by the tax. But Alabama and six other states have no billionaires and California and New York combined have 44% of them, so equally apportioning the tax among the states would be impossible. This constitutional hurdle might explain why advocates for a tax on unrealized gains, such as Treasury Secretary Janet Yellen, are steadfast in telling us that this is not a wealth tax.
Whether we consider the economic costs of a tax on unrealized capital gains, the historical precedent of nations abandoning wealth taxes, or the constitutionality of such a tax, the proposal appears to be unworkable. Politicians and policymakers will need to look elsewhere to fund the social spending bill or, better yet, drop the idea for the giant bill entirely.