A Democratic Capital-Gains Tax That Isn’t Worth It

(Bloomberg Opinion) -- Oregon U.S. Senator Ron Wyden recently proposed an interesting idea -- taxing unrealized capital gains. There are advantages and disadvantages to this idea, which shares some similarities with a wealth tax. But ultimately, adopting this change probably isn't worth it.

Now, if you own stock or another asset, and it goes up in value, you pay tax if and when you sell it. As long as you don’t sell, you don’t owe tax. The tax rate is lower if you hang onto the asset for longer than one year, which is a way of encouraging people to hold on to assets -- especially stocks -- instead of trading them for short-term gains.

Wyden’s proposal would tax assets as soon as the price goes up, rather than when the asset is sold. The logic behind this is simple -- paper gains represent real wealth, since you could sell the asset and get cash any time you want. Waiting until the asset is sold in order to tax it allows the wealth to compound untaxed, which causes wealth inequality to accumulate.

In addition to eroding wealth as it builds up, taxing unrealized capital gains would cut down on tax avoidance. Investors and traders now try to skirt capital gains taxes by engaging in tax-loss harvesting -- selling assets that go down, pocketing a tax credit that offsets future capital gains tax liabilities, and then buying similar assets to keep one’s holdings roughly constant. There are rules that are supposed to prevent the selling and buying of identical assets for tax purposes, but these rules can often be evaded by simply buying similar assets instead of identical ones.

In addition to allowing wealthy people to avoid taxes, tax-loss harvesting represents a waste of resources from society’s point of view. The time and effort of the smart people who game the tax system could be better spent doing something more productive. But if unrealized gains were taxed instead of realized gains, as Wyden wants, this kind of shenanigan would no longer work, and would thus disappear.

So taxing unrealized gains does have some appeal. But it also has major downsides. First, it would encourage an increase in trading. Investors now pay lower taxes if they hang on to an asset for longer than a year, but if taxes were independent of when assets were sold, this incentive would disappear. That would encourage more trading of assets back and forth -- something that other Democratic senators want to curb. There are theoretical reasons to believe that much trading is wasted effort.

A second problem is that taxing unrealized gains would force asset owners to sell some of their holdings in order to pay their taxes. For some assets, like publicly traded stocks, that’s no big deal, because their markets are big and liquid, with many buyers and sellers. But imagine the stock of a startup under a system like Wyden’s. When the startup’s stock appreciates in value because it accepts funding at a higher valuation, the founders, early employees, and early investors would probably have to sell some of their stake in order to make the tax payments. Finding a buyer would be difficult and time-consuming, and they might have to sell at a big loss, hurting the company’s development.

For assets that can’t be cleanly divided up, like houses, the difficulty would be even greater. Homeowners typically pay property taxes every year, requiring them to either have some other source of income or to borrow (expensively) against the value of their house. Taxing unrealized capital gains would add to this burden, making it more costly to own a home.

Taxing unrealized gains would also require illiquid assets to be frequently appraised or modeled in order to determine their value. This would create a cottage industry in lowball appraisals and models that understate asset values. The effort put into this industry would also represent social waste.

The problems associated with taxing illiquid assets are also hurdles for wealth taxation. They aren’t insurmountable. But scrapping the current capital-gains tax code in favor of an unrealized-gains tax would sacrifice a system with many advantages in favor of one with a different set of advantages, and it’s not clear the country would come out ahead.

Instead, there are better ways to modify the existing capital-gains tax regimen. Charging interest on untaxed gains -- an idea proposed by economist Alan Auerbach in the 1980s -- would limit the degree to which untaxed wealth could snowball. And limiting the number of asset sales that could be used to generate tax-loss carryforwards to help reduce taxes on future income could cut down substantially on gaming the system.

And of course, the most important reform would simply be to raise the capital gains tax rate, as Microsoft founder Bill Gates has suggested. That would be unlikely to harm business investment, and would be an effective way of making the distribution of wealth and income in the U.S. a bit more equal.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

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