“Tax justice” is a powerful rallying cry that has the potential to generate a seemingly limitless number of bad tax policy ideas. The latest is a “mark-to-market” capital gains tax proposed in the New York Times by tax attorney David Miller. Appalled that Mark Zuckerberg is expected to pay only $2 billion in taxes this year, Miller proposes fundamentally changing the definition of income so as to include fair value changes in net worth. The idea would generate such elaborate, expensive, and economically counterproductive tax schemes that it is perhaps not that surprising that it was proposed by a tax attorney.
According to Miller, the basic problem is that the current tax system is based on realizations. Capital gains are only included in gross income when the underlying asset is sold. If you buy a stock for $100 and it increases in value to $200 during the course of the year, the $100 change in net worth is only taxable if you sell the stock. In short, a tax liability is only generated by a transaction that generates liquidity for the investor. If there is no sale of the stock, there is no transaction and thus no tax liability is generated.
As supply side economist Art Laffer explained in a recent Wall Street Journal column:
Mr. Buffett stated in his op-ed that he paid $6,938,744 in total income and payroll taxes in 2010, representing 17.4% of his taxable income…[however] Mr. Buffett's net worth rose by $10 billion in 2010 to $47 billion…[this means] Mr. Buffett's true income in 2010 was much closer to $11.6 billion than the $40 million figure cited in his op-ed. Hence his true effective tax rate was only 6/100ths of 1% as opposed to 17.4%.
Thus, as Miller argues, the way to increase taxes on people like Warren Buffett is not through a “Buffett rule” that creates a new Alternative Minimum Tax (AMT) to ensure millionaires pay tax rates of at least 30%, but by redefining income so as to tax unrealized capital gains. If the 15% capital gains tax rate were left in place, but Buffett’s $10 billion in unrealized gains was included as income, his tax bill would increase from $7 million to over $1.5 billion. This would be a 21,300% increase in Buffett’s tax bill.
The first problem with this “solution” is that this $10 billion is really phantom income. Since there was no transaction, taxpayers impacted by the rule would not have any liquidity to pay the tax. Maybe Warren Buffett has $1.5 billion laying around in a bank account somewhere, but the typical household impacted by the tax would have to liquidate assets – against their will or better judgment – simply to pay the tax man under this new proposal. These sorts of tax-induced asset fire sales are likely to be very costly to economic efficiency and could very well erode the ability of household savings to finance long-term investments.
Secondly, the tax would dramatically increase the pro-cyclicality of tax receipts. Miller’s proposal would allow for tax refunds when taxpayers suffer mark-to-market losses. So when the stock market is on a bull run, the Treasury will receive a huge windfall, but would then have to make large payouts when the market tanks. According to the Federal Reserve (B.100), the value of financial assets held by U.S. households fell by $9.3 trillion in 2008. Assuming households impacted by the tax own 90% of these assets, the total tax refund would amount to $1.255 trillion. Does anyone really believe it would be smart tax policy to have the government mail $1.255 trillion in refund checks, many of which would go to millionaires at the precise moment when the economy is down, household incomes and tax receipts are depressed, and social welfare needs are rising?
Finally, while mark-to-market gains are easy to identify on liquid instruments like publicly traded stocks, corporate equities only account for 10% of household assets. What about instruments without readily identifiable market values, like real estate, or equity in partnerships and privately held businesses? The inability to precisely value instruments for which there is no market creates enormous loopholes for tax planning. Smart tax attorneys would likely turn this proposal into a huge net winner for their clients through total return swaps and other devices to effectively transfer ownership. Moreover, since this proposal would apply to households, it creates a huge incentive to hold assets through corporations, trusts, or other third parties. There is no demonstrated or proven way (to our knowledge, at least) for the IRS or Treasury regulations to even begin to contemplate all of the structures that would be used to avoid this tax. Unfortunately, the money devoted to this tax planning exercise would almost surely take-up some of the finite national resources that go to investments in property, plant, equipment, or intangibles like the next iPhone or Facebook.
Even if Zuckerberg’s estimated $2 billion (looming) tax bill isn’t enough for some, an important point that is overlooked in the article is that the fair value of his stake in Facebook will be subject to the estate tax if he tries to pass it to his heirs. The bottom line: proposals to allow the IRS to increase its $2 billion share during his lifetime will inevitably spark important trade-offs that policymakers need to keep in mind, especially when taken collectively they could be so counterproductive to facilitating economic growth.