No tax on unrealized capital gains

This is a response to a proposal by presidential candidate Kamala Harris to tax the wealthiest citizens on unrealized capital gains, as described in the following articles

A tax on unrealized capital gains is a bad idea and people should vote against it.

The intent of the proposal, which is to ensure the wealthy pay their share of taxes even when they don’t have a personal income from a job like most other people, can be met with better proposals.

To understand the major problems with taxing unrealized capital gains, we need to examine the definition of capital gains. Capital gain refers to the difference between the price at which an asset is sold and the price at which it was bought, for assets that increase in value. If an asset is sold for less than the price at which it was bought, this is considered a loss. A broader definition of capital gain includes the transactions costs so instead of comparing sale price to purchase price, the sale price less costs of selling are compared to the purchase price plus costs of buying, because the owner of the asset only gains from the net profit. An unrealized capital gain is the difference between the current market value of an asset and the purchase price or, in the broader definition, the total acquisition cost of the asset. It’s unrealized because the owner of the asset doesn’t actually gain anything from that value until the asset is sold.

This leads directly to the two major problems with taxing unrealized capital gains:

First, the owner has no control over the market value of an asset. An owner can do certain things such as make improvements to attempt to increase the market value, but such work doesn’t guarantee the value will increase. The market value is only what other people are willing to pay for the asset, and it’s not really known until the asset is sold. Until the asset is sold, such a market value is only an estimate. There are professional appraisers who specialize in developing good and useful estimates of value, but they are still only estimates. So the first problem is that taxing an owner on unrealized capital gains is taxing an individual based on what other people think the individual’s assets are worth, which is an opinion over which the individual has no control at all. It allows people other than the owner and the government to create a liability of the owner to the government.

Second, a person may have a modest income compared to the market value of their assets and may not be able to pay a capital gains tax based on the current market value. For example, a person may have purchased a house 30 years ago and recently finished paying off the mortgage. In that time, the neighborhood may have become very in demand, increasing the value of all the houses in it. A person may find themselves the owner of a million-dollar house but have an income of only $45,000 a year. If such a person were to be taxed on hundreds of thousands of dollars of unrealized capital gains, it may be a devastating expense. Harris’ proposal is to only do this for very wealthy individuals but the problem is the same. Their assets may be valued far more than their income. What would a person do who cannot pay the unrealized capital gains tax? They might have to sell the asset when they don’t intend to, or borrow against it and then pay interest on the money they borrowed to pay the tax.

Taxing unrealized capital gains is similar in principle to the property taxes that are due every year and that are based on the current market value of a property, except that 1) property taxes tend to be very low, in many places low single digits, whereas the proposed tax is 25% so it’s much higher, and 2) the property tax goes to local government, whereas the proposed tax would go to the federal government.

Besides these two major problems, who is going to keep track of these changes in value and collect the tax? The revenue service must be staffed to handle this extra work. Who will be appraising all these properties? Will the government be prepared to vigorously pursue all the cheaters out there whose asset values will suddenly stop appreciating? And what will happen when wealthy people start moving assets around so they don’t technically own them?

Wealthy people should pay their share of taxes, but taxing unrealized capital gains is not the right way to do it.

Here are better ways to ensure the wealthy pay their share of taxes:

First, replace the personal income tax with higher sales tax for everyone. No more income tax at all. The sales tax would vary by category of goods, so that the essentials like groceries and utilities are taxed at a very low rate, while comfort items are taxed at higher rates and luxury items are taxed at even higher rates. That will naturally lead to wealthy people paying more taxes, because they use their money to buy more things, and the things they buy are more expensive and in more luxury categories. Investments and donations would not be taxed because they’re not sales, so those two useful behaviors would be encouraged and those are good for the economy and they’re good for charitable causes. Will a higher sales tax raise the cost of living? Yes, but also people won’t have to pay income taxes. For middle class incomes and below it should be a wash or even save them money, and for wealthy people it will appropriately increase the taxes they pay.

Second, a modest corporate income tax that applies to all organizations not exempted as non-profits and that does not allow any deductions. This will ensure that every business entity pays taxes. If a business makes more money, it pays more taxes. No playing games with deductions and depreciation. The rate can be lower for small business and higher for large business, where small and large is defined in this case by how much revenue they earn in a year, not by the number of employees. Sales tax that people pay on items does not count as the company’s revenue, it is money that the company is collecting on behalf of the government. Investments that are made in the company also do not count as revenue. Loans do not count as revenue, and businesses have to pay interest to the lender anyway. Although corporate income taxes will generally be passed on to consumers in the form of higher prices, the taxes will be easier for the government to collect and more difficult for corporations to avoid, which means the government will end up with more money from those corporations which it’s currently not able to collect.

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