Taps Coogan – October 26th, 2021

Enjoy The Sounding Line? Click here to subscribe.

A New Tax Is Coming

For the first time since 1916, an entirely new type of type of taxing power is likely to be enacted into law by Congress in the coming weeks or months.

This new tax will be a sort of wealth tax, a tax not on how much money you make as income, but a tax on change in the value of your assets.

Very few specifics have been released about this new tax, but here is what we know so far: the proposal would apply capital gains taxes to unrealized capital gains.

As is the case with all new taxes, proponents of this new unrealized capital gains tax promise that it will only apply to the wealthiest Americans, billionaires and people making $100 million a year.

A Terrible Idea

Taxing unrealized capital gains is an exceptionally bad idea. Here is why:

1.) Without a shadow of a doubt, this new tax will apply to you within a handful of years.

When the income tax was implemented in 1913, it was promised to be a tax exclusively on the super-wealthy. The rate started at just 1% and only applied to the wealthiest 3% of Americans at the time.

By 1918, just five years later, the top rate was 77% and income down to $1 was being taxed at 6%. In 1944, the top bracket hit an eye watering 94% and the lowest bracket hit 23%. After bouncing around in the 1950s, the top bracket was still 94% in 1963.

It was the same story for the corporate tax. The idea for that tax was sold to the public in 1909 on the basis that it would be just 1% and apply to only the largest companies. That rate peaked at 52.8% in 1969 and now applies to all companies no matter how big or small.

The death tax was implemented in 1916, yet again on the exact same premise. It was to start at 1% and only apply to the absolute wealthiest families. The top rate was to be just 10% on families with more than $5 million in 1916, the equivalent of $125 million today. Needless to say, the rates and thresholds all rocketed higher.

Neither party in Congress is done passing multi-trillion dollar pork-filled spending bills. Under budget-reconciliation rules, some of that future waste will need to be paid for with new sources of revenue. When Congress cobbles together its next trillion dollar spending bill in six months or a year, they will need to lower the income/wealth threshold on this new tax to $50 million, or $10 million, or $1 million. Then they will just apply it to everyone, because to have unrealized capital gains of any consequential amount means that you are likely in the top 50% of households that already pay 97% of net taxes.

2.) Investors become net sellers.

An investor gets exactly zero actual income from unrealized capital gains, a reality that derives from the very definition of term. So, for people who get any meaningful amount of their income from investing, they will have to sell parts of their investments to pay their taxes on unrealized capital gains. Forcing people to sell parts of their investments every year to pay their taxes is a great way to make investors net sellers of financial assets and liquidators of productive capital. That is also known as a bear market.

2.) What happens when investments go down?

Imagine that a billionaire makes an investment that loses money. Will Uncle Sam send him or her a check in the mail for the negative taxes on their unrealized capital loss? Let’s assume that they’ll get a rebate instead.

What happens when there is a recession and nearly everyone’s unrealized capital gains taxes are negative and rebated into future years and the government wants to pass even more multi-trillion dollar stimulus bills? They’ll need to raise new taxes.

3.) Taxing unrealized capital gains means that your effective tax rate is arbitrary and path dependent.

Imagine the following situation: You start a successful company and that company’s value goes from zero to $1 billion in one year. December 31st passes and under the proposed tax law you now owe taxes on those unrealized capital gains. Let’s assume that the unrealized capital gains rate is the same as the long term capital gains rate: 23.8%.

So, now it’s the next tax year and you need to sell $238 million of shares to pay your unrealized gains tax from the prior year (assuming you could just sell 23.8% of a company at the drop of a hat).

Imagine that the price goes down 50% between when your unrealized capital gains are determined (presumably on December 31st) and when you sell $238 million of your company to pay those taxes. Well, now you would need to sell much more than a 23.8% of your shares to pay your tax bill from last year, a tax bill that is for unrealized capital gains that no longer exist. So now you have sold perhaps half of your company to pay a 23.8% tax that you will be rebated for next year. If the share price then rises, you will only participate at half the rate that you would have if the share price didn’t temporarily dip when you had to pay your taxes. That means that your decisions about when to buy and sell investments, the effective tax rate and returns you get, and how much of your own company you will ultimately own, are now an arbitrary function of the coincidences of tax dates and asset price volatility.

But wait, are your unrealized capital gains taxes deductible against your future realized capital gains?

Presumably they are for federal taxes, otherwise truly bizarre scenarios are possible, but what about state taxes? Let’s say you happen to live in California. Will state taxes incurred on the sale of shares used to pay unrealized federal capital gains taxes also be refunded? How on Earth would that accounting work? Wouldn’t that technically be a tax cut for billionaires? Would it require changes to state laws?

If not, now you have to pay state taxes of 13.3% on the shares you sold to pay your federal taxes. So of the $238 million in shares that you originally sold to pay your unrealized capital gains taxes from last year, you only have $206 million after paying all your state taxes. So in order to pay your unrealized capital gains taxes of $238 million, you actually need to sell $274 million worth of shares.

Good luck trying to figure out what your effective tax rate is going to be on an investment when you are forced to pay state taxes on stock sales made to pay federal unrealized capital gains taxes on gains that no longer exist. The longer you hold the investment, the higher the effective rate is likely to be. It is also technically possible that you end up losing more than 100% of your money on an investment. You simply have to have a trade that is profitable for many years, upon which you pay state taxes when you liquidate your shares in order to pay federal unrealize capital gains taxes every year, that ends up eventually becoming unprofitable. That’s hardly an unlikely scenario.

5.) What about illiquid assets?

What about billionaires’ who own private companies that don’t trade publicly? What are those companies even worth? What’s their actual value if the owner is a forced to sell a quarter of the company every year? Who on Earth is going to buy them and where would they get the money? Presumably wealthy foreign investors that don’t have to follow these new rules. How would real-estate be handled? How would you sell a quarter of a home to pay the unrealized capital gains taxes?

For that reason, the current proposal applies only on liquid publicly traded assets, but how is that fair? A billionaire who’s company is private or who puts his or her money in real-estate doesn’t have to pay these new taxes? Wouldn’t that incentivize companies to go private, depriving small investors of the opportunity to invest in some of the most profitable companies in the world?

Before we know it, we’d be forcing billionaires to itemize and declare the value of everything they own to the IRS every single year. Before we know it, we’ll be asked to do the same.

6.) What about the cutoff?

If you have $999.999 million dollars in stocks this rule doesn’t apply to you (for now). That last penny could cost you the ownership of the company you started and wildly transform your taxes for the worse. One can imagine a situation in which the value of your kitchen table may be the difference between massive taxes. Anyone near $1 billion of assets or $100 million of income is going to make sure they are below that threshold on December 31st. In addition to being bad policy, that will produce big market volatility.

One can go on and on forever with examples of why taxing people on unrealized investments is, simply put, an incredibly dumb idea.

That being said, there is no correlation between the merits of an idea and whether or not it will become law. The current mood in Washington is that billionaires are bad and need to pay more taxes and so it is entirely possible that something like this proposal will pass.

Would you like to be notified when we publish a new article on The Sounding Line? Click here to subscribe for free.