10 Problems with Taxing Unrealized Gains

Democrats are pushing a tax on unrealized gains. This “mark to market” regime, or wealth tax would force Americans to pay taxes every year on the paper gain in the value of assets (i.e. stocks, collectibles, real estate).

Currently, taxpayers only pay the capital gains tax when an asset is sold. This makes sense because the asset is illiquid until it is disposed of. This tax on unrealized gains would create a new tax system that requires taxpayers to pay tax on the value of an asset based on the value of these assets on a particular arbitrary date.

Here are 10 reasons to be concerned with a tax on unrealized gains:

1. The Tax would Empower The IRS

In order to enforce this tax, the IRS would have to be given vast new powers to value the assets of taxpayers. This would be an extremely invasive and difficult task. As noted by Howard Gleckman of the Tax Policy Center, taxing unrealized gains is not practical and would be extremely complex:

“The concept is theoretically appealing but raises many practical problems. While in principle it could work for publicly traded securities and other investments with easily determined market values, many assets don’t fit that bill.”

With the IRS’s history of discrimination and malpractice, it should be concerning to have agents collect this information. There would be significant compliance and administrative issues with this tax. For instance, the IRS would have to monitor assets of taxpayers to determine if they hit the thresholds and are encompassed by the tax. Many assets cannot easily be valued so both the taxpayer and the federal government would be required to hire armies of accountants and lawyers to determine valuations.

2. The Tax Would Likely Grow to Hit Millions of Americans Over Time

According to media reports, the tax would apply totaxpayers with over $1 billion in assets or a taxpayer that earned $100 million in income for three years. This would impact 700 taxpayers according to reports. However, it is likely the tax will grow in size in future years to hit thousands or even millions of taxpayers.

When the federal income tax was first imposed in 1913, it imposed a 1 percent tax on incomes above $3,000 (4,000 for married couples). The top rate was 7 percent on incomes of $500,000. In Today’s dollars the 1 percent tax would be imposed on incomes above $83,124 for an individual and $110,832 for a married couple, while the top 7 percent rate would be imposed on $13.8 million in income.

Today, the bottom income tax bracket is 12 percent and applies to income of $9,950 for a single filer and $19,900 for joint returns, with a $12,550 standard deduction ($25,100 for joint returns). The top rate is 37 percent on incomes above $523,600 ($628,300 for joint returns).

Similarly, Congress enacted the Alternative Minimum Tax (AMT) in 1969 following the discovery that 155 people with adjusted gross income above $200,000 had paid zero federal income tax. Over time, The AMT grew so large that millions of Americans paid the tax and millions more saw increased tax complexity. By 2010, the AMT grew so large that Congress had to step in and prevent it from hitting nearly 30 million Americans (20 percent of filers).

3. The Tax Will Encourage Taxpayers to Move Overseas or Move States

Taxpayers impacted by the tax on unrealized gains will be incentivized to move overseas in order to avoid the tax. In response to this concern, several proposals have created an “exit tax” on taxpayers that want to leave the country. The Washington Post editorial board said this arrangement “conveys a certain authoritarian odor,” as it binds people to the United States with severe financial consequences for deciding to leave.  

In addition to encouraging taxpayers to leave the country, it would result In taxpayers leaving states with high capital gains taxes, like California to states with no capital gains tax. Blue states would like to ensure their state capital gains tax would apply to unrealized gains so taxpayers would be hit twice In many states.

4. The Tax Will Harm Jobs and the Economy

This tax would lead to a reduction in new investment in the economy, which would harm working families and small businesses and lead to a reduction in jobs and wages. An American Action Forum (AAF) study, on Senator Elizabeth Warren’s (D-Mass.) $3 trillion wealth tax proposal found that the tax would decrease innovation and investment, driving down wages and causing unemployment. 

It would shrink GDP by $1.1 trillion over the first ten years, and then continue to shrink it each year by $283 billion, or 1 percent of GDP. 

This tax would result in a loss of $785 billion in labor income. Over the long run, wage losses would amount to $241 billion annually. As described in AAF’s study, “In short, over the long run Warren’s wealth tax is more damaging to workers than anyone else.”  

The tax on unrealized gains being considered by Democrats would undoubtedly have similar negative Impacts on workers and the economy.

5. The Tax Code is Already Steeply Progressive

While Democrats routinely assert that the “rich” need to pay their “fair share,” the tax code is already steeply progressive.

According to the Congressional Budget Office, the top one percent of earners paid 41.7 percent of income taxes in 2018 and 25.9 percent of federal taxes. The top 20 percent of earners paid 90.9 percent of income taxes and 69.8 percent of all federal taxes.

While the “rich” pay over 40 percent of income taxes, they earn just 21 percent of all income, according to the Heritage Foundation. The bottom 50 percent pay just 3 percent of income taxes, while the bottom 75 percent pay just 13 percent of income taxes.

In addition, the Joint Committee on Taxation found that taxpayers with incomes of $1 million or more pay an average federal tax rate of 31.5 percent, while the bottom half of income earners ($63,179 or less) pay an average rate of just 6.3 percent.

6. The Tax would Likely be Unconstitutional

Article I, Section 9 of the U.S. Constitution bars the federal government from imposing direct taxes unless they are apportioned. To get around a decision made by the Supreme Court in Pollock v. Farmers’ Loan & Trust Co. (1895), which ruled the income tax unconstitutional under Section 9, the Sixteenth Amendment was adopted. This amendment authorized an unapportioned tax on income “derived from a source.” Commissioner v. Glenshaw Glass (1955) described the “derived” requirement as income that constitutes “an accession to wealth, clearly realized, over which the taxpayer has complete dominion.” 

In the context of mark-to-market taxation, “unrealized” gains certainly do not meet the “clearly realized” condition. This form of taxation is also, indisputably, not apportioned. Further, the Supreme Court explicitly said that unrealized gains do not qualify as “income” under the 16th Amendment. The Supreme Court ruled in Eisner v. Macomber that realization is a requirement for a tax to be considered income under the 16^th Amendment: 

“… we are brought irresistibly to the conclusion that neither under the Sixteenth Amendment nor otherwise has Congress power to tax without apportionment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder.” 

If mark-to-market taxation of capital gains is a direct tax, is not covered by the 16^th Amendment, and is not apportioned, then it is unconstitutional.

7. Americans Oppose Taxing Unrealized Gains

Americans oppose taxing unrealized gains by a ratio of 3-1, according to a survey experiment with 5,000 respondents published in May 2021. The paper, The Psychology of Taxing Capital Income: Evidence from a Survey Experiment on the Realization Rule, is authored by Professor Zachary D. Liscow of Yale University Law School and Edward G. Fox of the University of Michigan Law School. 

Specifically, 75 percent of respondents opposed taxing unrealized gains, with all demographic groups opposing the measure:

“Respondents strongly prefer to wait to tax gains on publicly-traded stocks until sale versus taxing unsold gains each year: 75% to 25%. Though this opposition is strongest among those who are wealthier or own stocks, all demographic groups oppose taxing unsold gains by large margins. This opposition persists and is often strengthened when looking across a variety of other assets and policy framings.”

Survey-takers’ massive rejection of abandoning the realization rule held up even after they heard arguments in favor of this kind of taxation, when they themselves don’t own stock, and even if they’re Democrats. Respondents did not consider the gains “real” until the stock has yielded cash in the taxpayer’s hand. Simply put, taxing unrealized gains cuts deeply against Americans’ sense of fairness and common sense.

8. The Tax has Failed and Been Repealed in Foreign Countries

Foreign countries have tried taxing wealth before, and it has failed. In 1995, 15 countries implemented a wealth tax. Since then, 11 have been repealed.  The countries that have repealed their wealth taxes are Sweden, Denmark, the Netherlands, Austria, Finland, France, Germany, Iceland, Luxembourg, Ireland, and Italy.

In addition to cost of enforcement, which Austria cited specifically, and the difficulty of valuing assets, these countries also found that the tax was ineffective at combating wealth insecurity and did not redistribute wealth in favor of low-to-middle income earners.     

9. The Tax Will Force Taxpayers to Liquidate their Assets and Could Create Market Volatility

The tax would force taxpayers to liquidate their assets because many will have their wealth tied up in a business. For publicly traded companies, taxpayers will have to sell stock which could affect the value of the company, reduce the value of retirement portfolios and harm investors.

It could also result in taxpayers losing control of parts of their business if the company is privately held or lead to a company being broken up.

There is also the problem of how this tax would treat losses. It could require the federal government to refund taxpayers if they have a loss in a given year. At the very least, it could zero out the tax liability for wealthy taxpayers in a certain year.

10. It Would Impose Taxes Retroactively

A tax on unrealized gains would punish taxpayers for past decision making by taxing paper gains from the original date that asset was acquired. It would impose significant tax liability when first implemented as taxpayers would be required to pay taxes on assets they first acquired years or decades ago. Even if this payment was spread out over several years, it would be a significant tax liability.

The tax code must be applied with consistency, certainty, and fairness. Taxpayers routinely make decisions based on a reasonable interpretation of the law with the expectation that future changes to the law will not be applied looking backwards.

Retroactively changing the tax code and requiring taxpayers to pay taxes on assets they acquired years or decades ago undermines these principles by changing the rules after the fact.

This also undermines confidence in the tax system and discourage taxpayers from taking advantage of explicit tax incentives (e.g., for charitable contributions, business investments, and energy efficiency) if they fear Congress might retroactively eliminate these incentives in the future.