One of many ongoing debates about U.S. tax policy is the relative treatment of labor income versus capital income. Currently, income from capital gains—profits from the sale of an investment or property—is taxed at a lower rate than “ordinary income,” also known as wages and salary.
This preferential treatment for capital gains is often justified on efficiency grounds: Taxing capital at the same rate as labor would hurt growth. The usual case against a lower tax rate for capital gains, however, is the inequity of the situation, with a particular emphasis on the “carried interest” loophole that allows certain fund managers to pay the lower capital gains tax on their regular income. This problem has a considerable political weight to it, so much so that the proponents of different flat-tax systems pitch equal treatment of capital and labor income as a plus. (For a fuller breakdown of the benefits of and potential problems with equalizing capital gains and ordinary income tax rates, check out this Wall Street Journal piece featuring Bentley University professor Scott Sumner and Tax Policy Center Director Len Burman.)
Yet note that this whole debate is just about the capital gains tax rate. The capital gains tax is realization based, meaning that you only pay tax on the income once you “realize” the asset, which in most cases when you sell it. So if you buy a share of a company at $10, wait a while, and sell it later when it’s worth $15, you pay the capital gains tax on that $5 in gains. But imagine if you never actually sell the stock. You purchase it at $10 and just hold onto it for the rest of your life. Assuming the stock generally trends up over time, your wealth is increasing over time. In other words, you’re earning income but you don’t get taxed on it. These unrealized gains are income in the economic sense, yet you never pay a capital tax under this situation. (Those readers who consider such a situation to be fanciful should look into the situations of Mark Zuckerberg and Warren Buffett.)
If policymakers want to consider taxing this unrealized capital income, a realization-based tax system isn’t going to get at those gains. So what are other options?
The first is to move to a mark-to-market system. Under such a system, the gains on an asset would be taxed as they happen over a set time period, say a year. So instead of waiting for an investor to sell a share of a company, taxation would happen on the gains in that year regardless if the gains are realized or not. So if the price of a share went up $1 over the course of the year, the investor would be taxed on that dollar regardless of whether they sold the share or not.
But this proposal has its own problems as well. It might be difficult to sell the public on a tax that would hit their retirement fund every year, for example. At the same time, a mark-to-market tax system would require the tax system to pay investors back when an asset goes down in value if the decline is larger than the investor’s other income. Imagine the reaction if the general public had found out that wealthy investors were getting a huge check from the government in 2008 when the stock market tanked.
Another option to deal with unrealized gains would be to institute a wealth tax. Unrealized gains don’t show up as taxable income, but they do show up in calculations of net worth. So an annual wealth tax would get at the gains without needing them to be realized. The wealth tax also has problems, however, including the fact that it may be unconstitutional in the United States.
Perhaps it’s too soon to completely blow up the current capital gains tax system. But if we’re thinking about how capital and labor income are treated differently, it’s worth remembering the role of unrealized gains and contemplating how they fit into our current tax system.
Photo by Vitaly Korovin, veer.com
