Taxing Unrealized Capital Gains Is a Nutty Idea

By DAVID L. BAHNSEN

April 5, 2019 

On a proposal from Democratic senator Ron Wyden.

If an idea is being put forward these days by a Democratic candidate for president or a freshman member of Congress, it is probably a good idea not to take it too seriously. This is not to say that there are not legitimately dangerous things being proposed by the Kamala Harrises and AOC’s of this era — tuition-free college, Medicare-for-all, fossil-fuel elimination, 70 percent tax rates, racial reparations, court-packing, ending the Electoral College, legalized infanticide — but I am not so sure that an elimination of private health insurance (Harris) or the funnier implications of the Green New Deal (AOC) are intended as legitimate policy prescriptions rather than rank base-pandering. Trying to run to the left of Bernie Sanders to get attention makes people say and do some crazy things.

But Senator Ron Wyden of Oregon is the top-ranking member of the Senate’s tax committee, not a candidate for president, and not a 29-year-old bartender-turned-Instagram-star. And his recent policy proposal to tax unrealized capital gains is just as extreme, silly, impractical, dangerous, and inane as any of the aforementioned policy whiffs floating around in the leftist hemisphere.

The current capital-gains tax works this way: When one purchases a capital asset such as a stock or a piece of investment real estate, the purchase price becomes the “cost basis,” and when it is sold, the difference between the cost basis and the sale price becomes a “capital gain.” If the asset was held over one year, its gain is taxed at a 15 to 20 percent rate (depending on the taxpayer’s overall income). Additionally, a 3.8 percent surtax exists (the Obamacare tax) for all making over $250,000. So for simplicity’s sake, we have a capital-gains tax in our country of somewhere between 15 percent and 23.8 percent whenever an asset is sold at a profit after one year. (The rate is higher if the asset is sold within one year – basically, it’s taxed at ordinary income-tax rates.)

Senator Wyden has proposed taxing the asset each year regardless of whether or not it has been sold, based on a subjective assessment of how much value it has gained. The problems here are almost as severe as the problems with getting a wind-powered ride across the Pacific Ocean in the Green New Deal.

First and foremost, the compliance costs would be the biggest boondoggle our nation’s financial system has ever seen. How in the world is illiquid real estate that has not sold supposed to be “valued” each and every year, let alone illiquid businesses, private debt, venture capital, and the wide array of capital assets that make up our nation’s economy but do not fit in the cozy box of “mutual funds”? What kind of drain to the economy would such an annual exercise in “mark-to-fantasy” represent, as professionals driven by an objective of tax efficiency are tasked with valuing an asset out of thin air?

But let’s ignore that deal-breaker of a problem for a moment. Let’s just assume we are talking about Microsoft stock, which has an easily definable market value and infinite trading liquidity: What should we do each year when the stock price has gone down? In current law, we tax realized capital gains at the point of sale, but we also allow a deduction on realized losses. Realized losses can be infinitely deducted against other realized gains, and if losses exceed gains one can take a $3,000 income tax deduction in perpetuity, and “carry forward” that loss against future gains. The cluster-you-know-what that would be created in allowing people to take losses year-by-year on investments that have not been sold probably has the most sophisticated and tax-savvy investors salivating at the opportunity to game this mess of an idea to their own favor.

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Another problem exists for this delusional plan: How do smaller investors pay the tax on an investment that has not yet returned the cash to them? Wyden is selling the tax as a blow to “millionaires and billionaires,” though he hasn’t yet released the detailed white paper on how exactly it will work. But I am sure the party of the “little guy” is aware that many working Americans saving and investing for their retirement do not sandbag additional surpluses of cash on top of their stock portfolios for additional taxes. When a stock or real-estate gain is realized, the cash is there to pay the tax because the investment was sold. Where does the senator propose an electrician get the cash to pay the annual tax in his modest stock and real-estate appreciation year by year? And since the obvious answer is “from his other income,” does the “party of the little guy” want to let millions of Americans know that they will have less monthly cash flow to pay their bills and dine out with their kids?

There is a reason why we tax realized gains in our society — and not theoretical gains. Because one is actually a gain, and the other is theoretical. We do not tax theoretical income — money your employer might pay you; we tax money you receive. And a capital gain is not a capital gain until it is sold at such, and that is true because of the meaning of the word “gain.” Yes, one could have a real and definable increase in the value of an investment, but values go up and down, and correlating our tax receipts to the volatility of asset prices is inherently destabilizing, logistically farcical, and ethically unforgivable.

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Underlying all of the mess of this silly proposal from Senator Wyden is the Democrats’ continued lack of understanding about what is most needed in our economy — business investment. The war on capital is a war on jobs, on productivity, on growth, and on wages. Taking bold actions to disincentivize productivity, investment, risk-taking, and capital formation is akin to discouraging diet and exercise for someone trying to lose weight. That this particular disincentive is a code red in its extremism just adds to the problem.

Senator Wyden may or may not be serious in making this proposal, but it is not a serious proposal. It represents an economic disaster from start to finish and should be rejected by serious-minded Americans of all political persuasions. That sentence is becoming useful as a response to more and more things these days.