Towards a fairer tax code

One of the pillars of our current tax code is that unrealized capital gains are not taxed. That is, if you buy and don’t sell a stock that has appreciated during your holding period, your gain is defined to be “unrealized” and hence untaxed.  This treatment seems to be somewhat of a sacred cow; but to my mind, it deserves reconsideration.  Unquestionably, a change of this type would involve resolving some knotty practical problems; but I don’t believe these considerations to be nearly as troublesome as the fact that the different tax treatments for realized versus unrealized gains under current rules seems to be inherently unfair.

To illustrate my contention, consider two households. In the first, the wherewithal to either spend or save arises solely out of wages received. In the second, that same capacity arises entirely from appreciated assets that the household owns.  Assume both amounts are equal such that both households are enjoying identical economic benefits.  Failing to categorize the second household as enjoying any “income” misrepresents the true economic realities of the two households. For me, it’s unsettling to see two economically equivalent households being taxed differently.

Given that background, I make a distinction between financial assets that are “readily convertible to cash” – i.e., where formalized institutional market mechanisms exist, like exchanges or dealer networks, where these assets can be easily traded – versus more illiquid assets. I was first introduced to the concept of readily convertible to cash in my professional life as an economist focusing on the use of derivative instruments. 

For the uninitiated, derivatives are contracts that generate profit or loss based on a stipulated payoff function that relies on some external reference price like the price of a commodity, an interest rate, or a currency exchange rate. About 25 years ago, the Financial Accounting Standards Board (FASB) issued a new standard relating to the accounting treatment for derivatives. One of the qualifying features of derivatives was that these instruments were readily convertible to cash, and thus they were effectively cash substitutes.  As such, if used as a trading instrument (or more technically, if not qualifying and documented as hedging contracts), gains or losses on derivatives should be recognized as income.

Conceptually, I’ve come to appreciate the legitimacy of this starting point, and it seems equally appropriate now in the context of determining taxable household income as it did then for derivatives.

Critically, making unrealized capital gains taxable doesn’t necessarily mean that the applicable tax rate on these gains should be the same as other types of income, but as the current tax rate on these unrealized gains is zero, it seems like we have ample room to find some level of taxation that people could accommodate to. 

I appreciate that this proposed adjustment to the tax code will generate a fair amount of resistance for a variety of reasons. Some might raise the objection that having this category of taxable income would exacerbate the volatility to federal revenue collections, with boom years in the stock market fostering larger revenue collections and bear years having the reverse effect. This problem, however, is surmountable. Volatility could be smoothed if the taxable amount used in tax liability calculation were determined not based on a single accounting period, but rather using a rolling average of multiple periods. 

Others may argue that it’s not fair to tax gains on just one type of asset.  I make this proposal, however, recognizing two problems with taxing less liquid asset categories than those that are readily convertible to cash. First, some minimum level of liquidity is critical to come up with accurate and consistent valuations; and second, I doubt that there would be much tolerance for a tax liability that could potentially force people to sell a real asset (think of a home), as opposed to liquidating financial assets.  We hold financial assets to meet any and all financial obligations that come our way. We have very different motivations for, say, buying houses or other forms of property. 

And still others would be discomfited by the fact that periods where unrealized losses dominated relative to gains.  This concern doesn’t resonate with me, however. Those unrealized losses genuinely decrease the economic well-being of the household; and to the extent that that translates to a lower tax obligation for such a household, so be it.

I’d like to see this change to the IRS code knowing full well that it would probably be a hard sell. I think it could be made more palatable, however, in several ways. For instance, initiating it with the application of a preferential tax rate would likely dilute resistance to the change. Secondly, doing away with any distinction between short-term and long-term holding periods would make the change easier to swallow by those who might otherwise be against it. 

While the lower tax rate on realized long-term gains makes holding periods longer than a year preferable to shorter holding periods, it has the negative consequence of forcing investors to hold their investments longer than they might be appropriate on economic grounds, exposing them to the risk of seeing their gains erode in the expectation of paying a lower tax rate.  That feature plays havoc with economic efficiency. Taxing long- and short-term gains equally (and preferentially) would correct this problem.

Finally, it’s beyond my pay grade to estimate the benefit of taxing unrealized capital gains in terms of quantifying how much additional revenues the US Treasury would stand to receive, but it doesn’t seem unreasonable to me that the added collections could be sufficient to allow for some downward adjustment to the tax rates applied to the existing taxable income categories – yet another way to make this proposed change more palatable to the taxpaying public.

Taxing unrealized capital gains wouldn’t be so difficult, and it would move us in the direction of a fairer tax system. Under the new regime that I’m suggesting, I’m recommending that a preferential tax rate be applied to all capital gains – realized and unrealized. We’d still see economically equivalent households being taxed differently, but the magnitude of those differences would be reduced relative to where they stand today, and that would be a good thing.