Taxing unrealised gains is almost always a bad idea

In theory, taxing unrealised gains—that is, paper wealth that has not yet been “realised” (sold)—is a relatively efficient way to reduce wealth inequality and ensure a progressive tax system. This is basically the argument the likes of Piketty, Saez, and Zucman have popularised over the years.

In practice, taxing unrealised gains via a wealth tax is almost always a bad idea. The only way such wealth taxes have a chance of working is if they’re designed perfectly. If not—and remember that it will ultimately be designed by politicians, not angels—then it will fail, because rich people will change their behaviour to avoid it (e.g. capital flight, emigration, adjustments to asset and income composition).

Such behavioural changes can even reduce total tax revenue compared to before the tax, and make the tax system less progressive overall. At least that’s what happened in Spain, France, the Netherlands, and is happening in the UK and Norway.

According to a new report by the UBS Center Policy’s Florian Scheuer there are other issues, too. Namely, the interaction between interest rates and stock prices:

“Take a stock that pays a constant dividend of $100 per year forever, and suppose the interest rate is 10%. Then the stock price, which reflects the present-discounted value of the flow of dividends, must equal $1,000. Now suppose the interest rate falls to 5%. As a result, the stock is now worth $2,000: The stock price doubles, a massive capital gain. But notice that the dividends paid by the stock have not changed at all: They are still $100 per year. Therefore, the income and lifetime consumption possibilities for someone who does not sell have not gone up. The capital gains of $1,000 are a pure “paper gain.” Of course, an investor who sells the stock can cash in on the gains, resulting in an increase in consumption. Conversely, an investor buying the stock loses: She needs to pay twice the amount for the same flow of future dividends. In sum, sellers gain, buyers lose and those who hold the stock are unaffected. This is why a tax on realized gains is aligned with who gains and loses from asset price fluctuations. By contrast, a tax on unrealized gains (or a wealth tax) would fully tax the “paper gains” of those who neither buy nor sell even though they do not benefit from their capital gains.”

In short, taxing paper “gains” (wealth) can be highly inequitable because it punishes people who haven’t actually gained anything. Here’s Scheuer again:

“Taxes that are optimal in environments with constant asset prices cease to be optimal, or change in counterintuitive ways, when asset prices fluctuate. While a wealth tax may be optimal with constant asset prices, its progressivity needs to change whenever asset prices move and optimal taxation may even prescribe tax cuts for the wealthiest when asset prices rise. Intuitively, if the rich are net purchasers of the assets they hold, they should be subsidized rather than taxed when asset prices increase. This illustrates why the fluctuating market value of investors’ wealth is a problematic target for tax policy.”

This is obviously relevant for Treasurer Chalmers’ planned superannuation wealth tax. In the world in which we live, asset prices do fluctuate due to factors completely unrelated to their income streams, so wealth taxes may hit hard—with all sorts of ugly unintended consequences.

Now if you did want to tax wealth, Scheuer offers up a more efficient and equitable solution: close the “buy, borrow, die” loophole with estate taxes. Basically, when you die and your assets pass to someone else, any gains or losses should be “realised” for tax purposes, triggering the capital gains tax.

This doesn’t happen in Australia, which means wealthy families could, at least in theory, buy and hold assets without ever realising a capital gain. I’m not sure how big of a problem it is but in terms of improving the tax system, you could do much worse than closing loopholes.

Comments

Comments have been disabled and we're not sure if we'll ever turn them back on. If you have something you would like to contribute, please send Justin an email or hit up social media!