The value of assets can increase more than their costs while it is held unsold due to the impacts of various market forces like market sentiments, demand, and supply. These increases are called unrealized capital gains and they have been observed in a range of asset classes like stocks, bonds, pooled investment funds, real estate, and even cash equivalents, among others.
For example, if an investor purchases a share of stock at USD 20.00 per share and its stock price increases to USD 23.00 per share the next day, the unrealized capital gain is USD 3.00. This gain is also called theoretical profit or paper gain. It will be considered a realized capital gain if the same investor decides to sell the share at a newer and higher stock price per share.
The Controversy Surrounding Unrealized Capital Gains Tax: Notable Advantages and Disadvantages
There is an ongoing debate about taxing unrealized capital gains. The issue centers on the question of whether it is fair or efficient to tax potential gains rather than realized ones. It is also worth noting that this proposed tax policy first took ground in the early 20th-century discourse on wealth and income taxation and gained further traction in the 1920s and 1930s when a progressive taxation scheme was put forward to broaden wealth taxation.
Debates over wealth and income inequality in the 1960s and 1970s resulted in the resurfacing of proposals to tax unrealized capital gains. Advocates argued that the wealthiest individuals were able to accumulate large amounts of wealth through investments. Policymakers like former United States Senator William Proxmire proposed in the 1970s that this taxing scheme would resolve the problem of tax avoidance by affluent individuals.
The debate has continuously resurfaced throughout the decades. Economist Thomas Piketty, in his book “Capital in the Twenty-First Century,” argued for a broad wealth taxing scheme that includes unrealized capital gains tax. This scheme was positioned as a vehicle to address the concentration of wealth. Nevertheless, while the idea has been gaining public traction, there is still significant resistance due to its drawbacks and negative implications.
Pros: Unrealized Capital Gains Tax Advantages
1. Increasing Tax Revenues
One of the purported advantages of unrealized capital gains tax is its supposed impact on increasing tax revenues. For example, in the United States, estimates from the Federal Reserves have noted that the 1 percent of the wealthiest Americans hold over 50 percent of all unrealized capital gains. The Penn Wharton Budget Model estimated further that a proposal to tax these gains could raise about USD 250 million to 500 billion over 10 years.
A small number of countries have implemented this controversial tax policy. Norway has been taxing unrealized capital gains in certain circumstances within the context of wealth tax and certain exit taxes. Data from 2020 showed that overall wealth tax alone contributed to about 1.1 percent or about USD 1.9 billion of its gross domestic product. The specific impact of the exit tax has not been documented since it was only introduced in 2020.
2. Addressing Tax Avoidance
Many high-net-worth individuals are spared from paying tax liabilities because a significant portion of their wealth is tied up in assets like stocks, bonds, real estate, and other investments. Some of them utilize a common tax avoidance strategy called “buy, borrow, die” in which they invest in appreciating assets, hold them throughout their lifetime, borrow against them to fund their lifestyle without selling them, and then pass them on to heirs
Even the average investor can defer taxes indefinitely by not selling his or her assets. This strategy allows them to accumulate significant wealth without paying taxes. Some have noted that this is a form of tax avoidance. Taxing unrealized capital gains would reduce the incentive to defer taxes or engage in aggressive tax planning strategies. The U.S. Congressional Budget Office reported that about USD 3 trillion in capital gains in 2021 were unrealized.
3. Resolving Wealth Inequality
Another notable argument for taxing unrealized capital gains relates to the broader issue of wealth inequality. Proponents have emphasized the fact that 1 percent of households in the United States own more than 30 percent or about USD 14 trillion of the combined wealth of the population in the form of investments. However, because the gains from these investments are not taxed until they are sold, wealth is often held and concentrated over long periods.
Proponents have specifically argued in support of wealth distribution. Countries like France and Spain have levied wealth taxes on individuals with net assets above specific thresholds. The tax collected from unrealized capital gains can contribute to more equitable wealth distribution. The government can use the proceeds to fund social programs like healthcare, education, and housing. These would benefit lower-income and middle-income households.
4. Promoting Economic Efficiency
There are also several economic benefits from unrealized capital gains tax. Untaxed paper gains are considered inefficient because investors are holding appreciating assets instead of reinvesting them in potentially more productive opportunities or reallocating their capital more efficiently to fuel value-adding economic activities. It has been argued that the taxes from these unrealized gains are better utilized in activities that can help boost economic productivity.
Some of these activities include funding infrastructure, education, research and development, and business initiatives. The U.S. Congressional Budget Office noted that every dollar invested in infrastructure generates up to USD 2.20 in economic output over time. Research by the National Bureau of Economic Research revealed that reducing capital gains tax deferral could enhance market efficiency by increasing market liquidity by 10 to 20 percent.
Cons: Unrealized Capital Gains Tax Disadvantages
1. Valuation Accuracy Challenges
One of the main disadvantages of implementing unrealized capital gains tax centers on the issue of the difficulty in accurately valuing assets that have not been sold. This issue especially affects illiquid and less liquid assets that are not traded in the public because their market prices are either not readily available or fluctuate regularly. Examples of these assets are real estate, art collections, and luxuries. Assessing their value often requires appraisals.
The process of valuing assets for tax purposes can be complex, time-consuming, and expensive. It is worth noting that the results of appraisals can differ significantly depending on the appraiser, market conditions, and the specific methods used. The costs of appraisal can also be as high as 1 to 2 percent of the value of the assets being taxed. Even assets like stocks can also be difficult to evaluate. Some stocks experience extreme market volatility.
2. Creating Liquidity Issues
Remember that there are affluent individuals whose bulk of their wealth is tied to non-cash assets. Taxing unrealized capital gains from these assets could create liquidity issues and problems in cash flow for individuals because they would need to face tax liabilities without having the cash on hand to pay them. People who are vulnerable to these problems include those whose net worth is based on assets like family-owned businesses, real estate, and collectibles.
The aforementioned issues became commonplace in France where wealth tax was in place in 2018. A number of individuals encountered financial constraints in fulfilling their tax responsibilities owing to the non-liquid nature of their assets. This resulted in situations where individuals were compelled to liquidate their assets or incur debt to fulfill their tax obligations. Take note that forced sales of assets could lead to downward pressure on asset prices.
3. Double Taxation Concerns
There are also concerns about the possibility of double taxation. This happens when an asset held by an individual is taxed for unrealized capital gains and then taxed again for the realized capital gain when this same asset is sold. Consider holding a stock portfolio as an example. This portfolio will be taxed if it appreciates while being held. Furthermore, if the holder decides to sell the entire portfolio or a portion of it at a later time, it will be taxed again.
Investors might be deterred from making long-term investments in assets that are expected to appreciate significantly over time and pursue a more conservative approach to investing due to the prospect of double taxation. This can reduce capital available for high-growth sectors. Implementing a tax on unrealized capital gains would require delicate mechanisms to avoid double taxation. This renders the tax code more complex.
4. Negative Economic Impacts
Another argument against unrealized capital gains tax revolves around the purported negative economic impacts that negate its supposed economic benefits. The policy can create depress the market for illiquid assets like real estate, art collections, luxuries, and collectibles. People will not have an incentive to purchase them. Those who hold these assets could be compelled to sell them. Forced sales would result in oversupply and asset depreciation,
Investors in the financial and capital markets may also become more risk-averse. They will have no incentive to invest because of the attached tax liabilities. This can stifle economic growth due to the potential reductions in investments in high-growth-potential and volatile assets like startups or innovation-driven industries. A particular country could also be at a competitive disadvantage due to capital flight to other countries with more favorable tax regimes.
The Arguments and Counterarguments in a Nutshell: The Pros and Cons of Unrealized Capital Gains Tax
Taxing unrealized capital gains is a controversial topic. There has been a clamor from progressives and critics of liberal economic policies to tax these gains as part of their push for a broader wealth tax policy. Their main argument centers on the need to redistribute wealth health by affluent individuals and use them for more productive purposes to address the growing wealth inequality. Critics of this tax policy have argued based on various merits. The most notable ones are the issues or challenges in valuation accuracy and implementation. The controversy ultimately hinges on the reconciliation of the objectives of fairness, revenue generation, and economic efficiency with the practical challenges and potential unintended consequences of such a tax. This discourse mirrors broader societal tensions concerning wealth, taxation, and the role of the government in redistributing resources.