Authored by Peter C. Earle via TheDailyEconomy.com,
Fiscal Year 2025 Budget of the United States includes a proposal to tax unrealized capital gains: a new, dark turn in the annals of the history of US government revenue collection. Only one of several tax increases sought, it is a terrifyingly consequential one. It could potentially send massive distortions rippling through the US economy, destroy businesses, fundamentally alter how firms operate, drive capital offshore, discourage investment, and immeasurably reshape the American business landscape. At its core, requiring taxes to be paid on unsold financial assets, ownership stakes, fixed investments, intellectual property, collectibles, and other forms of wealth would act as an economic earthquake, disrupting the capital markets that undergird innovation. Such a tax would severely undermine long-term economic growth by choking off its funding, dealing lasting and perhaps fatal damage to both long-standing and nascent enterprises.
Pointing out the far-reaching effects of such a paradigm shift in revenue generation measures is challenging at best, but a modest effort follows. (For a primer on how the new tax might work, a summary can be found here.)
A Tidal Shift in Size and Scope
The number of privately owned businesses in the United States vastly outnumber those that are publicly traded. Of the latter, trading on exchanges and in other market centers, the estimated number is 4,000. Those firms can be valued relatively easily using their market capitalization and a handful of other financial ratios. Determining the value of the 25 million other companies, the vast majority of which are closely-held, is a considerably more complex and nuanced process. For this reason, the imposition of taxes on unrealized capital gains would require a massive increase in the size and scope of the US government’s taxing power. Its intrusiveness would surpass even the imposition of income and employment taxes.
The Internal Revenue Service (IRS) would first need to impose an annual (or periodic) valuation requirement on a wide range of assets. For some assets, like securities and derivatives, that calculation would be burdensome but at least possible. On others, in particular where valuations are subjective or liquidity is low, there would be considerable debate over the value upon which the tax assessment should be based. This would be the case with assets ranging from real estate to collectables to intellectual property. The IRS would need to be granted sweeping appraisal powers or the authority to hire/appoint nominally-independent consultants to handle the assessments associated with the massive broadening of assets subject to the new tax.
In light of the vast capital stock in the corporate and high-net-worth world, reporting obligations would increase several-fold. Ironically, the Constitutional guarantee of property rights has facilitated the massive accumulation of assets to which the Beltway bandits now seek to help themselves. Targeted taxpayers and their firms would be required to report the details of all of their assets annually, including their estimated market values, at their own expense. The compliance costs and reporting obligations would expand tremendously as compared with the current tax liability on sales transactions alone. Drawn into this process would be third-party entities such as financial institutions, insurance appraisers, art galleries, franchisers, marketing firms, auction houses, copyright and trademark registries, pawn shops, and countless other intermediaries involved in asset purchases, sales, and transfers. Even your local comic book store or baseball card shop will be enlisted to provide valuations and make detailed, periodic reports on customer activity to tax authorities. Most of us, at this point, will have been conscripted by the IRS.
The audit and enforcement arm of the IRS would need a sizable beefing up as well. Tax collectors would gain authority to audit and investigate taxpayers’ holdings, financial records, property titles, and transaction details, especially for illiquid or hard-to-value assets. Expanded powers would follow to enforce the tax on offshore or foreign-held assets, likely with the kind of international cooperation agreements like those currently advancing global minimum corporate or wealth taxes. New penalties for non-compliance will cover such violations as under-reporting asset values, failing to disclose assets, or underpaying taxes on unrealized gains, with penalties to include monetary fines, asset seizures, and criminal charges.
A new and highly complex realm of taxation would also need new mechanisms for dispute resolution for taxpayers to challenge valuations they find inaccurate or unfair. Legal challenges, in turn, would necessitate greatly increased capacities for both judicial and administrative review processes. And because squeezing tax revenue out of illiquid assets inevitably causes liquidity shortfalls, a new array of deferral options or installment payment plans would have to be drawn up and administered. Over time, forced sales – whether legally ordered or made to avoid running afoul of the tax man – are likely to depress asset values of all types.
Government agencies far outside of the IRS would have to build information-sharing and coordination networks for tax authorities aiming to track ownership and asset valuations. Increasingly close collaboration between the Treasury Department and financial regulators, motor vehicle departments, patent offices and beyond would be needed to cross-reference and share information. Monitoring overseas assets and high-net-worth individuals would expand tax treaties and new data-sharing with foreign governments.
All of that will generate a flood of data from annually tracking and valuing assets, so advanced technology and data-collection infrastructure would follow in short order. Real-time systems would monitor the disposition of financial assets, real estate, intellectual property, and other possessions. For liquid assets like stocks and bonds, automated systems will likely be developed to assess and tax unrealized gains as they occur.
A growing government confiscatory apparatus has historically not been kind to US citizens, typically extending its reach far beyond revenue assessment. The individual mandate of the Affordable Care Act was upheld as a tax, and the support for entitlements like Social Security and Medicare came to be levied through openings first established by payroll taxes. Environmental regulations have expanded through fuel taxes, shifting behaviors in energy consumption and investment, while state and local school taxes have entrenched teachers unions. Gasoline taxes and tolls have altered commuting patterns and the establishment of population centers. The expansion of the taxing power not only takes incrementally more money over time, but impacts life and distorts our behavior in ways vastly beyond financial dimensions, often invisible even to us.
A Coerced Reinvention of the Economic Landscape
Because a large portion of the targeted unrealized gains will come from corporate ownership stakes, there is likely to be a knock-on effect in both the formation choices and attractiveness of investments going forward. Many of the over 20 million privately-owned, closely-held businesses in the US are deeply intertwined with the lives of families or small groups of owners whose personal financial well-being is dependent on those enterprises. And despite what may be high valuations, in most cases those owners have limited liquid assets with paper wealth tied up in highly illiquid holdings.
Going forward, investment interest in firms characterized by having substantial fixed capital holdings and/or long-term appreciating assets, such as in real estate, utilities, transportation, and telecommunications would likely diminish. Companies in volatile industries, such as those with commodity market exposure (energy, materials, and so on), are also likely to decline in attractiveness owing to the risk posed by unforeseen fluctuations endangering the ability to meet tax obligations. Service and other low-asset businesses are likely to generate more entrepreneurial and investment interest as their value is tied to ongoing revenue or income generation rather than long-term asset appreciation. Firms with constant asset turnover, such as retail or wholesale businesses, are also likely to become popular as their operation depends more upon high inventory turnover rather than holding appreciating assets.
This outcome carries a particular irony because most of the advocates pushing for these tax schemes are simultaneously calling for a revival of America’s industrial heyday. By discouraging investment in capital intensive, asset-heavy firms like manufacturing, the proposed tax further undermines already unrealistic objectives.
Equity markets would face significant challenges from the new tax, foremost among which would be downward pressure on equity prices in the months/quarters before tax dates, as investors sell assets and raise cash to pay taxes. Market volatility would rise as investors frequently adjust their portfolios. A shift toward stable, income-producing stocks would reduce investment in high-growth sectors and rapidly-growing firms.
In terms of government debt and deficits, the tax is being marketed as a means to reduce gigantic accumulations of US government debt and deficits by providing a new revenue stream, a threadbare justification which provides meager solace at best. To do so, the new assessment would have to be tied to extensive, far-reaching, and unwavering fiscal restraint. Not only are those conditions not cited as a sidecar to the new tax, they’re vastly unlikely in any case in the modern era. And even if those austerity measures could be put in place, the new tax on unrealized capital gains is likely to set off widespread tax avoidance and capital flight which would likely diminish any potential budget benefits. Not only that, but higher borrowing costs due to reduced market liquidity could offset some of the hoped for increased revenue.
Why now?
Why are proposals for an unrealized capital gains tax being floated now, despite seeming far outside the Overton Window? There are several likely accelerants.
Mounting clamor over wealth and income inequality have intensified since the pandemic. Americans facing an inflated cost of living and the highest interest rates in 17 years have years have tilled a ready soil for class warfare. Most Americans are unfamiliar with profligate central bankers or the lingering effects of lockdowns and other pandemic-era policies. Growing financial hardships have stoked desires to hold some group or another accountable for their struggles, and so activists increasing pressure on public officials to ‘soak the rich’ are once again weaponizing envy and economic ignorance.
Also, despite their silence and crushing blitheness, the US Congress, the Executive Branch, the US Treasury, the Federal Reserve, and beyond are well aware of widening deficits and unsustainably mounting debt levels. So it may be that the ground is already being laid to normalize new avenues for taxation in advance of a debt crisis or a dedollarization-based breakdown.
The proposal to tax unrealized capital gains also serves as a trial balloon; a ‘recon-by-fire’ in the war of ideas. Hurling the concept into public debate without any immediate intention of pushing it softens public opinion, affords an opportunity to gauge responses, and makes moderate tax proposals in this direction seem more acceptable by comparison.
Looking Ahead
Other questions abound. How would capital losses be handled — if at all? Won’t the imposition of this new tax framework suddenly result in an astonishing, statistically implausible burst of individuals and corporate entities worth $99.9 million or less? And won’t short-term speculation increase precipitously, after the government imposes a de facto maximum holding period? Will encouraging higher time-preference investment behaviors encourage scammers? Is discouraging seed-stage investment, risk taking, and commercial innovation worthwhile to collect a volatile, limited portion of government revenue?
The proposed carveout for those worth less than $100 million offers no reassurance. Most significant taxes and regulations that now affect Americans’ income and savings were sold as targeted measures aimed at a small, wealthy segment of the population. In 1913, the income tax was aimed squarely at the wealthy, with a top rate of 7 percent on incomes over half a million dollars ($10 million today). Today’s federal income tax includes seven brackets, with marginal rates as high as 37 percent. Sold to the people as a single-digit tax on the very top earners, the income tax now claims 24 percent from a family earning more than $100,000 annually. Social Security and Medicare taxes take an additional 15.1 percent from most paychecks on top of that. The Alternative Minimum Tax, designed to catch a handful of well-positioned high earners, has gradually slithered down the income scale and now threatens nearly every two-income, middle-class family. (It was ultimately arrested by the 2017 tax reforms, but may be poised for a comeback.) What today applies to the Forbes Billionaires List may apply to all net taxpayers in a decade or less.
Entrepreneurs will shift from high-growth, long-term ventures toward safer, more liquid investments, reducing innovation in any areas which require large scale, long-term fixed assets (like, say, alternative fuel cells or cancer research).
A tax on unrealized capital gains constitutes an end-run on rights of private property and subverts fundamental market principles by taxing assets not yet sold or converted into income. It radically distorts incentives and creates profound uncertainty in financial planning. This tax would discourage long-term investment, spur reactive liquidation of assets, and penalize growth, disrupting the natural risk-reward balance essential to efficient capital allocation. Entrepreneurs will shift from high-growth, long-term ventures toward safer, more liquid investments, reducing innovation in any areas which require large scale and/or long-term fixed assets (like, say, alternative fuel cells or cancer research). Ultimately, it stifles technological advancement and restricts the entrepreneurial environment, limiting breakthroughs in technology and R&D-heavy industries.
The distortions created by a tax on unrealized capital gains would cost the national economy far more than could be culled from valuations, and nowhere near enough to touch the cavernous national debt. Takings would inevitably extend beyond the wealth levels currently specified — the middle class is where the money is. Like all heedlessly extortionate government policies, this one would almost certainly grow over time, incrementally clawing away ever more from productive investment and the pockets of citizens it ostensibly serves.
