One of the more bizarre tax policy moments this year was the Chairman of the Senate Finance Committee calling the distributional tables produced by the Joint Committee on Taxation (JCT) “junk math.”

Why bizarre?  Well, for starters, Wyden is the Chairman of the JCT.  Those estimates were being produced under his leadership, in preparation for a hearing he chaired. Far more importantly, there is nothing “junk” about them. The JCT has been producing similar tables using the same methodology for decades, as has Treasury, the Tax Policy Center, and others.

So why attack his own staff? To promote the idea that the rich need to pay more. The JCT distributional tables are a direct challenge to this idea. They depict a Tax Code that is strongly progressive, where the rich pay multiples of tax over lower income taxpayers:

Our past Winston Group surveys show that American voters are very reasonable about what they think is fair and it is clear that 34 percent exceeds what most feel even the wealthiest Americans should pay. So what’s a class warfare champion to do?  Challenge the validity of the tables. As Marty Sullivan summarized in Tax Notes the other day:

In its fact-filled, 81-page overview provided for the September 12 Senate Finance Committee hearing on the taxation of high-income taxpayers, the staff of the Joint Committee on Taxation failed to raise a point that was central to the hearing’s topic. Left completely unmentioned was the fact that most economists and many regular people consider unrealized capital gains to be income that should be subject to tax.

In other words, Wyden wants to tax unrealized gains and he wants the “non-partisan” JCT to go along with the plan. That’s a huge lift in all respects — policy-wise, politically, and constitutionally. The policy challenges are made clear by the Chairman’s own proposal to tax unrealized gains. It’s a mess.  The constitutional challenge is similarly imposing, as Justice Thomas’ dissent in the recent Moore case makes clear:

Sixteenth Amendment “incomes” include only income realized by the taxpayer. The text and history of the Amendment make clear that it requires a distinction between “income” and the “source” from which that income is “derived.” And, the only way to draw such a distinction is with a realization requirement. Our precedent says as much.  

So the policy and the constitutional challenges are real. So is the politics. To overcome that, Wyden has to demonstrate that our standard measure of tax burdens is unfair and needs to change.  Again, here’s Sullivan:

When it comes to evaluating the distribution of the tax burden, nothing is easy.… What goes into the denominator? That is, what is income? Again, we run into several puzzling and often nonintuitive issues. For example, economic income should include the implicit rental income that homeowners generate from their investment in housing. That’s difficult to estimate and impossible to explain to your average member of Congress. Here we focus on one aspect of economic income that is of little concern to most taxpayers but is enormously important to the superrich, especially with a booming stock market. [Emphasis added]

The “aspect” referenced here is unrealized capital gains. According to Wyden, these untaxed gains are going to tank our entire $5 trillion dollar tax system. That’s obviously silly, but are unrealized gains so important they should be considered income and taxed? Some thoughts:

Taxable income has never embraced “economic income”

Let’s be clear – this debate is not about defining economic income. It’s about taxing unrealized capital gains. That is what Wyden and his allies would like to do. Yet at no time in our history has “economic income” defined the tax base.  Why?  Because it would be administratively impossible. Marty identifies one major component of economic income missing from taxable income – imputed rents – and notes how difficult it would be to impose a tax on something that’s income in concept only.

But imputed rents are only one example of economic incomes that don’t get taxed. Fringe benefits like employer-provided health care and childcare accrue predominately to middle- and lower-income families, but they escape taxation. (For context, the typical employer-provided health plan for a family of four is worth about $30,000.)  Qualified retirement plan returns also aren’t taxed. These plans largely benefit the middle-class taxpayers Marty claims are not concerned about this debate – they are — and they include many unrealized capital gains.

So the US tax system has never embraced the idea of economic income to define the tax base, and that wise decision results in a more reasonable and administrable code that benefits taxpayers of all income levels.

Are the JCT estimates flawed?

Tax base aside, should the JCT include unrealized gains in its tax burden estimates?

The answer is no, for the same reason that taxing unrealized gains is not allowed under the 16th Amendment. It’s not income in the plain meaning of the word. The most obvious example is that of a farmer whose land value rises due to its potential as a housing development.

As long as the farmer continues to farm, he gets no value from those potential gains, nor does anybody else.

The farmer could borrow against the appreciated value of his land to finance his life and/or farming operations, but that’s a loan on which he owes interest. The bank pays tax on the interest and the farmer must pay the loan back.  That’s not income, it’s debt. Moreover, if the value of the land declines after the loan is made, the farmer is totally screwed. Lots of farmers and even members of Congress have run into that problem.

Instead, to realize its appreciated value, the farmer must sell his land. At that point, the farmer is no longer a farmer and the unrealized gains are no longer unrealized – they are now income in the full sense of the word. They are also subject to tax.

The only difference between this example and the “Buy, Borrow, and Die” scheme outlined by the Chairman is the lack of the Robin Leach-like rhetoric about billionaires financing their rich lifestyles. Farmers, rich guys, it is all the same, as are the hazards of borrowing against appreciated assets.

This example also demonstrates why it is easier to make the case for including imputed rent in taxable income than unrealized gains. Homeowners get an economic benefit from their homeownership in real time — they live there rent free. The farmer, on the other hand, gets no economic benefit from owning appreciated property until he sells the land, at which point he’s no longer a farmer. If you think this debate will end with the inclusion of realized gains in taxable income, think again.

What about the corporate tax?

Chairman Wyden’s rhetoric (and plan for the time being) is focused on owners of high-flying C corporations like Amazon and Tesla, not farms.

Does that change the debate? Perhaps, but only because the assets in question might have already been taxed. The value of publicly traded shares is largely dependent on how much income the corporation has earned (retained earnings) or will earn (projected earnings). Those earnings are subject to the corporate tax, yet that tax is largely ignored in the “Buy, Borrow, Die” discussion.

But the corporate tax does indeed get paid and its burden falls on somebody. The JCT and Treasury include the corporate tax in their tax burden calculations. Perhaps those payments could be included in the “Buy, Borrow, and Die” rhetoric too?

This is not a new issue. As we noted in 2011 when Warren Buffett erroneously claimed his secretary paid a higher tax rate, the company he owned (Berkshire-Hathaway) paid $6 billion in federal taxes. Those taxes were excluded from Buffett’s tax liability, while the income base he used to calculate his secretary’s tax burden was not adjusted gross income but rather taxable income. Seriously.

What about the estate tax?

Another “dog that didn’t bark” in this discussion is the estate tax. A big villain in the unrealized gains narrative is the stepped-up basis assets receive when they are passed from one generation to the next. That’s the “die” part. If those assets include unrealized gains, some say, they might avoid taxation forever. Here’s Senator Wyden:

An ultra-wealthy investor uses his riches to acquire valuable assets. He watches them appreciate, and he borrows against that value to generate cash. Then he sits on those assets, enjoys all the cash he’s pocketed, and when he dies, any tax owed on that increase in value disappears into the ledgers of history.

The “ledgers of history” reference is stepped-up basis. This policy is part of the estate tax regime and its goal is to avoid double taxing the same assets. When a wealthy person dies, their assets are subject to the estate tax. The remaining assets then are given a new basis to reflect the fact that they have already been taxed. Wyden’s “Buy, Borrow, and Die” narrative ignores this dynamic.

What’s happens when assets depreciate? 

Another thing — assets don’t just appreciate. They depreciate too. How does a tax on unrealized gains deal with falling asset prices?  Here’s Richard Rubin at the Wall Street Journal:

There will be some years in which a given billionaire will lose money as assets decline in value, and the prospect of the government sending tax-refund checks to billionaires is politically unappealing.

The plan would allow affected taxpayers carry losses forward to use as deductions against future gains. That is, someone who has a $2 billion paper loss in 2022 could shield his first $2 billion in gains during 2023 from taxes. In addition, Mr. Wyden would let people carry their losses back for up to three years to offset gains from that tax and apply for tax refunds. So someone who had $5 billion of paper gains in 2022 and paid taxes could get refunds if they then had paper losses up to $5 billion in 2023.

Sounds messy. How exactly does one account for basis in all this? And how do you treat non-traded assets like a family-owned business? Lawyers and business valuation experts will get rich, even if the business owners don’t.

Finally, Marty says, “[M]ost economists and many regular people consider unrealized capital gains to be income that should be subject to tax.

We’d like to see some data on that one. Most economists?  Probably not. But “many regular people”?  Ha! The American taxpayer isn’t stupid. They know policies targeted at “billionaires” will eventually come to bite them instead. Look at the history of the Alternative Minimum Tax, or the luxury tax from the 1990s. Enough said.

Conclusion

The Chairman of the Senate Finance Committee wants to tax unrealized gains. To do that, he needs to convince us that the current approach to taxing income is unfair, the corporate and estate taxes don’t exist, the rich don’t pay their fair share, and the estimates produced by his own staff are flawed.

None of these things is true and in normal times, the Chairman’s policies would be going nowhere. But these aren’t normal times, so it’s imperative that private business owners educate themselves on these issues and communicate to their representatives just how harmful “mark-to-market” and other “tax the rich” proposals would be.  It’s now or never.  As always, S-Corp is happy to help.