Taxing capital-gains is a bad idea, and taxing unrealized capital-gains is much worse.
Capital is not income. It is an estimate of future income. So taxing capital-gains is, in fact, triple taxation - income is taxed 3 times: when a company earns a profit, when it gives dividends, and when its stock price rises and is sold. And taxes, especially capital-gains taxes, discourage effort, innovation and value-creation. Now Oregon Senator Ron Wyden wants to rub salt on the wounds by taxing unrealized capital-gains – this in addition to raising the tax rate on capital-gains to the higher rate at which ordinary income is taxed. If his proposal ever became law the destructive consequences would be extreme.
The value of a business’s capital is always based someone’s (perhaps an accountant’s) best estimate of the business’s future earnings (less all relevant expenses) over the remaining life of the business. This remains true for the value of a public company whose daily share price is a reflection of people’s expectations about the company’s future earnings. When a business or a share of stock on the stock market is sold for more than the buyer paid for it, this indicates that the buyer believes that the future earnings that the company justify the price that he paid. This is true whether the buyer intends to hold onto the purchased asset or not. If he intends to resell it after a short time he must believe that whoever buys it from him will pay him a higher price still and thus either intends to hold onto to it as the earnings materialize or will sell it again in the near future. Somewhere along the line the price paid for the asset will have to be justified by actual earnings, that is, income, or its value will fall and whoever holds it at that point will suffer a capital loss. Any capital-gains along the way will be offset by the capital loss. And although the gains are currently taxed, relief from tax for the losses is severely limited. This is yet another unjust aspect of the way capital-gains are taxed.
Income is the stream that flows from capital if capital is to maintain its value. So taxes based on income should apply only to income and not to gains in capital-value. In fact the capital value of an asset at any point of time already reflects the anticipated taxes that will be paid on the anticipated income.
Yet, Ron Wyden wants to go even further. He has a scheme to tax capital-gains even before they are realized, that is, before the asset is sold at a higher price than its purchase price. This is what is meant by unrealized capital-gains. He wants to tax the value of business assets according to their “market values” on an ongoing basis. Common sense reveals that the market value of any asset is a speculative matter. It is a guess about what price the asset could be sold for in the market. At any one time the estimated market valuation of all business assets taken together exceeds by a wide margin the actual prices at which all those assets could all be sold. This is because in a competitive market such valuations rest upon expectations that are mutually inconsistent. The dreams of some entrepreneurs conflict with those of others. The competitive process rewards the more accurate expectations and punishes the less accurate ones. Thus taxing all assets according to the gains they would hypothetically earn if they were to be sold would be taxing many values that will be proved in the event to have been based on incorrect expectations.
Senator Wyden has tried to anticipate such objections and to imagine a formidable set of rules and a bureaucracy to deal with them. Not least, the so-called “mark to market” exercise that would be necessary for his scheme, to provide an estimate of the momentary value of any asset were it to be sold, would create a nightmare for those trying to evaluate the real value of any business and having to estimate the ongoing capital-gains taxes that will accrue going forward.
Financial markets in which assets are routinely valued and revalued over time according to the estimates of real live buyers and sellers are absolutely indispensable for the creation of economic value in a dynamic, innovative growing economy. Senator Wyden’s scheme would severely compromise this spontaneous market process. Let us hope it suffers an early and permanent demise.
Peter Lewin is a clinical professor of finance and managerial economics and Director of the Colloquium for the Advancement of Free-Enterprise Education at the University of Texas at Dallas.