On one side of this argument, people see billionaires and are disgusted with it. I get it, with Elon Musk in the news almost everyday, it strikes me as similar to the royal family in the UK. On the other side of this argument, there are people that say we shouldn’t tax wealth because it’s inherently unfair. They argue that this wealth only imparts material gains (what we’re actually taxing most of the time) when the wealth is sold, and so that’s when it should be taxed. They believe that taxing the wealth before this transaction is unfair because it’s basically impossible to calculate how much it’s worth.
Before dissecting this argument, let’s make sure we’re attacking their “best” arguments. First of all, wealth can be divided into two components, the principal and the gains. The quest is, are we arguing about taxing the principal or the gains? I think it would be pretty tough to make an argument that taxing the principal is fair. On the other hand, I think it’s much more reasonable to make an argument about whether we should tax gains. In chapter 8 of Wealth of Nations, even Adam Smith argues that Capital always has more power than labour. There are less capitalists, and more laborers so it’s easier for the smaller group to collude. This seems like it could be used to support the idea that the “masses” ought to pay taxes on their labor, while the rich ought to pay taxes on their capital gains, right?
The second major question is, can we actually measure the principal from the gain given that prices fluctuate by the second? Coincidentally, FTX wen’t from being worth $32B, to $1 in a day. What would have happened if we would have taxed Sam Bankman-Fried based on his meteoric valuation? Should we also give him a tax credit the next year when he lost it all? It seems unreasonable to base somebody’s wealth on the “market capitalization” or the “valuation” given on paper. Instead, I’d argue that we should base it on the cost of every unit of wealth the last time it exchanged hands. For example, if there were 1000 shares of FTX, the value should be calculated on the actual amount of money that those shares were purchased for. For simplicity, let’s say 500 of them were bought for $1M each, and 500 of them were bought for $2M each. In this case, we would calculate FTX’s value to be $3B, not $32B. Admittedly, our financial systems are not set-up to calculate with this way, but this is how it ought to be for the point of this argument.
OK, with that out of the way, we’re attacking the best argument. We are not arguing to tax the principal, and we have a decent system for actually calculating gains. Now, for methodology…
There’s a text book called “The Foundations of Financial Markets and Institutions” (latest edition here) which is used in Robert Schiller’s “Financial Markets” course at Yale (you can watch it free here). In this book, Frank Fabozzi et. al. break down financial assets into 11 essential properties. I’m going to walk through these properties and explain how they might apply to the properly measured gains on wealth.
Moneyness
Some wealth is used to buy things like food, water and shelter. This is called money. Dollars, Euros, and bank deposits which can be used to write checks are all considered money. Other assets are considered “near money” like US Treasuries, because they can be changed into money quickly and cheaply. The question is, can these gains on wealth be converted into money quickly? You bet they can, people in Silicon Valley take margin loans on their unrealized stock all the time. And, if the value of their stock goes up, so does their margin loan, but if it goes down, they can get margin called, forcing them to sell shares, and pay taxes, so it’s not without danger.
So, do the wealthy have Moneyness with their unrealized gains? Yeah, I’d call it near money.
- Unrealized Gains: 8/10
- Labor Income: 10/10
Divisibility and Denomination
This relates tot he minimum size of a financial asset. Is it dollars, cents, etc. Crypto has a LOT of divisibility, more than US dollars. Whether it’s cold, hard cash, or unrealized gains on wealth, the divisibility, really isn’t affected.
- Unrealized Gains: 10/10
- Labor Income: 10/10
Reversibility
This is the cost to invest in a financial asset, then sell it again for cash. Obviously, the wealthy cannot sell their assets, or they have to pay taxes. Wealthy people have no reversibility on their unrealized gains, they have to hang one to them to avoid taxes.
- Unrealized Gains: 0/10
- Labor Income: 10/10
Cash Flow
This refers to dividends on stocks and coupon payments on bonds, even interest on savings accounts. Net revenues from a company are another form of cash flow. Cash flow from stocks, bonds, and business are taxed under current laws, so wealthy people don’t really have any special to avoid it.
- Unrealized Gains: 5/10
- Labor Income: 5/10
Term to Maturity
This is the time it takes until the financial asset is schedule to pay it’s final payment. Bonds for example, can range from a few days all the way to years. Like cash-flow, it’s tough for me to see how this applies to unrealized gains in wealth.
- Unrealized Gains: 5/10
- Labor Income: 5/10
Convertibility
This is the ability to change one asset into another. Some stock can be converted into bonds, and vice versa. Sometimes common stock can be converted into preferred stock. As far as I know, this doesn’t play a major role in avoiding taxes on unrealized gains.
- Unrealized Gains: 5/10
- Labor Income: 5/10
Currency
Assets can be denominated in US dollars, Yen, or Euros. If a rich person has unrealized gains, they are pretty much trapped in that currency. The only way to convert them is to sell them, so again there is no special protection from taxes here.
- Unrealized Gains: 0/10
- Labor Income: 5/10
Liquidity
There isn’t really a standard, accepted definition for liquidity. Professor James Tobin proposes that a definition based on how much sellers stand to lose if they wish to sell immediately versus taking a bunch of time to find the best price. Since a wealthy person typically doesn’t have to sell their wealth to pay taxes, they have complete control over liquidity. They get to choose when to sell, which can have huge consequences on it’s value. With margin loans, even more so.
- Unrealized Gains: 10/10
- Labor Income: 5/10
Return Predictability
Return predictability has to do with how reliably it will go up in value, or consistently it will give cash flow. I can’t see any special case where predictability is hurt by a wealthy person just hanging on to it for a long time, nor does it really help them.
- Unrealized Gains: 5/10
- Labor Income: 5/10
Complexity
This has to do with derivatives assets which are made up of one or more foundational assets. Think of ETFs made up of a bunch of stocks. Extremely wealthy people usually rely less on complex assets for diversification. They can build their own bond ladders, or diversified stock portfolios. Though, they may rely on them for buying into larger private equity deals. I don’t think complexity is affected in any negative way by not selling, again this retains all of it’s advantages and disadvantages.
- Unrealized Gains: 5/10
- Labor Income: 5/10
Tax Status
Here’s the fun one. Tax status is obviously an important property. Regulations for tax of ownership or sale of financial assets varies widely between countries, but I’m talking mostly about the US here. But, even in the US, tax rates differ by year and even among states and municipalities. I would argue that the wealthy have a lot of control over when and how gains become taxed, often waiting until they die and passing these assets on to their children without a step-up in basis. This is an extremely powerful way to avoid taxes on gains almost indefinitely. Wealthy people can pass assets down for generations without a “transaction” which resets the price, and hence never pay taxes. Wealth gains win hands down against income from selling your labor, which is always taxed unless it’s under the table.
- Unrealized Gains: 10/10
- Labor Income: 1/10
Alright, let’s add them up and see:
- Unrealized Gains: 63/110
- Labor Income: 66/110
So what does this mean? Well, it means that you retain a little more control, like 2% that unrealized gains on wealth. Stated another way, wealthy people retain 98% of the control they’d have if it was regular income, but without ever selling it. That seems like a reasonable trade off. It might be a decent argument to tax these unrealized gains a little less than income tax. Well, that’s my 2c. Feel free to comment, or argue or do whatever it is you people do!