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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, April 23, 2012

Gordon: A Better Approach to Taxing Gains?

Investment News:  A Better Approach to Taxing Gains?, by Robert N. Gordon (NYU):

Paying tax on unrealized capital gains has some advocates, but it is ultimately unworkable.

Late last year, I attended a hearing of the congressional Joint Committee of Taxation on the taxation of financial products. One of the four speakers testifying that day was attorney David S. Miller, who put forth the idea that really rich people should mark their assets to market at year-end and pay tax on unrealized profits every year. A professor from Columbia University testifying at the hearing also thought that an annual tax on unrealized profits wasn't a bad idea. Tax lawyer Andrea Kramer was the lone voice of skepticism, having thought through the practical problems with such an idea.

On April 1, the blog TaxProf reported that Warren E. Buffett liked Mr. Miller's idea so much that he would start the ball rolling by paying a 15% tax on his unrealized appreciation in Berkshire Hathaway Inc. The blog reported that Mr. Buffett had sent a check for $1.2 billion to the IRS voluntarily. Thankfully, on later inspection, I found out that his largess was only an April Fools' Day hoax. But the drumbeat for mark-to-market taxation can still be heard.

In looking for literature on the subject, I found that every 20 or 30 years, Congress toys with the idea of changing the realization-based capital gains taxation model. A few of these forays ended after pretty much everyone came to the conclusion that asking people to pay tax on phantom profits just isn't fair. Others got past the fairness issue but got bogged down on the problems that taxpayers would face trying to find the money to pay the tax on the unrealized appreciation. ... If the analysis gets past these hurdles, the practical realities of administering the tax come into play. ...

Mr. Miller's answer is to apply this concept only to those publicly traded securities that have easily ascertained year-end values. ...In the case that publicly traded securities were singled out for harsh tax treatment, there would be an evolution of new financial products. These investments wouldn't fit within the definition of marked-to-market securities, yet would mimic direct holdings as best they could.

Most studies and testimony on the subject of timing capital gains taxes conclude that realization-based taxation is the right way to go. In addition, even if it were preferred philosophically, the mark-to-market method couldn't be levied on all assets and thus wouldn't work. Like democracy, a realization-based taxation system may not be perfect, but it is still the best method that exists.

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Why not simply let businesses expense dividend payments, just like they can interest payments?
Do that and make dividend income taxable just like ordinary interest. All of the sudden there's a significant incentive to disburse profits to shareholders in the form of dividends, which are nice and transparently taxable.

Posted by: Jehu | Apr 23, 2012 10:36:52 PM

I propose a different solution to taxing phantom profits: Redefine the concept of a long-term investment, as one-year and a day hardly justifies a twenty basis point reduction in the applicable tax rate.

Posted by: Steve Katkov | Apr 25, 2012 7:20:38 AM