Lately, many political candidates are asked to comment about, and many of them have released, proposals to narrow the economic inequity gap by taxing wealth more heavily. This Essay highlights three alternative capital taxation regimes, namely annual wealth tax, mark-to-market, and retrospective capital gains through their exposure to different types of uncertainties.
An annual wealth tax and a mark-to-market income tax are similar in their operation. The annual wealth tax would require taxpayers to estimate the value of all of their assets each year and pay a tax equal to a percentage of that value (perhaps after subtracting the value of liabilities). Thus, an annual wealth tax would have minimal information requirements and will rely only on a point-in-time snapshot of net worth. Yet, under an annual wealth tax, taxpayers will not have to account for assets sold during the year if the proceeds were consumed before the next valuation date. Such a regime was featured in Senator Elizabeth Warren’s proposal to impose 2% tax on $50 million net worth and 3% on $1 billion of net worth.
A mark-to-market income tax would likewise require taxpayers to estimate the value of all their assets each year and pay tax on the change in value over a period of time, e.g. on the value of those assets minus their value a year before. A mark-to-market income tax would require year-to-year recordkeeping. Senator Ron Wyden recently proposed to apply ordinary tax rates on unrealized capital gains under a mark-to-market regime.
A retrospective capital gains tax (see Auerbach, Bradford, and Kwak’s proposals) is vastly different from the other two regimes in that it does not require annual valuation. No tax would be due until a taxpayer realizes profits by selling or exchanging an asset in an arms-length transaction. The tax due would be equal to the amount necessary to leave the taxpayer in the same position that she would be in if the asset had appreciated at an assumed rate of return over the holding period (ending with a value equal to the realized value) and the taxpayer had paid tax each year on a mark-to-market basis. In its essence, the retrospective capital gains tax is designed to leave the taxpayer as well off as she would have been under a mark-to-market regime if her portfolio had grown at the assumed rate.
In terms of fit with the current tax system, the annual wealth tax is typically envisioned as an add-on to the existing income tax system that already taxes flow income from assets (e.g., dividends and interest). By contrast, a mark-to-market income tax or a retrospective capital gains tax would be embedded within the current income tax system. Accordingly, an annual wealth tax would result in a double burden on the risk-free return from assets that generate flow income (unless taxpayers can deduct the risk-free return from the flow-income tax liabilities).
While many comparisons of these approaches thus far focused on qualifications such as liquidity, treatment of abnormal returns, and allocation of risk across the private and public sectors, Hemel focuses here to the effect of (not quantifiable) uncertainty on the implementation and operation of the three alternative regimes to draw useful insights about the advantages and disadvantages of each. To do so, the Essay focuses on three types of uncertainties: valuation uncertainty, political uncertainty, and constitutional uncertainty and how they interfere with the operation and revenue-raising potential of each tax regime. “Valuation uncertainty” refers to ambiguity concerning the fair market value of thinly traded assets. “Political uncertainty” refers to lack of foresight regarding legislative changes to tax rules and rates. “Constitutional uncertainty” refers to the likelihood federal courts will hold that the capital taxation regime is beyond Congress’s constitutional authority.
AHemel demonstrates that a retrospective capital gains minimizes valuation uncertainty and effectively eliminates constitutional uncertainty but remains highly exposed to political uncertainty. An annual wealth tax entails a low level of exposure to political uncertainty, a high level of exposure to valuation uncertainty, and high exposure to constitutional uncertainty. A mark-to-market regime falls somewhere in the middle on dimensions of political and constitutional uncertainty but shares in a wealth tax’s exposure to valuation uncertainty. It involves low (but nonzero) exposure to constitutional uncertainty, intermediate exposure to political uncertainty, and high exposure to valuation uncertainty. It seems that from all three regimes, the retrospective capital gains tax has more advantages over the other regimes. Although currently not a feasible option, retrospective capital gains tax minimizes valuation uncertainty and effectively eliminates constitutional uncertainty.
Hemel caveats that the Essay does not aim to yield a single “best” answer in light of the uncertainties at subject. The three types of uncertainty are not necessarily commensurable, and one should not conclude that a retrospective capital gains tax is preferable to its alternatives simply because it has a lowest “uncertainty average” of the three regimes. Eventually, he concludes, our choice of capital taxation regimes must encompass a tradeoff among the different uncertainties (and I add, political viability).