As a rule, unrealized gain is not recognized as income for tax purposes. It is only when the appreciated property is sold that the gain is subject to tax. Tax scholars agree that the only impediments to taxing unrealized income are valuation and liquidity: the market value of a particular asset may be difficult to determine and the taxpayer may not have the necessary cash. The sale of the property – and specifically the sale of the property in a cash transaction – removes these two obstacles: the tax administration does not need to engage in speculative valuation and the taxpayer presumably has the wherewithal to pay the tax. Nevertheless, the realization doctrine carries considerable cost in terms of both equity and efficiency. It is horizontally inequitable because taxpayers whose accession to wealth takes the form of unrealized gain bear a lower effective burden than similarly situated taxpayers whose income is taxed currently. It is vertically inequitable both because the wealthier segments of society own more assets and because they have a greater ability to defer the realization of the gain. It is economically inefficient because of the lock-in effect: taxpayers who would otherwise want to sell an appreciated may be unwilling to waive the advantage of deferral.
What about property such as publicly traded securities, for which valuation and liquidity do not present a problem? In such a case, there is little reason to defer tax until realization and to incur the equity and efficiency costs inherent to the realization doctrine. Any asset that is easy to value and that can be inexpensively and incrementally turned into cash should be taxed on a mark-to-market basis.
At least that is the opinion of almost all tax scholars. The argument for current taxation of publicly traded securities seems so compelling as to deserve a Q.E.D. Yet anyone who has taught a class on income taxation knows how reticent students are to accept this apparently ironclad logical proof. “How can you tax paper gains?” “What happens if the stock goes down the next year?” One can respond that the tax system has means of recognizing and taking into account losses. One can point out that a business may lose money next year, but that doesn’t prevent us from taxing the profits it earned this year. One can point out that multi-billionaires pay no tax on the appreciation of their stock and that the rest of us have to make up the shortfall. Students eventually run out of arguments, but one can see that they are not really convinced. I have often speculated that part of the problem is semantic. To realize is to make something real. The implication is that unrealized gains are not real gains.
Professors Liscow and Fox were apparently not content with such anecdotal evidence and decided to conduct an extensive survey to determine what people think about the taxation of unrealized capital gain. Not unexpectedly, given our common classroom experience, the vast majority of those surveyed expressed opposition to such a tax. There were, of course, variations in the degree of opposition. For example, Democrats tended to support a tax on unrealized gain more than Republicans. Those who actually held publicly traded stock tended to oppose the tax to a greater extent that those who did not. Nevertheless, across every demographic, a clear majority expressed opposition to such a tax. To my mind, the most surprising result was that a majority was opposed even if mark-to-market taxation would be limited to those with over $10 million in assets and when it was stipulated that not adopting such a tax regime would result in their own taxes being raised. Opposition to mark-to-market taxation runs deep.
What underlies this seemingly irrational opposition to a tax regime that is both theoretically sound and would promote the respondents’ own self-interest? The authors report that the most strongly supported explanations include mental accounting (people tend to regard stock investments as open until sold and do not fully internalize paper gains and losses), a reluctance to upset the status quo, perceived complexity, and a sense that what really should be taxed is not income but consumption.
While the article is primarily descriptive, the authors very briefly discuss some of the implications of the findings for tax policy. For example, they suggest that having brokers calculate and withhold the tax or, alternatively, imposing the burden of paying the tax on the corporation itself (that is, taxing the corporation on changes in its market value) may be more palatable than requiring individual shareholders to calculate their “paper gain” each year and write a check to the IRS.
From my perspective, the most interesting facet of the article is its shedding light on the not infrequent discrepancy between what theory considers optimal tax policy and what the public is willing to accept. Theoreticians tend to have the almost paternalistic attitude that their function is to give the public what it needs and not necessarily what it wants. Even if that is the appropriate job description of tax theoreticians (and the demarcation line between tax theory and tax policy), it nevertheless is important occasionally to consider why theory and practice are so often at odds.