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Friday, February 7, 2025

Weekly SSRN Tax Article Review And Roundup: Kern Reviews The Role Of Unrealized Gains And Borrowing In The Taxation Of The Rich By Fox & Liscow

This week, Adam Kern (San Diego; Google Scholar) reviews Edward Fox (Michigan; Google Scholar) and Zachary Liscow (Yale; Google Scholar), The Role of Unrealized Gains and Borrowing in the Taxation of the Rich.

Adam kern

Just before Mark Zuckerberg was born, William Andrews dubbed the realization rule the “Achilles heel” of the income tax. The main costs of the rule are well-known: It allows taxes on capital income to be deferred and, in some cases, avoided entirely. Journalists report that some of the richest people in the world—including Elon Musk, Jeff Bezos, Warren Buffet, and, yes, Mark Zuckerberg—have deferred or avoided tax on much of their capital gains simply by declining to realize them, instead borrowing funds to finance their consumption.

But how much income actually escapes taxation due to the realization rule? And to what extent do the rich use borrowing to unlock untaxed appreciation? 

We know surprisingly little about the answers to either of those questions. In a significant new paper, Edward Fox and Zachary Liscow estimate unrealized gains and borrowing across the distribution of wealth in America. Their findings are often surprising.

Main Findings

Fox and Liscow report four main findings. First, they compare our actual tax base (adjusted gross income, or AGI) to a hypothetical tax base of “economic income” (AGI plus newly accrued but unrealized gains). Fox and Liscow find that our actual tax base captures almost all economic income earned by the bottom 50% of American households, a figure that declines to approximately 60% for the top 1% of households (those that hold at least $14 million of wealth) and 50% for the top 0.1 percent (holding at least $62 million).

For those of us who support taxing the rich, this is good news and bad news. The good news is that the realization rule does not allow the wealthiest Americans to escape the income tax entirely. In fact, approximately half of their economic income is included in our tax base. The bad news is that the other half is missing.

Fox and Liscow’s second finding is related to their first. They compute average tax rates with economic income as the denominator, do the same for AGI, and compare the two. Measuring average tax rates against economic income rather than AGI makes the income tax considerably less progressive. For the top 0.1% of households (excluding the Forbes 400), average tax rates drop from 24% using AGI to 12% using economic income, while rates fall only from 10% to 9% for the 50-90th percentiles.

Third, Fox and Liscow estimate borrowing across the distribution of wealth, focusing on borrowing at the top end of that distribution. While aggregate borrowing by the top 1% is substantial ($1.02 trillion in 2022), Fox and Liscow find that new borrowing each year is relatively small compared to unrealized gains. The authors interpret this result to suggest that “buy, borrow, die” is not a dominant tax-avoidance strategy.  

The paper’s fourth finding helps explain why the wealthy borrow relatively little against their appreciated assets: Their consumption is generally less than their income that is taxed. The top 1% has substantial AGI from various sources, including business income, taxable salaries, realized capital gains, and interest and dividends. People within the top 1% tend to consume considerably less than their income from these sources. Thus, they can fund their lifestyles without resorting to borrowing against unrealized gains.

Implications

One of the paper’s many virtues is that it bears directly on important policy debates. As the authors note, the paper lends support to different reforms that are sometimes put in opposition with each other. Because the wealthiest Americans have a substantial amount of unrealized gains, the paper strengthens the case for fundamental reforms to the structure of the income tax (such as the Biden Administration’s proposed tax on unrealized gains of centimillionaires). At the same time, because the wealthiest Americans also have a significant amount of AGI, a lot of revenue could be raised simply by raising rates. 

The paper also sheds light on proposals targeting “buy-borrow-die.” Because the wealthiest Americans have a substantial amount of debt, a tax that deems existing debt to be a partial realization of appreciated assets could raise a substantial amount of revenue. Nonetheless, because wealthy Americans borrow relatively little as compared to their unrealized gains on an ongoing basis, a purely prospective tax might do relatively little.

Fox and Liscow have given us a much clearer picture of how unrealized gains and borrowing affect taxation at the top of the wealth distribution. Their findings challenge parts of the conventional wisdom while confirming others. The realization rule does allow a substantial amount of income to avoid taxation, especially at the very top of the wealth distribution—though it does not allow the wealthy to escape the income tax entirely. The data also suggest a more complex story about how wealthy Americans achieve this result. While some may “buy, borrow, die,” many appear to follow a different path: buying and holding appreciated assets while funding their consumption out of their substantial taxable income.

Here’s the rest of this week’s SSRN Tax Roundup:

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