More on taxing unrealized capital gains (from my email)

 [[{“value”:”No double indent, from the excellent Matthew Lilley: “Hi Tyler, I thoroughly agree with both of you on taxing unrealised capital gains. I am intrigued though by Furman’s rejoinder of “why are you guys opposed to broader and flatter taxes?” Except for loopholes like step-up basis (just fix those directly), how is taxing unrealised capital
The post More on taxing unrealized capital gains (from my email) appeared first on Marginal REVOLUTION.”}]] 

No double indent, from the excellent Matthew Lilley:

“Hi Tyler,

I thoroughly agree with both of you on taxing unrealised capital gains.

I am intrigued though by Furman’s rejoinder of “why are you guys opposed to broader and flatter taxes?” Except for loopholes like step-up basis (just fix those directly), how is taxing unrealised capital gains “broader”? It’s not like two different classes of consumption goods or income, with some being exempted, like taxing apples but leaving bananas tax-free. Every dollar of unrealised capital gains eventually either disappears or becomes a dollar of realised capital gains (and every dollar of realised presumably starts unrealised). Either it’s essentially no broader at all, or the increased breadth comes from transitory gains. And why should the latter ever be taxed? (Aside from being deeply unfair, in equilibrium, this penalises high-variance investments. Why should we desire to do that?) Additionally, it means taxing unrealised capital gains is mostly a way for governments to get their hands on tax revenue now rather than later (and thankfully governments are reliably good stewards with money windfalls), and perhaps create the vibe of sticking it to billionaires.

Furman’s response is as if you can just say “broader and flatter” as a self-evident argument, without it being clear remotely what this substantively means. Why not pay taxes on unrealised labor income – sounds broader to me? (If not, why not?) And when should you pay? At birth? When they give you your SAT results? When you receive the Harvard admission or tenured employment letter?

Of course this is sarcastic, but there is a grain of truth here. In an early stage startup, a huge proportion of the implicit value is uncompensated future labor value. (In fact, one argument given for taxing capital gains more like labour income is that a lot of capital gains is indeed just delayed founder labour income etc). The raw idea has value, sure, but most of the startup value disappears if everyone in the organisation quits for some reason and you try to just “sell the idea off”, and that person-specific labor value is sufficient to ensure people don’t randomly quit – which is why the value of future labor is priced in.

So why should we tax some forms of future labor income but not others? The argument ends at broader and flatter, right?

As for Dylan Matthews’ claims about not taxing unrealised gains being an interest-free loan from the government, this appears to be confused and relies on contradictory assumptions about rates of return. Here’s Matthews:

It effectively offers capital income an interest-free loan: if I get $1 billion in unrealized gains at a 2010 IPO and owe $250 million in taxes, I can wait a decade and still only pay $250 million, with no interest, if I just don’t sell in the interim.

This is only true if the asset doesn’t grow or earn interest in the interim. Suppose the asset grows at the rate R for n years. Then the government will get 250m * (1+R)^n tax revenue when the asset is sold n years later. The government hasn’t been cheated out of money – in expectation these should have the same net present value. (In expectation, such assets grow faster than the risk free rate, so the government comes out ahead in dollar terms by waiting because the tax revenue captures this risk premia too, but if it’s truly compensation for risk the taxman should be indifferent).

By comparison, Matthews assumes the asset owner has an expected return of zero over the intervening decade, but also that this distorts them not to sell. Why would they delay selling if it doesn’t make them any more money? Perhaps he means that the market interest rate is zero too, but then how is the government being cheated out of revenue?

Cheers,
Matt”

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 Economics