The tax code needs a fix

Recent investigative reporting by ProPublica revealed that some of the richest Americans lawfully avoided paying federal income taxes over multiple years highlights just how messed up the US tax system really is. An easy fix, however, is within reach.

As a prelude, it’s important to appreciate the distinction between income and taxable income. Taxable income is the amount upon which a tax rate is applied; and not all income qualifies as taxable. For instance, interest income on tax exempt bonds isn’t included in taxable income, and hence that category of income is exempt from taxation. Similarly, only realized capital gains are taxable; paper gains aren’t. In other words, you only incur a tax liability upon the sale of an asset. Given this feature, anyone who sits on an appreciating portfolio gets to watch wealth grow without incurring any tax liability, unless or until they sell.

This feature is essentially the basis upon which rich folks have paid little or no taxes, relative to their income. By and large, their realized investment returns are trivial relative to their unrealized investment results. Moreover, in many cases, they can engineer an outcome of zero taxable income by pairing off sales of appreciated assets with sales of depreciated assets. With a perfect offset, taxable income is zero and no taxes are due. Some may assume that assets will ultimately eventually be sold, so the current regulations merely defer the tax payments; but much wealth generation can escape taxes altogether by various gifting allowances and generous estate tax provisions.

So what can (and should) be done?

One answer is a wealth tax. Often, this proposal is dismissed due to the difficulty of measuring wealth, given that many assets are idiosyncratic. Valuing such assets is problematic and subject to chicanery, if not actual fraud. This concern, however, can largely be sidestepped by limiting the scope of assets covered. I think it reasonable to focus first on assets that are readily convertible to cash — i.e., assets for which an active secondary market exists, where institutional settlement practices are in place that result in cash transfers that occur within, say, a three-day period. Beyond that, in recognition that creators of investment vehicles, such as hedge funds, would likely be exempt from this treatment by imposing lock-up periods or waiting periods before liquidations are settled, I’d also require any investment vehicle that prepares audited financial statements to be subject to this treatment.

I realize that this approach leaves investments in most non-financial assets (e.g., real estate, commodities, art works) exempt from coverage, but so what? Nothing says that the measurement of wealth necessarily has to be all inclusive. I’m unconcerned that the differential treatment will shift investors to these exempt asset classes. To my mind, these are still largely fringe assets, and the seemingly more onerous tax treatment of other assets is compensated for by their clearly superior liquidity. I expect any expectation of a massive shift into these less liquid asset classes to be exaggerated.

Elizabeth Warren had suggested a wealth tax of 2 percent on assets in excess of $50 million, rising to 3 percent above $1billion. It’s hard to view this as being punitive. (I’d go so far as to say Warren is guilty of being too timid.) Critically, people with less than $50 million would be totally unaffected. Moreover, this tax would have literally zero impact on the lives of those required to pay it. Affected taxpayers could afford this tax without the slightest impact on their lifestyles. Meanwhile, about 40 million people are deemed to be living below the poverty line in America, while millionaires and billionaires watch their wealth appreciate, untaxed. Something’s not right with this picture.

If a wealth tax is truly off the table, the alternative should simply be redefining unrealized investment returns as taxable income. A wealth tax or a more expansive definition for taxable income — one or the other — would be an improvement over the current IRS treatment. The only thing that should be out of bounds is leaving the status quo intact.