HomeBudget & Tax NewsThe Dangerous Asymmetry in Taxing Capital Gains

The Dangerous Asymmetry in Taxing Capital Gains

The proposal to tax unrealized capital gains is dead. Again. For now. Like the mythological phoenix, it’ll probably rise from the ashes again. Let’s try to end the idea for good.

At year-end 2021, Amazon had risen from a 1997 IPO valuation of $438 million to $1.7 trillion. That’s a 386,200% gain, which works out to very nearly 40% per year, compounded. If we ignore tax-exempt investors, and if Biden’s proposal to tax unrealized capital gains at 20% had already been law 25 years ago, these fortunate Amazon investors (or the people the original investors sold to along the way) would have paid $340 billion of their stupendous $1.7 trillion in gains, whether realized or unrealized. That seems reasonable to many.

Consider how the investor pays the taxes. Suppose Amazon had distributed 100% of its cumulative earnings since its IPO, reinvesting nothing. That quarter century of profits of $68 billion would cover barely 20% of the cumulative tax bill, and there would have been no reinvested profits to fund a quarter century of innovation. Your daily or weekly Amazon or Whole Foods delivery? Good luck seeing those, if this kind of burden had been imposed on the investors who made Amazon possible.

Retained profits are, by far, the easiest source of investment capital. Consider Microsoft, Google, Facebook, Amazon, Apple, Dell, and from past generations, Disney, Hewlett Packard, Harley-Davidson and Mattel. Entrepreneurs started all of them on a proverbial shoestring, in a garage or a dorm room; all reinvested their profits for years, to facilitate early growth. Imagine a world in which none of these exist. When we tax unrealized capital gains, we take money out of a business either directly or indirectly, at a time when it still needs that reinvested capital to grow. Does anyone really think the government will have spent the proceeds more wisely than an entrepreneur’s reinvested capital?

Capital gains taxation introduces a dangerous asymmetry. With a few peculiar exceptions, no one earns a negative income. Taxes on income will collect revenue, albeit while introducing incentives to work less and earn less. By contrast, many investments lose money. Ask anyone who has ever played the stock market. If we tax capital gains before an investor sells, we warp incentives in a very dangerous way.

Suppose $100 million in unrealized capital gain is taxed at 20%, while an unrealized loss does not reduce the investor’s tax bill. Heads – the investor must pay the $20 million tax, probably by selling some of the stock, but the investor is still ahead by $80 million. Tails – the investor loses $100 million. Simple arithmetic tells us that an investor would have to expect five heads for every four tails just to break even on taking a risk.

It gets worse. No success is linear, without setbacks. By year-end 1999, Amazon was worth $25 billion. Great! The owners chip in a very reasonable $5 billion of this gain toward government spending. One year later, the stock was down 80%. Amazon was worth $5 billion, on its way to a late-2001 low of $2 billion. By year-end 1999, the shareholders will have paid 100% of the entire year-end-2000 value of the company, and more than 200% of the late-2001 low valuation of the company. Does the government return the tax on the now-vanished capital gain? No entrepreneur will willingly put their money at risk of 100% or 200% taxation.

Even a tax on realized capital gains impedes innovation. Suppose we raise capital gains taxes to match income tax rates, as is perennially proposed by the left. In California or New York, the combination of federal, state and local taxes sums to around a 55% top tax rate. Heads – an investor keeps $45 million; tails – the loss is $100 million. An investor needs to expect 20 wins for every 9 losses, and needs even better odds to cushion against the risk of losses after the taxes were already paid, in order to justify taking the risk. Why not spend the money at Walmart, rather than investing it to create Amazon?

Critics will say that investors are taxed on their net gain across many investments, so that diversification smooths these risk. Try explaining that to the Bezoses of the world, the innovators who risk everything on an undiversified single-stock portfolio, pursuing their dreams. Or maybe we should just forgo dreaming of a brighter future.

Rob Arnott is founding chairman of Research Affiliates, LLC. Originally published by RealClearPolitics. Republished with permission.

Rob Arnott
Rob Arnott
Rob Arnott is founding chairman of Research Affiliates, LLC.

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