Thursday, March 31, 2022

Why Is Taxing the Rich So Difficult? In Part Because People Who Should Know Better Are Being Foolish

by Neil H. Buchanan
 
The Biden White House recently proposed what it calls a "Billionaire Minimum Income Tax."  On his show last night, Seth Meyers quipped that the proposal was "part of [Biden's] 2023 budget, specifically the part they'll have to cut out before it'll pass."  He is right, which is a shame, because this is another instance in which completely sensible tax policy is going to give way to ignorance and bad faith.

It is no surprise that Republicans oppose this idea.  Not only do they oppose anything that Democrats favor, but their very reason for being is to reduce taxes on the rich.  What is annoying, however, is that people who truly should know better are saying completely fatuous things about the proposal -- statements that are so misguided that it makes me think that there is simply no way that our political culture could ever move forward with even the most promising improvements to tax policy.

The Biden proposal is based on plain-vanilla tax concepts that have been settled for decades, not just as a matter of law but as a matter of simple logic.  Nonetheless, some non-Republicans are arguing that he is trying to pull a fast one to get his way.  Nothing could be further from the truth.

There is no need to go into the guts of the proposal, because the confusion has to do with the simple fact that we currently do not tax an entire category of income known as "unrealized gains."  This term might be vaguely familiar to readers, because Senator Ron Wyden offered a proposal last Fall that was similar to what Biden has now put forward to tax unrealized income.

What is unrealized income?  The most basic definition of income says that, in addition to consumption, a person's income includes changes in his wealth.  That is, if I consume $40,000 of goods and services in a given year and my wealth (net worth) increases by $35,000 during that year, then my total income was $75,000.  What might increase my wealth?  I can receive money from salary or wages, or by coming into possession of property like land or shares of stocks.  Either way, I am richer than I was before, so I have received income.

In addition, the property that I already own could go up in value (as I hope it will), which would also make me richer and thus constitute income.  If I have money in a savings account, I will be credited with interest, and whether or not I withdraw that money and spend it, I have received income.  If I have money in stocks, they could generate income through issuance of dividends or by going up in value.  Again, if any of that happens, my net worth is higher, and that means that I have received income.  This is taught in virtually every tax law class in the US (and perhaps the world), because it is the core definition of income.

The "realization rule" was adopted as a policy choice by Congress, which said that increases in the value of property do not have to be included in gross income unless and until the property is sold or otherwise "disposed" of.  The standard idea is that increases in property values are only "paper gains," which seems somehow unreal to many people, so they should supposedly not be taxed until converted into actual cash.

There are various reasons why that might be a sensible policy choice in limited areas, but not in the all-encompassing form that Congress adopted a century ago.  In particular, people understandably blanch at the idea that they could be required to pay federal income tax when their net worth increases due to their house becoming more valuable.  They cannot access that gain easily, and if they had to pay taxes on it, they might have to sell the house itself, which seems perverse.

But consider two people, A and B.  A receives $100,000 in salary for doing her job for the year, while B becomes $100,000 richer not from working but from watching his stock portfolio rise in value.  Even if A does not need to spend her salary, we treat it as "realized" and thus immediately taxable, yet we say that B does not have to include his gain in that year's taxable income unless he decides to sell those shares.  It becomes even more untenable when we consider that it is possible for the richest people in the world to arrange their compensation packages by receiving unrealized gains but zero salary.
 
Even though a person has no realized gains, he would be quite upset (outside of the tax context) if someone said, "Geez, you're poor.  You didn't make any money last year."  He might respond: "Are you kidding?  I raked it in last year.  I'm $500 million richer today than I was a year ago."  And if that person decided to take out a loan for any reason, he would say to the lender: "Look, my property generated $500 million in income for me last year."  (And he would not even have to commit Trump-like fraud by overvaluing properties for some purposes and undervaluing them for others.)

When Senator Wyden proposed taxing rich people's unrealized income last year, there was a general freakout on the right, with some people arguing that the proposal was a tax on wealth, not income, and thus unconstitutional.  That analysis was wrong at every step, as I explained in a Verdict column and a Dorf on Law column at the time.

That was all bad enough, but the response to the Biden proposal has been even worse, with people claiming that unrealized income is not income at all.  So to be clear, we should remember that Presbyterians and Catholics are Christians, that sports cars and family cars are cars, and that tall people and short people are people.  Income can be realized or unrealized, but in both cases it is income.

Again, a person can believe that there are good policy or administrative reasons not to include some unrealized gains in a year's taxable income.  Even so, the choice not to do so does not make the unrealized gains "not income" but only "income that does not have to be included in a given year's tax computation, because we made a policy choice to do it that way."

This is an example of people taking a policy choice for granted and thinking that the policy entitles them never to be taxed on an entire category of income.  People are so used to the current regime that they act as if it is unacceptable even to consider changing the policy, even though the policy was (and still is) a giveaway to people who are lucky enough to derive some or all of their income from owning property rather than working for a living.

And the tax giveaway is made worse by the fact that we often have not required that property owners' losses be realized in order to be used to reduce their taxes.  For example, when a company buys a machine that depreciates over time, the tax law has generally allowed the company to subtract from its income the reduction in value of that machine each year.  Congress often writes those rules in ways that allow companies to deduct much more than the reduction in value of the machine (yet another giveaway) — sometimes even the entire amount in one year — but even if done right, depreciation costs are just as much "paper losses" as increases in properties' value are paper gains.  Yet no one thinks it odd that Congress has allowed those unrealized losses to be subtracted immediately.

To repeat: There is nothing new, innovative, or even slightly unusual about any of this analysis.  Unrealized income is income, and Congress could change its mind and decide to tax some or all of it in the year accrued, as a matter of simply changing the relevant statute.  On the merits, businesses would surely claim that this would be a "job killer," and Republicans would call it socialism (natch), but that is par for the course.

Also expected is Senator Joe Manchin's silly claim that one cannot be taxed "on things you don’t have.  You might have it on paper," he says, but that is not the same thing.  But of course the people who have unrealized incomes "have" the property, and it has gone up in value.  Being a paper gain does not mean that it does not benefit the person immediately by making his net worth rise.
 
Amazingly, and unexpectedly, that line of reasoning has been parroted by some who present themselves as non-ideological or even clearly on the left.  In the latter category, that quote from Manchin just above was approvingly included in an article in The New Republic, where the author (Tim Noah) calls taxing unrealized gains "a somewhat radical proposal" and then explains: "The radical part—the part that sounds dodgy to a lot of Washington policy wonks—is that 'income' would include unrealized capital gains, which, strictly speaking, aren’t income at all."
 
As an initial matter, any "Washington policy wonk" who thinks that this proposal sounds dodgy has no idea what they are talking about.  It is, as I emphasized above, not only non-dodgy but a straightforward application of the definition of income.  More to the point, however, Noah (who appears to have a penchant for smarty-pants contrarianism) cannot even keep the objection straight in his mind.  "Strictly speaking," he says, unrealized capital gains are not income.  What he appears to mean is something like this: "Well, technically, I guess it's income, but it sure doesn't feel like it to most people."  But at most, that is a (weak) political argument, not a "strictly speaking" argument.

Even worse, a journalist who has a very good track record -- Peter Coy of The New York Times -- sounded a similar note when he described Biden's proposal as an attempt to pull off a "neat trick."  Biden wants to tax wealthy people, Coy says, but Biden wants to "raise taxes on the wealthy without directly taxing wealth."  He then correctly notes that "[w]ealth is not income," but he immediately adds quite incorrectly that "courts have found that straight-ahead wealth taxes are unconstitutional."  No they have not, as the continued existence of the estate tax -- as straight-ahead as a wealth tax could be -- demonstrates.

But Coy goes completely off the rails when he writes that "Biden’s plan gets around that large obstacle by taxing billionaires on the increase in their wealth. That gain, the administration argues, can be considered income."  Yes, it can be considered income because it is income.  To his credit, Coy then spends the rest of the article discussing how the Republican-dominated courts might try to strike down Biden's proposal, and he does quote a business school professor saying that this proposal is very much like other taxes that currently exist.

Even so, the headline of that piece and the first couple of paragraphs are all about how Biden is supposedly being tricky, trying to hide his true desire to tax wealth by taxing increases in wealth instead.
 
One of the reasons that it is difficult to talk about what it means to be "rich" is that most rich people have both high wealth and high incomes, but it is possible to have wealth without income (think "Downton Abbey" and the English gentry) or income without wealth (first-year BigLaw associates with high salaries but huge student loans).

In any case, that a progressive change to the income tax will mostly affect people with high wealth does not make it a wealth tax, nor does it mean that Biden is a trickster.  It merely says that wealthy people have been given a pass for decades on their income, and Biden wants to change that by changing the income tax.

None of that matters, however, because even if Noah and Coy are unrepresentative of the non-Republican commentariat, their gross misrepresentations of reality are making it easier for others to say that "even those guys admit it."  It is difficult enough when non-Republicans can agree with each other -- that climate change is real, that vaccines work, that the 2020 election was not stolen -- but when even a few non-Republicans so badly misunderstand and misrepresent reality, all hope is lost.
 
The richest people in the world are able to pay nothing in taxes, completely legally, in large part because of the realization doctrine; but ignorance and hubris are making it impossible to attack that problem head on.

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