This week, President Biden introduced a new tax proposal as part of the White House fiscal year 2023 budget to raise taxes on households with net wealth over $100 million. The proposal would require wealthy households to remit taxes on unrealized capital gains from assets such as stocks, bonds, or privately held companies.
Biden’s proposal would take the tax code in the wrong direction by imposing a complicated tax on a narrow segment of high-earning households in a way that’s never been tried, adding new compliance and administrative challenges for an already overburdened IRS while weakening the U.S. economy by raising the tax burden on U.S. saving and entrepreneurship.
Under current law, households pay taxes on the appreciated value of assets when they are sold (or realized). Gains on assets held for less than one year are subject to ordinary income tax rates, while gains on assets held for longer than one year are taxed at a top rate of 23.8 percent. Additionally, inherited assets receive a “step-up” in tax basis, eliminating tax owed on capital gains.
Under the new proposal, households with net wealth over $100 million would be required to pay a minimum effective tax rate of 20 percent on an expanded measure of income that includes unrealized capital gains. Households would calculate their effective tax rate for the minimum tax, and if it fell below 20 percent, would owe additional taxes to bring their effective rate to 20 percent. In other words, households would owe taxes on capital gains each year, even if the underlying asset had not been sold, and amounts paid would be treated as prepayments of future capital gains tax liability.
For example, consider a household with net wealth of $200 million, $5 million in ordinary income, $10 million in accumulated unrealized capital gains from a privately held company, and an ordinary tax liability of $1.8 million in 2023 (see accompanying table). When including unrealized capital gains as income, the household’s effective tax rate is 12 percent, below the proposed 20 percent minimum.
To increase their effective tax rate to 20 percent, the household must remit an additional $1.2 million in tax ($3 million in taxes paid with a $15 million income inclusive of unrealized gains). The $1.2 million could be paid in equal installments over nine years (for capital gains moving forward, tax owed could be paid over five years) and would be credited against future capital gains tax liability on the asset when sold.
An Example of the Proposed Minimum Tax on Unrealized Capital Gains
| Step of the Calculation
|A. Net Wealth
||Tax phases in starting at $100 million in net wealth and applies fully to households with net wealth over $200 million (unclear if the proposal will index thresholds to inflation)
|B. Ordinary Income
|C. Ordinary Income Tax Owed
||$1.8 million (B * ordinary effective tax rate of 35.5%)
||Ordinary income tax liability without additional deductions from ordinary income or credits offsetting tax owed
|D. Unrealized Capital Gains
||Unrealized gains from increase in value of privately held company
|E. Original Minimum Tax Effective Tax Rate
||12% (C / B+D)
|| Effective tax rate inclusive of unrealized gains before the minimum tax payment
|F. Minimum Tax Owed
|| Amount of prepaid tax owed to raise effective tax rate inclusive of unrealized gains to 20%
|G. New Effective Tax Rate Under Minimum Tax
||20% (C + F / B+D)
|| Effective tax rate inclusive of unrealized gains including the minimum tax payment
Source: Author calculations.
When the household eventually sells the company, it would square up its taxes by using the prepaid taxes to offset capital gains tax liability. For example, if the household sold the private company in 2024 and owed $2 million in capital gains taxes, it would reduce its liability by its $1.2 million prepayment made in the year prior and only owe an additional $800,000. If an asset declined in value and a household had an unrealized capital loss, it would reduce a household’s tax liability. An unrealized loss would first reduce remaining payments of tax owed on previous unrealized gains being paid over five or nine years before being refunded in cash.
Overall, the proposal moves in the opposite direction of sound tax policy because it would be administratively costly, reduce U.S. saving, and its revenue potential is uncertain.
Changing the definition of taxable income to include unrealized capital gains presents significant administrative challenges, including how to value non-tradable assets and how to treat illiquid taxpayers who may have paper gains but lack cash on hand to pay their minimum tax bill.
The proposal attempts to meet such challenges with a separate formulaic rule to value non-tradable assets, payment periods of nine years and five years, and an entirely separate tax regime with a deferral charge instead of prepayments for illiquid taxpayers. All options, however, introduce new complexities, opportunities for tax planning, and the potential of disputes with the IRS—in other words, economically wasteful activities. Additionally, the tax is levied on assets net of debts, meaning it could encourage additional borrowing to avoid the tax, unless mitigating rules are added.
The proposal would increase the tax burden on U.S. savers, placing foreign savers at a relative advantage as they would not face the minimum tax. Raising taxes on domestic savers reduces the amount of domestic saving, which means that foreign savers would finance a greater share of investment opportunities in the U.S. Over the long run, it would lead to a reduction in American income as investment returns flow to foreign savers instead of American savers. It would also manifest in a shifted balance of trade, increasing the trade deficit, all else held equal.
A higher effective tax rate on capital gains could also discourage angel investing, entrepreneurship, and risk-taking, because the higher the capital gains tax rate, the greater the tax disadvantage for pursuing risky investments.
Shifting from taxing gains when they are realized and toward the risky regime Biden outlines goes in the opposite direction of international norms. In fact, most countries in the Organisation for Economic Co-operation and Development tax capital gains when they are realized and at lower rates than the U.S., and tax capital income overall at lower average tax rates.
Another challenge is the minimum tax would likely not be a stable source of revenue. Much of the estimated $361 billion in revenue it would raise in the first decade is from taxing previously accumulated capital gains, which would be payable over nine years. Once the taxes on past accumulation of capital gains are paid, the permanent increase in revenue going forward would be smaller. It also introduces instability, as most of the revenue generation in a year would depend on how taxpayers’ assets perform on paper.
The minimum tax proposal would be a highly complicated new tax regime that would create difficulty for an already overwhelmed Internal Revenue Service and complexity for taxpayers without serving as a stable source of permanent funding. The administrative and economic cost would certainly not be worth it; lawmakers have much better options, such as progressive consumption taxes, to raise revenue from top earners.