Subject: Low-rate Tax on Unrealized Gains (TUG)
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Low-rate Tax on Unrealized Gains (TUG)
Proposal to the President‘s Advisory Panel on Federal Tax Reform
1440 New York Avenue NW
Washington, DC 20220
Keith Jarett, individual
Lafayette, CA 94549
Fax: (925) 256-1024
Submitted April 29, 2005
Summary and Description
This proposal raises revenue by closing one of the largest loopholes in all income taxes, while affecting only a tiny percentage of taxpayers. Furthermore, this proposal has the potential to defuse the political conflict over the estate tax. It can be used as an add-on to almost any systematic income tax reform.
Under all existing income taxes, capital gains are taxed only when an asset is sold. If a taxpayer dies holding the property, the gains can go entirely untaxed through what is called step-up basis. If the taxpayer is a corporation, the capital gains tax can be deferred virtually forever by never selling the asset.
Today, government does not tax unrealized capital gains because we do not want to force the sale of an asset to pay the taxes on that asset. Forced sales are unfair and arguably confiscatory. Yet current and future needs for federal revenue will force Americans to sacrifice in many ways that seem unfair. Therefore I propose a limited, low-rate tax on unrealized capital gains above a generous threshold level. This will raise significant revenue, helping make other important tax reforms possible.
Specifically, I propose a 10% to 15% annual tax on unrealized capital gains not previously taxed. This Tax on Unrealized Gains (TUG) would be usable as a carryforward credit against capital gains tax on sale or, at the taxpayer’s option, against estate tax. In effect, the TUG would be a prepayment against future capital gains or estate taxes. It is similar in concept to the mark-to-market reporting method that professional traders are required to use. An individual taxpayer’s first $10 million of gains ($20 million for a joint return), indexed to inflation, plus any amount of unrealized gain on one’s primary residence, would be free of TUG. Corporate taxpayers would get a $1M threshold, in order to limit the attractiveness of shifting personal assets into corporate ownership. Indexing the threshold to inflation is essential in order to avoid the same problem we currently have with the AMT.
The large threshold level would allow the IRS to focus audits on taxpayers with over $10M in assets. These audits would need to be numerous for a few years until taxpayers discover that compliance is not optional. Other practical problems and potential solutions are discussed in the next section of this proposal.
Under current law, the estate tax is due to expire, to be replaced by repeal of the step-up basis rules which allow capital gains to escape tax on death. To a great extent, capital gains taxes will then take the place of the estate tax. The public is not currently aware of this, but they will hear about it by 2010. Under the TUG proposal, capital gains taxes for large gains are effectively prepaid before death. Therefore Congress could eliminate the estate tax and still gain revenue over current law. Both parties could keep their promises to their constituents.
Potential Problems and Solutions with TUG
Not to put too fine a point on it, practical problems with the TUG proposal are numerous. Let me address some of them.
1. High net worth taxpayers would need to list all their appreciated assets on Schedule D or an equivalent form, not just the assets they sold during the year. I propose a checkbox for taxpayer whose assets excluding primary residence total less than the $10M threshold, making any computation moot. Required reporting of all assets for the relatively few who exceed this threshold is similar to the mark-to-market requirement for securities dealers enacted in 1993.
2. How would taxpayers value assets like stocks which fluctuate in value during the year? I propose averaging the year’s high price and the year’s low price, but other methods are possible.
3. How could taxpayers fairly and accurately value real estate and other illiquid property? I propose baseball-style arbitration. The taxpayer proposes one figure and the IRS proposes another. Two arbitrators chosen by the parties appoint a third arbitrator who then chooses one figure or the other, with no splitting the difference allowed. This encourages reasonable proposals from both the taxpayer and the IRS. Arbitration is expensive, but the amounts of money involved for TUG warrant the expense. The IRS should reimburse reasonable costs for determining the value of illiquid assets.
4. Should existing unrealized gains be included in the TUG? Economists will tell you that doing so, while it is certainly an unfair change in the rules, is the most pro-growth policy you could propose. This is precisely because of the unfairness: Taxing past gains does not promote growth-reducing avoidance in the future. I propose including existing gains but allowing payment of the first-year TUG to be spread over 10 years.
5. Should appreciation in retirement accounts be taxed? I propose that it should be taxed, in that the $10M exclusion seems generous enough to cover this. Congress could go either way on this one, but exempting retirement accounts without limit would create a sizeable loophole.
6. Should taxpayers be required to pay estimated taxes on unrealized gains? The practical difficulties here appear to warrant exempting TUG from the requirement to pay estimated taxes.
7. Should the threshold be based on total unrealized gains or just on total assets (excluding one primary residence either way)? This proposal uses the former, but the latter may be more practical, since it’s both easier to compute and easier to verify.
8. Would this proposal be fair to people like Bill Gates and Warren Buffett who built their fortunes by holding shares in companies that they grew so successfully? I like to think so. Paying 15% rather than 0% along the way would have slowed the growth of their wealth, but they would have been successful regardless. Their share of the tax burden relative to their increase in assets would have been much closer to what average Americans pay on their income.
9. Will this proposal drive wealthy Americans to renounce their citizenship and move to other countries? I doubt many would actually decide to move. Also, Congress has already addressed this issue in another context.
10. How should foreigners be taxed under TUG? Does TUG reduce our competitiveness? I don’t know the answers to these questions. Fairness seems to require taxing foreigners on unrealized gains on US-based assets (e.g., real estate) with the threshold, if any, to be based on worldwide assets. Like any other tax on capital, TUG will reduce economic growth. The more important question is whether TUG will reduce growth more or less than other taxes that would raise the same amount of revenue.
? TUG raises revenue.
? TUG reaches currently untaxed increase in net worth of the truly wealthy. People who pay TUG will still have below-average effective tax rates on their economic income, and the TUG rate is low enough not to cause too much distortion.
? TUG could allow repeal of the estate tax while still gaining revenue. Under TUG, capital gains taxes for large gains are prepaid, making a second tax on death (either capital gains tax or estate tax) superfluous.
? The current alternative minimum tax treatment of incentive stock options (ISO AMT provision) could be eliminated as redundant, at least for the large gains that the provision originally targeted. Those gains would face the new TUG instead.
My Ph.D. is in Electrical Engineering from Stanford University. I do not have the specific tax expertise to refine or “score” this proposal. I expect someone on your staff or at Brookings can do the heavy lifting if the concept interests you. I hold over a dozen US patents, and my engineering work demands thinking outside the box. When I had this particular idea last week, I was impelled to share it with you. I tried to get Gene Steuerle to take it and run with it in my place, but he didn’t take the hint. He’s the most scrupulously non-partisan expert on tax matters that I have ever encountered. If you like this idea, please work with Gene (if he agrees) and just act as if he proposed it, because I don’t really have the time or expertise to do it justice.
Other than Mr. Steuerle, I have not corresponded with any tax-related group or individual tax experts regarding this idea. As I told Gene, I don’t care who gets the credit as long as it’s not me. I do not know what Heritage, Cato, Brookings, or any other group thinks about the fairness or practicality of taxing unrealized gains. You probably should ask them, especially for comments on potential loopholes in this proposal and how to plug them. As every tax hound knows, new rules always create new loopholes, and bigger change creates bigger loopholes.
I have great respect for the ability of the current income tax system to function at current revenue levels without excessively damaging the economy. This is an achievement unprecedented in history. If you discard the current complex, evolved, and largely successful system, you risk disaster. Incremental change is much safer. This proposal pushes the limits of incremental change, but I’m hoping that the $10M threshold will limit any disruptive effects.