BEYOND THE NUMBERS
Biden Proposal Would Eliminate Tax-Free Treatment for Much of Wealthiest Households’ Annual Income
A proposal in President Biden’s 2023 budget would ensure that households with more than $100 million in wealth pay at least 20 percent of their annual income in income tax. That includes their unrealized capital gains, which is the main source of income for many of these households and which, unlike millions of taxpayers’ wages and salaries, now goes untaxed unless the holder sells the asset — a glaring and long-standing flaw in the tax code that lets some of the country’s wealthiest go through life without paying annual income taxes.
And importantly, several aspects of the proposal would ease administrability, refuting critics’ claims that such a tax isn’t workable.
For most of the income spectrum the progressive individual income tax generally works as it should, with higher-income households paying a larger share of their incomes in tax than households with lower incomes. Someone whose annual salary is $500,000, for example, will pay income taxes at a higher effective rate than someone whose salary is $50,000. But this relationship often breaks down at the very top because capital gains, the primary source of income for many of the country’s richest people, aren’t taxed until the assets the gains are based on are sold.
A major ProPublica investigation last summer brought public attention to this major flaw in the tax code, finding that several of the world’s richest people, including Amazon founder Jeff Bezos and Tesla CEO Elon Musk, paid relatively little in federal income taxes, even managing to pay zero in federal income tax in some years.
Moreover, because of the “stepped-up basis” loophole, if these wealthy people never sell their assets that gain in value — in technical terms, they never realize capital gains from the assets’ appreciated value — the income tax that would be owed on those gains will simply be erased when their heirs inherit the assets. As discussed in greater detail below, the President’s budget separately proposes to end this major loophole for wealthy households. The budget would also end the special discounted rate that applies to capital gains.
Some might claim that unrealized capital gains shouldn’t be taxed as “income” because the asset owner hasn’t received cash in exchange for the asset, whose value can rise (or fall) until the asset is sold. But this argument ignores that the wealthy receive significant new value — or income — from their assets, even before they sell. Unrealized gains make asset owners better off in very real ways: stock purchased 20 years ago for $20 million that’s now worth $100 million has the same value as $100 million of stock purchased today (and that has no unrealized gains yet).
And, if asset owners want to access large amounts of cash, they can borrow against their holdings without ever generating taxable income. As ProPublica noted, in 2021 Musk pledged some 92 million shares, worth about $57.7 billion as of late May that year, as collateral for personal loans. And as the Wall Street Journal reported last year, “Banks say their wealthy clients are borrowing more than ever before, often using loans backed by their portfolios of stocks and bonds.” One financial advisor called the associated tax benefits “stunning.”
There’s also some precedent under current law for taxing unrealized gains each year. Stock brokers, for example, include their unrealized gains (and losses) in their taxable income each year. Though Biden’s proposal would broaden the scope of unrealized gains that are taxed, policymakers could look to aspects of these existing rules to inform the proposal’s implementation.
The proposed minimum tax would apply to a small subset of very wealthy taxpayers and would phase in based on wealth — starting for households with more than $100 million in assets and applying fully at $200 million. The proposal includes several thoughtful design mechanisms that would ease administration of the tax, including:
Timing. The Biden proposal would treat a wealthy person’s annual minimum tax liability as a “prepayment” of tax that would have been due if they had sold their investment assets that year — essentially, a down payment on future tax owed when assets are sold or after the owner’s death. Prepayment is analogous to employers withholding income and payroll taxes from their workers’ paychecks every month (a prepayment), with filers paying any balance due (or receiving a refund) at tax time. Once the minimum tax is imposed, households subject to it could make prepayments over nine years for previously accrued gains and five years for gains accrued after enactment. Spreading out the payments in this way would help these households account for having gains in one year and losses the next, a situation that critics claim make taxing unrealized gains impractical. According to Jason Furman, former chair of President Obama’s Council of Economic Advisers, spreading payments “would solve this problem for most taxpayers, because if the gains disappear, they would have paid only a fifth of the taxes upfront and wouldn’t be on the hook for future tax payments.”
The Biden budget would also end the stepped-up basis loophole for those with capital gains greater than $5 million for a single taxpayer ($10 million for couples). This proposal complements the minimum tax, which is only a partial prepayment of the full tax liability on unrealized gains. By applying the capital gains tax at death and then subtracting the prepayments already made, the proposal would ensure the full amount of tax is paid and no double taxation occurs.
- Liquidity. Some have raised concerns that taxing unrealized gains would force owners to prematurely sell their assets, such as shares in a closely held company, to pay the tax bill. This proposal would let taxpayers who primarily own non-publicly traded assets, which may be more difficult to sell or borrow against, defer their tax payments until they sell assets or until the owner’s death. (A one-time deferral charge akin to interest would be added to their tax liability.) Spreading tax payments over several years also helps address this potential issue, because taxpayers would only owe a portion of the total tax in a given year.
- Valuing assets. For some assets that aren’t publicly traded, like a work of art or an ownership interest in a closely held company, the needed annual asset valuations could impose administrative burdens on filers and the IRS. The Biden proposal addresses this by creating simple rules to estimate these assets’ current value — for example, by using the asset’s cost upon purchase plus a pre-determined adjustment that’s assumed to rise at a set rate each year.
Adding the wealthiest households’ unrealized capital gains to the tax rolls would boost revenues from the individual income tax, which raises roughly half of federal revenue even without taxing unrealized capital gains. These new revenues could be used for a range of policy priorities. Similar legislation from Senate Finance Committee Chair Ron Wyden and from Representative Jamaal Bowman, for instance, would include certain unrealized capital gains in taxable income each year and would use the revenues for needed investments — the Bowman bill to expand opportunity for children, and Wyden’s both for that purpose and for addressing climate change.
But whether it’s part of a revenue-raising economic package this year or in another, future vehicle, policymakers should enact these or similar reforms. The current system, where the incomes of the wealthiest among us regularly go untaxed each year, is untenable.