The tax code's Achilles' heel is surprisingly popular — and that's a problem for taxing the rich

The tax code's Achilles' heel is surprisingly popular — and that's a problem for taxing the rich
© getty: Jeff Bezos

Jeff BezosJeffrey (Jeff) Preston BezosThe billionaires' space race is just the beginning It's time for US to get serious about cleaning up space junk Press: Give those unemployed writers a job! MORE’s wealth increased by $99 billion from 2014-2018. New reporting from ProPublica shows that he paid less than 1 percent of that in income taxes. Our research shows that, although people don’t like the rich paying so little in tax, the tax provision that lets this happen is overwhelmingly popular. That’s a problem.

The key provision is the “realization rule.” Bezos hasn’t sold – and thus “realized” the phenomenal gains on – the great majority of his Amazon shares, so he’s not taxed. This story is common among the richest Americans and, when this effect is multiplied across the U.S. economy, trillions of dollars of capital income go untaxed for years or escape taxation altogether. This makes it the income tax’s “Achilles’ heel.”

We could, by contrast, tax gains on market-traded stocks and bonds each year as income, even without a sale. This would solve the Bezos problem. Indeed, the Senate Finance Committee chair has a proposal to do exactly that for rich taxpayers. As with any new proposal, there are important details to work out, including how to treat falling stock prices. Still, this tax is definitely practical. For publicly traded stock like Amazon, it is easy to calculate the taxpayer’s gain each year and, if necessary to pay the tax, she can sell some of her appreciated stock at little cost. 

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So why then do we – and every other country – still use the realization rule for these assets? Yes, the interests of the rich probably play a role. But part of the answer seems to be that the rule matches public intuitions about how to tax so-called “paper gains.” We recently surveyed a demographically representative sample of 5,000 Americans on these issues. Across a variety of assets, respondents overwhelmingly preferred to wait to tax gains until sale, rather than each year. This view shifts only modestly if the policy is limited to just the very rich.

Our main question focuses on publicly traded stock. There, people preferred to wait to tax gains until sale 75 percent to 25 percent. Surprisingly, even among those who do not own stock, nearly half prefer increasing ordinary tax rates on everyone, including themselves, to a tax on unsold stock gains that would not affect them. Likewise, even among our (quite liberal) law students, most remain opposed to taxing unsold stock gains, even after enduring a semester of us explaining the many problems of the realization rule.

Where do these attitudes come from? To figure that out, we asked people why they hold their views and also asked for their reactions to a variety of alternative policies. There appear to be several explanations for favoring the realization rule. One is the “status quo effect”: some people are inclined to stick with what we do now. But largely the attitudes seem to arise from the view that, prior to sale, gains exist only on paper and are thus simply just not income. We tried to persuade people otherwise, but most didn’t budge.

So, our tax code is in a difficult spot. The realization rule is the key reason that our richest citizens avoid paying taxes, but ending it is viewed by most of the public as just not consistent with an income tax. Crucially, these attitudes are basically just a limitation for taxing capital income (earned overwhelmingly by the rich), not wages (what most ordinary people earn), because wages are realized every year. That gives capital – and the rich – a crucial leg up.

We shouldn’t be too pessimistic, though. Attitudes can change, especially with significant public discussion. So, there is value in the Senate Finance Committee pursuing its proposal — to at least prompt a public debate.

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Still, the public’s predisposition against taxing unsold gains suggests looking at other taxes that fall on the capital income of the rich. One of the surprising results of the paper is that we find strong support for many of these other taxes. (One exception: others find strong support for a wealth tax, though we do not, perhaps because we emphasize that it would tax paper gains.)  For example, in our survey, support is high for raising taxes on corporations or capital gains, as well as taxing unsold gains on assets when people die.

Indeed, the Biden administration is pursuing all the items in this last group. These are all things that would likely help make the tax system fairer and would at least put a bit more armor over the tax code’s Achilles’ heel.

Edward Fox, an economist and a lawyer, is a professor at the University of Michigan Law School. Zachary Liscow, also an economist and a lawyer, is a professor at Yale Law School who has served on the staff of the White House Council of Economic Advisors.