The standard promise of the progressive politician is that he/she will increase taxes on the "millionaires and billionaires" so that they will pay their "fair share." Certainly, this promise was central to the de Blasio playbook when he ran for mayor two years ago. Today a form of this promise is front and center for Bernie Sanders ("[Bernie Sanders demands] that the wealthy and large corporations pay their fair share in taxes.") and for Hillary Clinton ("Hillary supports . . . enacting the 'Buffett Rule' that ensures that no millionaire pays a lower effective tax rate than their [sic] secretary.") Typically in practice this promise translates into raising the marginal income tax rate on taxable income above a certain level, say $250,000.
Now, if you understand some basics about how the income tax system works, you immediately know that these proposals are next-to-completely irrelevant to the actual mega-billionaires. But the proposals surface so often (indeed, the raising of marginal rates on top taxable incomes has been the central feature of the tax increase programs of Bill Clinton and Barack Obama, as well as Andrew Cuomo here in New York and Jerry Brown in California, and of many others elsewhere) that eventually you realize that most people just don't understand how this works, and the politicians are cynically playing off the ignorance of the low-information voters.
I do think that the readership here is fairly well informed; but again, the ignorance on this subject seems so pervasive that a serious corrective is in order. So it's time for the Manhattan Contrarian to perform a basic public service and explain how the mega-billionaires became mega-billionaires without paying any meaningful income tax on the billions as they were accumulated. And further, to explain that the reason that the accumulation of these billions has not been taxed is that it is next to impossible as a practical matter to levy a tax on the most typical form of major wealth accumulation.
The simple answer to the conundrum is "unrealized capital gains." I'll use the abbreviation "UCG." When you get paid a salary, you owe tax every time you get a paycheck. But when you own an asset -- like stock in a company -- you only owe tax when you sell the asset for a gain. If you hold on to the asset for forty years without selling it, you owe no tax, even if the asset has gone from being worth $1 to being worth $10 billion. All you have is UCG. Indeed, even if the asset has gone from being worth $1 to $10 billion, you have incurred no taxable income, because you have not sold the asset.
Consider the top ten list of mega-billionaires from the Forbes 400 that I named in Sunday's post: Gates, Buffett, Ellison, Bezos, C. Koch, D. Koch, Zuckerberg, Bloomberg, Jim Walton, Page. With the exception of Walton (who mainly inherited his wealth), all of these people have made their big money the same way, namely in the form of UCG, by owning some or all of a company and not selling while the company increased hugely in value. For those who don't know, the companies are Microsoft (Gates), Berkshire Hathaway (Buffett), Amazon (Bezos), Koch Industries (the Kochs), Facebook (Zuckerberg), Bloomberg LLP (Bloomberg) and Google (Page). Again, the mere increase in value is not a taxable event. And thus these people have become mega-billionaires while paying little to no tax. (The "little" would apply to whatever salary they paid themselves, to any dividends the company may have paid along the way, and to any voluntary sales of shares of the company's stock that the owner may have made. Relative to the vast increases in the values of these companies over the years, the amounts of the taxable salaries and dividends are relatively trivial. As an example, Warren Buffett is famously paid a salary of $100,000 by Berkshire Hathaway. Forbes gives his net worth as $62 billion.)
So, if you are of the progressive persuasion, you are undoubtedly thinking, obviously we need to tax UCG! Well, unfortunately, there are very good reasons that UCG are not taxed. Attempting to tax UCG would be a nightmare for millions of taxpayers, and also a nightmare for the IRS to try to administer, if indeed they could administer such a tax at all. First, taxing UCG poses a huge collection problem, because most of the assets out there that increase in value are illiquid and don't provide the owners with any means of paying the tax unless and until they are sold. When you get paid a salary or sell an asset, by definition you have cash to pay the tax, and the taxman takes the occasion to swoop in and collect. But UCG more often than not are not associated with any available cash. Far and away most of the untaxed UCG out there are in the form of residential real estate. Are you really going to ask every homeowner to pay a tax every year on how much the value of his house increased? Most people just aren't going to have that money unless they sell the house. So are you going to force hundreds of thousands and even millions of people to sell their houses every year just because the value went up? Second, how do you know how much the value went up if the asset was not sold? Does everybody now need to get their house appraised every year? How about the car(s)? How about the art? The baseball card collection? Third, sometimes values go up and sometimes values go down. If your $500,000 house went to $600,000, and you paid a $20,000 tax on that, what happens the next year when the value goes back down to $500,000? Do you get the $20,000 back?
Sensible people considering these challenges have long realized that taxing UCG is just not a practical option. The realization is so pervasive that the whole subject of taxing UCG is never mentioned, at least not explicitly, when the subject of getting the "millionaires and billionaires" to pay their "fair share" is discussed. Perhaps taxing UCG may be part of what Bernie Sanders is referring to when he talks about getting rid of "loopholes," but I doubt it. Really, it's not accurate to refer to non-taxation of UCG as a "loophole"; more accurately, this is just a basic feature of how our income tax system works, and of how it has to work as a practical matter.
But then, if UCG are to continue to go untaxed, then no matter how much tax rates get increased on "taxable income," people are going to continue to be able to accumulate billions of dollars of fortunes without paying any meaningful amount in tax during the period of accumulation. The Buffett Rule? That's like the magician's trick, diverting your attention from the real issue. According to Hillary's website linked above, the Rule supposedly "ensures that no millionaire pays a lower effective tax rate than their [sic] secretary." Pay attention to that term "effective tax rate." UCG are not income! Therefore, presence or absence of UCG has no effect on "effective tax rate."
Now you must wonder, do Bernie Sanders and Hillary Clinton understand this issue? I'm quite sure that Hillary understands it, and realizes perfectly that her core supporters are not going to be meaningfully touched by her proposed tax increases. Bernie? Sorry, but I think he has no clue.