The Real Danger Isn't a Wealth Tax, It's Mark-to-Market Taxation

In the Democratic primary, wealth taxes have been all the rage. As Warren and Sanders duel over ownership of the idea, many (myself included) have devoted significant amounts of ink to explaining the problems with the proposals. But ultimately, wealth taxes are still currently a fringe idea unlikely to become law. A dangerous proposal that is far more likely to become enshrined in the tax code is mark-to-market taxation.

Currently, capital gains are taxed only when an asset is sold. Investors do not pay tax on the increase in an asset’s value until they sell it. This is partly an administrative convenience, because some assets are difficult to value until they are actually sold, at which point the valuation is clear. Mark-to-market taxation, by contrast, would require investors to pay tax every year they hold the asset. Changing the system in this way to tax unrealized capital gains on an annual basis would require a significant investment in Internal Revenue Service enforcement mechanisms to ensure accurate valuation and tax compliance.

Back in September, Senator Ron Wyden (D-OR) released a proposal to implement a mark-to-market regime to relatively little fanfare outside of the policy community. Yet the idea has support beyond just the Senator — leading Democratic presidential candidates Elizabeth Warren and Pete Buttigieghave also said in the past that they would support a mark-to-market regime.

Wyden’s proposal attempts to tackle some of the nuances of mark-to-market taxation, but succeeds only in highlighting why Uncle Sam has shied away from it in the past. Wyden would subject investors over certain thresholds ($1 million in income or $10 million in “qualifying assets”) to mark-to-market taxation, while potentially taxing long-term capital gains at ordinary income rates for all investors.

To handle liquidity issues for cash-poor investors, Wyden would allow for a “lookback period” for certain “non-tradeable assets.” In other words, the tax would be assessed on an asset on an annual basis, but the investor would not actually be responsible for paying the tax until the asset was sold.

This is a recognition of the burden that taxing non-liquid assets places on investors. Capital gains may increase an investor’s net worth, but they don’t always have an impact on the investor’s cash on hand. If an investor is asset-rich but cash-poor, taxing unrealized capital gains can force them to sell assets that they had wanted to hold onto just to pay their tax bill.

But a “lookback” solution, while better than no lookback period at all, is problematic. Wyden discusses imposing a surtax or interest charge on investors that utilize the lookback period, thereby punishing entrepreneurs whose wealth is tied up in forming a business and rewarding cash-rich investors, a rather arbitrary distinction. Defining a non-tradeable asset can be difficult as well.

Wyden also would have to find a way to treat capital losses. If assets are being taxed annually, volatility could quickly become a problem. For example, consider a case where an investor buys a share of stock at $40 whose value jumps up to $60 the next year, before falling back down to $30 by the time the investor sells it the year after. That investor gained nothing — in fact, he lost money on the transaction — yet he would still be liable for mark-to-market capital gains taxes based on the year the value increased unless there’s a system in place to treat losses properly. 

Wyden acknowledges this problem, saying only that investors would be able to deduct capital losses—but there are serious questions to consider on how to implement this needed protection. Ironically, deductions related to losses is one of the prime reasons for the zero corporate tax bills that so aggrieve Democratic candidates.

While mark-to-market rules would only directly impact wealthier Americans, Wyden’s plan also treats capital gains as ordinary income, which could represent a tax increase on a far greater swath of American taxpayers. Wyden justifies this by suggesting that capital gains currently enjoy a “preferential rate” in the tax code. But that is only somewhat true — capital gains are taxed at a lower rate than ordinary income because capital gains already face a few disadvantages compared to other types of income. Capital gains are not adjusted for inflation (so investors pay taxes on inflation “gains” that provide no actual benefit) and they are a second layer of taxation on income that has already faced corporate taxes.

And qualified dividend income, which would also be taxed at higher rates, is not exclusive to the wealthy — 15 percent of Americans with adjusted gross incomes (AGIs) between $40,000 and $75,000 had some qualified dividend income in 2017, as did 31 percent with AGIs between $75,000 and $200,000. These taxpayers could see their tax rate on these dollars increase from between 9 to 22 percent, depending on their tax bracket.

All told, Senator Wyden’s proposal represents a serious threat to good policymaking that has shown to have significant appeal from the left. A Democratic president would likely struggle to pass a wealth tax, while a mark-to-market regime would be more feasible — but with similar concerns about its structure and damaging economic impact.