Don't Turn Honest People into Criminals

On taxing unrealized capital gains

Alexander Lebed was a Russian general who ran for president in 1996 against Boris Yeltsin. He didn’t win, though he did go on to be Governor of Krasnoyarsk until his death in a helicopter crash. I remember that in Lebed’s presidential campaign he advocated scrapping Russia’s then-complicated tax system for a simplified tax. Lebed argued that given the still depressed economy in 1996, most people couldn’t pay the various taxes they owed and would have to cheat. He said that he opposed any system that turned honest people into criminals.

Gen. Alexander Lebed

This insight stuck with me, and recently came back amidst news that Kamala Harris supported Biden’s 2025 budget proposal. This includes a 25% minimum annual tax rate on centimillionaires, calculated on their income and unrealized capital gains. My guess is that the unrealized gains element of the proposal is there as a bargaining chip to trade for what they really want: higher rates on the wealthier. President Biden has never pushed for a tax on wealth or unrealized gains, despite pressure from the likes of Senator Elizabeth Warren, and Harris hasn’t mentioned either in her speeches. This makes sense: not only would such taxes face fierce opposition in Congress, but even if passed would likely be ruled unconstitutional by the Alito-Thomas Supreme Court.¹

Nevertheless, it is worth looking at the unrealized gains idea, as it could yet be tabled if the Democrats achieve a sweep in November and the party’s progressive wing forces the issue. I could not find much world history on the taxing of unrealized gains, but the idea looks most like wealth taxes, with which there is plenty of experience. In 1990, 12 European countries had such taxes, but after repeals there are only three left. France implemented a wealth tax in 2000 and killed it in 2018.

Some French friends were subject to the tax, and it was interesting to see how it affected their behavior. These were fundamentally honest people who as far as I know had always paid their taxes, but as General Lebed would have predicted, the wealth tax turned them into cheaters. Their assets were tied up in a family business and real estate, and the difficulty of liquidating parts of either asset class to pay the tax led to their first foray into avoidance. Before long they had a secret account in Geneva, as did many other countrymen, and when the French authorities cracked down there, they moved on to Dubai. Maybe now they’re in Wyoming or Vanuatu, who knows? The amount of wasted economic effort that went into tax avoidance was staggering, and 42,000 millionaires left France entirely during the first 12 years of the tax.

Turning back to the Biden-Harris budget, I am now going to make an unsupported claim, as is my style: a vast majority of American centimillionaires do not cheat on their taxes. While they may fudge at the margins, especially the more pages their returns run to, they pay roughly what they are supposed to. This is not just because they are moral, but because under our current system their claimed income and deductions are relatively easy for an IRS auditor to understand. Superrich people generally have enjoyable lives, and few want them ruined by scandal or prison, just to leave an even larger estate to their heirs (which must then be shared with the government anyway). Some are willing to take the risk, or even make a sport of it – some of those can even become president – but they are outliers.

Now consider the effect of a tax on unrealized gains. It seems simple enough to calculate the tax on stocks and bonds, if they are liquid and traded on an exchange. Even this raises obvious questions, though, like what happens when a stock ends year one on a high and then crashes, as happened with the entire Nasdaq in 1999-2000. As for illiquid stocks and bonds, they start moving us into the unworkable zone.

It is not clear whether the unrealized gains tax is meant to capture growth in the value of private companies or assets like real estate, art, etc. If these were not included, we can assume that centimillionaires would liquidate part of their securities portfolios and buy them instead – not great news for the stock market, the U.S. Treasury, or municipalities as they issue bonds. There are approximately 10,000 American centimillionaires; it has been estimated that the wealthiest 0.1% own 17% of stocks held by households. Besides the market impact, a tax-driven shift into illiquid assets would create economic inefficiencies, e.g., bubbles in properties, classic Ferraris (I don’t have one), Nolan Ryan rookie cards (I do have one), and many other asset classes.

If these kinds of assets were subject to the tax, the foreseeable consequences would be messy. If, say, a private single-owner business worth over $100 million appreciates in value by 20% one year, the tax due on that alone would be $5 million. If the owner has 95% of his net worth in the business and the rest in his house, which would not be unusual, he wouldn’t have cash to pay the tax. “That’s okay,” says the friendly IRS agent, “just sell a piece to raise it.” The owner explains that there’s no market for a 5% stake, “But tell you what, I’ll turn over 5% and you can be my partners.” Within a few years, the U.S. government becomes the majority owner, and good luck. Of course, under lobbying pressure “family farms” would be exempted from the tax, then oil royalty trusts, then whatever other group can bag a couple of Senators.

And who is going to value illiquid assets annually for the tax? Appraisers? The taxpayers themselves? This question leads us to the worst consequence of this idea, in my opinion. The worst is that it would be near irresistible for taxpayers to understate the value of their assets, and Lebed’s fear – law-abiding people who turn into cheats – would come true. And once the seal is broken, as it were, and previously honest rich Americans start cheating a little, they could start cheating a lot. Also, a new tax evasion industry would arise in this country and its offshore neighbors, including crooked appraisers and bank structures like those that helped Frenchmen evade the wealth tax.

To reiterate, the “centimillionaires supertax” will likely never happen both for practical and constitutional reasons, and all the tech and crypto bros hyperventilating on X can calm down. If Harris wins and the Democrats take the House, the traditional dance will play out: they will please their constituents by raising marginal tax rates on upper income earners, and when the Republicans return in a few years they will please theirs by lowering rates again. It’s a symbiotic relationship as useful for both sides as any seen in the animal kingdom.

One more note. In addition to our old friend the Alternate Minimum Tax, there already is a recently imposed significant tax that falls primarily on the wealthy: the 3.8% on unearned income (dividends and interest) that was implemented to help fund Obamacare. No politician, not Biden, Harris, Warren, Trump, or anyone else seems to remember it, but isn’t that how it is with taxes? You forget they exist when it’s someone else who is paying them.

1. Four conservative justices noted gratuitously in concurring or dissenting opinions to a recent decision that unrealized gains do not qualify as “income” for purposes of the federal tax code. Justices Roberts and Kavanaugh didn’t comment, but the issue was not presented, and I can guess what they would say if it was. Even Democratic constitutional scholars like Laurence Tribe have cast doubt on the constitutionality of federal wealth-based taxes.