Unrealized Gains Tax is an Economic Fallacy

President Biden delivering his 2024 State of the Union address

Taxing unrealized capital gains on property, stocks, and other assets is not just a bad idea, it’s an economic fallacy that undermines economic growth and personal liberty. Unfortunately, President Biden’s $7.3 trillion budget proposes such a federal tax. Vermont and ten other states have made similar moves.

This tax should be rejected, as it is fundamentally unjust, likely unconstitutional, and would hinder prosperity and individual freedom.

A tax on unrealized capital gains means that individuals are penalized for owning appreciating assets, regardless of whether they have realized any actual income from selling them. 

If you purchased a stock for $100 this year, for example, and it increased to $110 next year, you would pay the assigned tax rate on the $10 capital gain. You didn’t sell the asset, so you don’t realize the $10 appreciation, but must pay the tax regardless. The following year, it dropped to $100, so there was a loss of $10. Would you be able to deduct that loss from your tax liability? 

The devil is in the details of the approach to this tax, but the devil is also in the tax itself.

Adam Michel of Cato Institute explained two types of unrealized taxes in President Biden’s latest budget:

Under current law, capital gains are taxed when the gain is realized — when the investment is sold and there is an actual profit to tax… The budget proposes eliminating step‐​up in basis, making death a taxable event. The change applies to unrealized capital gains over $5 million for single filers ($10 million married).

And secondly,

The budget proposes a new minimum tax of 25 percent on income and unrealized capital gains for taxpayers with more than $100 million in total wealth. This new minimum tax would be a third, parallel income tax system, adding to the existing alternative minimum tax. The new minimum tax applies to two entirely new tax bases — wealth and unrealized capital gains. Defining and taxing wealth and unrealized capital gains pose numerous practical challenges and high economic costs.

Taxing unrealized capital gains contradicts the basic principles of fairness and property rights essential for a free and prosperous society. Taxation, if we’re going to have it on income, should be based on actual income earned, not on paper gains that may never materialize.

Moreover, taxing unrealized gains hurts economic activity by discouraging investment and capital formation, the lifeblood of a dynamic economy. When individuals know their unrealized gains will be taxed, they have less incentive to invest in productive assets such as stocks, real estate, or businesses. This leads to a misallocation of resources and slower economic growth.

Additionally, this tax reduces the capital available for entrepreneurship and innovation. Start-ups and small businesses often rely on investment from individuals willing to take risks in the hope of eventually earning a return on their investment. By taxing unrealized capital gains, we discourage risk-taking and stifle innovation, essential elements for improving productivity and raising living standards.

The tax undermines personal liberty by infringing on individuals’ property rights and financial privacy. It gives the government unprecedented control over people’s assets and creates a powerful disincentive for individuals to save and invest. This is particularly troublesome in an era of increasing government surveillance and intrusion into private affairs.

Proponents of taxing unrealized capital gains argue that it is a way to address income inequality and raise revenue for social programs. This argument can’t withstand scrutiny. This tax does little to address the root causes of income inequality, such as government failures in fiscal and monetary policies. Instead, this new tax would merely redistribute wealth from productive individuals to the government, thereby further misallocating hard-earned money.

Furthermore, the tax revenue raised from this tax will be far less than proponents anticipate, as individuals will work less, invest less, and find ways to avoid such taxes through legal paths. This would result in less economic prosperity and a resulting decline in tax collections.

From an economic and moral perspective, taxing unrealized capital gains from property, stocks, and other assets is a bad idea. It undermines economic growth, stifles innovation, and infringes on personal liberty. Instead of resorting to the misguided policies of the Biden administration and some states, we should remove barriers created by the government. These include reducing spending, taxes, and regulations. We should also impose fiscal and monetary rules.

Achieving these goals and ending the bad idea of a new tax on unrealized capital gains will encourage investment, entrepreneurship, and economic opportunity for all. Only then can we truly unleash the potential of a free and prosperous society.