"Moments, springtime, Eiffel Tower ... Funny taxis, kids at play." — FROM "Azure-te" as performed by George Shearing and Nat King Cole
A new proposal calls for unrealized investment gains to be taxed annually, based on how much they've grown in value each year. Investment gains are currently taxed only when assets are sold, so if enacted, this proposal would mark a major departure from the methods currently used to tax wealth. The burden on investors, and the negative impact on markets, would be significant.
A dollar earned through investing has traditionally been taxed preferably to a dollar earned through employment income. Additionally, the gains on investment appreciation remain untaxed until the asset is sold. The new proposal would not only eliminate this unrealized “carry,” it would tax those paper gains at ordinary income tax rates which cap out at 37 percent, not at lower capital gains rates.
Letting investments grow without taxation until they’re sold encourages investment in capital markets and private businesses, which stimulates more economic growth. If unrealized investment gains are taxed annually, it would add a massive hurdle to any startup and would cause a myriad of other unintended consequences.
Let's say you invest in a business that appreciates in paper value every year for a decade and you pay taxes on those unrealized gains annually. Then, at the end of ten years, the company experiences a reversal of fortune and closes shop. You would have paid taxes for ten straight years on an investment in which ultimately you lost money. Surely the new proposal allows you to deduct that loss, but the economic reality of paying taxes on an unproven, eventually unprofitable investment seems nonsensical.
The majority of jobs in America are created by small businesses, most of which are privately held. Another word for privately held is “illiquid.” Business owners would have to perform an expensive, complicated valuation on their company, which may or may not be realistically salable, and pay taxes on the increase in “value” annually, in addition to their normal income taxes.
These small businesses would also be hard-pressed to come up with the cash to pay unexpected, large tax bills. A breakthrough year might beget a backbreaking tax liability. Everybody would have to hold much more cash at all times, which of course is not an efficient use of capital, both for businesses and for the economy. That’s money that will not be invested in companies which will be creating tomorrow’s jobs. Venture capital has traditionally relied on unrealized taxable gains as an incentive for taking business risks.
While the need to address wealth and income inequality is very real, attacking the heart of the investment system and potentially damaging capital markets and businesses does not seem the best way to accomplish this goal.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin. This column should not be considered personalized investment advice and provides no assurance that any specific strategy or investment will be suitable or profitable for an investor.