Appreciating Taxes

After failing to arrive at a consensus on healthcare reform, the Republican party recently passed a blueprint which marked their shift in focus to something less contentious: the American tax code. If the Republicans are successful, compliance with tax regulation in the United States may soon change. An aspect of the code likely to be reformed is how asset appreciation is taxed.

What is asset appreciation?

Asset appreciation is an increase in the value of an asset over time. The tax on asset appreciation represents a major source of revenue for the government. Most economists agree that appreciation on assets should be treated as profit and should therefore be taxed. However, there is disagreement over what taxing model should be adopted.

Taxing models

The current regulatory system known as the realization event model taxes asset appreciation after a realization event. A realization event is when a taxpayer derives a benefit from their assets, like when a person sells property they own for more than the purchase price.

Despite the seemingly sound logic behind the current regulatory framework, it has practical downsides. First, realization disproportionately benefits the wealthy since the asset tax scheme allows for several loopholes that keep appreciation from the government. Essentially, it allows the wealthy to hoard wealth. Second, the realization model contributes to the increasing wealth gap between the upper, middle, and lower classes. Since the upper classes draw a significant portion of their wealth from their assets, and the realization model allows this wealth to be kept from the government, it is the extremely wealthy who disproportionately benefit from the realization requirement. For example, death is not treated as a realization event, which means that asset appreciation can be shielded from government taxing if retained until death. That is, when a person dies the appreciation they have shielded from taxation transfers to their beneficiaries. This hoarding goes against the notion of equitable taxation.

The model most economists favor is the mark-to-market model. Unlike the realization event model, the mark-to-market model taxes asset appreciation as it occurs. This system would ostensibly eliminate the ambiguity since the code would no longer have to define what a realization event is. By taxing appreciation as it occurs, the tax code can function on a straight forward definition of “the net accretion of economic power.” A mark-to-market system would also aid in the alienation of property since the tax incentive to hoard property until death would be eliminated. The mark-to-market system would also help to stabilize the wealth gap since it would give the government access to wealth previously hidden from it. The government can use this extra revenue to support education, infrastructure, and various programs designed to reduce the wealth gap.

Despite the many advantages to using a mark-to-market system, there are two glaring downsides. The first issue is one of practicality. The adoption of a mark-to-market system would require the restructuring of the internal revenue code. Second, as a political matter, it is unlikely the taxpayer will be immediately amenable to the taxation of a benefit they have yet to realize.

Somewhere between the realization and mark-to-market models is the disposition model. Under the disposition model, the federal government can tax the asset when its disposition changes, regardless of whether the taxpayer realized a contemporaneous benefit. The disposition model would help improve the disproportionate allocation of burden by curtailing the ability to avoid taxation.

Despite its benefits, the disposition model is not without drawbacks. Like the mark-to-market model, any attempt to implement the disposition model will have to contend with a culture that looks down upon taxes on paper gains. Additionally, while it addresses some downsides of the realization model (e.g. transfers on death), it does not completely remove them. For example, rather than tax the asset appreciation as it accrues, the disposition model requires the asset have a change in disposition. Without a change in disposition the asset appreciation remains shielded from taxation.

Striking a balance

While ideally all forms of assets should be taxed in the same manner, a social planner coming up with a taxing system must consider the social utility of a proposed plan. Where there is wealth inequality, the federal government has a rational interest in bridging the gap. The tax code can be a powerful tool for the tax planner who seeks to reduce the wealth gap. A possible solution is to combine the current realization model with the disposition model.  The Realization Model in its current form can be preserved with its loopholes for those who make less than a certain amount. The Realization model creates incentive to invest in property and other assets. The loopholes the rich use to hoard wealth can be repurposed to incentivize the poor and middle class to build lasting wealth. One of the most accurate predictors of future success is the amount of wealth possessed by a child’s family. By allowing those below a certain income to make use of the realization system we can encourage them to build this wealth. The disposition system then can be created to apply to those who make above a certain threshold. Not only would this circumvent the logistical issue of amending the current system entirely, but it would also allow the government to focus on collecting the revenue hoarded by the super wealthy.

Striking this balance in taxing models may mean the difference between a nation that distributes its wealth properly and one that does not.