By Kyle Pomerleau

President Joe Biden’s newly released FY 2023 budget proposes a new “Minimum Tax on Billionaires.” This minimum income tax seeks to tax the unrealized capital gains of very high–net worth households each year as those assets appreciate.

How would the minimum
tax work?

Under the proposal, taxpayers with a net worth of $100 million or more would pay a top-up tax if their effective tax rate on what the administration calls “total income” is below 20 percent. “Total income” is equal to taxable income plus unrealized capital gains.

When a taxpayer is subject to the minimum tax, they do not
have to pay the entire tax liability immediately. Instead, they are required to
make equal payments over five years. For example, if a taxpayer’s asset
appreciates by $100 in a single year, they will be required to pay up to $4 per
year for the next five years. The tax on subsequent appreciation will be spread
over five years and added to their current stream of yearly payments, and any
losses will also be spread out over five years and subtracted from their future
payments. If a taxpayer has no tax payments to offset in a given year, losses
will generate a refund from the federal government.

The base of the minimum tax would include all assets.
Taxpayers would be required to value “liquid” assets, such as corporate stock,
each year. “Illiquid” assets, such as closely held businesses, would be valued
each year using a formula based on the asset’s last known market price and an
annual return equal to the five-year Treasury rate plus two percentage points.

The payments that taxpayers make as assets appreciate would
be treated as a “pre-payment” of taxes due when the assets are ultimately sold.
As such, the amount a taxpayer pays when the asset is sold can be reduced by
the amount of minimum tax already paid on that asset.

If a taxpayer has a large share of “illiquid” assets (more
than 80 percent of total wealth), they could choose to continue to defer
taxation on their “illiquid” assets until sold. However, they would be subject to
a “deferral charge,” which would approximate the amount of tax they would have
paid if they were taxed on the asset’s annual appreciation.

The proposal would also apply a one-time tax on the previously
untaxed appreciation of assets. Taxpayers can choose to pay the one-time tax in
equal installments over nine years.

What is the tax
trying to accomplish?

Under current law, capital gains are only taxed when sold.
This “deferral” allows taxpayers to reduce their effective tax rates on capital
gains. Very wealthy households often can borrow against their assets to finance
current consumption without triggering capital gains tax. Gains that are
deferred until the death of a taxpayer also receive a basis “step-up” when
passed to heirs, eliminating income tax liability on those gains.

Deferral is a benefit that other types of capital income generally do not receive. If a taxpayer purchases a corporate stock that pays dividends, they will face tax each year on those dividends. However, if the taxpayer purchases a “growth stock,” they will only face tax when the asset is sold. As a result, the after-tax return on the “growth stock” would be higher than the dividend-paying stock.

The benefit of deferral discourages taxpayers from selling
assets. This is sometimes called the “lock-in” effect.

This proposal, combined with Biden’s proposal to eliminate
step-up in basis at death, would scale back the benefit of deferral but not
eliminate it. Taxpayers would still spread their payments over five years,
which would allow capital gains to accumulate, after tax, faster than they
would under a pure mark-to-market income tax. The tax would also not eliminate
the “lock-in” effect for taxpayers not subject to this minimum tax.

How much revenue would
the tax raise?

According to the administration, the minimum tax would raise $360 billion over the next 10 years. This would raise about twice as much as the administration’s proposal to increase the tax rate on capital gains from 20 percent to 39.6 percent and tax unrealized gains at death over the same period.

The majority of that revenue is from the one-time tax on the unrealized appreciation of currently held assets which can be paid over nine years. The tax would ultimately raise less revenue in future years and have a smaller impact on the debt and deficit.

Is this a wealth tax?

Some may be tempted to describe this tax as a wealth tax. Indeed, this proposal requires taxpayers to value their assets like an annual tax on net wealth. However, this is an income tax, not a wealth tax. There are important differences between an income tax and an annual tax on wealth. An income tax only applies when there is appreciation. An annual tax on wealth will apply whether or not an asset appreciates. In addition, an income tax applies equally to assets with both high and low rates of return. A wealth tax, on the other hand, taxes assets with low returns at very high effective rates and only lightly taxes assets with high returns.

What are some of the
potential challenges?

This proposal attempts to address some of the traditional challenges with mark-to-market income taxation. Spreading payments and refunds over time reduces revenue volatility and the chance of providing large refunds to wealthy taxpayers when the economy worsens. Using a formula to value illiquid assets allows the tax to apply to assets that don’t have an obvious market price. The option for taxpayers to choose the deferral charge instead of the annual tax limits the tax’s impact on illiquid taxpayers who would otherwise have to sell their assets to pay the tax.

However, these features present some challenges. Spreading payments and refunds over time adds complexity to the proposal. The use of the deferral charge can either under- or over-tax some assets and would not fully eliminate the incentive to hold on to assets. In addition, the $100 million threshold could create incentives to reduce wealth to avoid the tax.

Are there potential macroeconomic
effects?

Scaling back the benefit of deferral helps equalize the tax burden on certain types of assets. However, it would also tend to raise the overall tax burden on saving in the United States. Saving ultimately finances productive investments, which leads to more productive workers, higher wages, and greater economic output. The impact of the tax on investment and economic output will depend on how responsive taxpayers are to changes in the after-tax returns and how readily foreign capital can flow into the United States.

This proposal would also raise the tax burden on the returns to entrepreneurship and could discourage that activity.

Conclusion

Biden’s billionaire minimum tax aims to raise revenue from very wealthy households by taxing capital gains as they accrue. This tax would raise revenue, would be highly progressive, and would also reduce the “lock-in” effect. It is designed to avoid some traditional challenges with mark-to-market income taxation, but some of the designs increase complexity and make the proposal less efficient. This proposal would also increase the tax burden on entrepreneurship and saving in the United States, which could reduce economic output.

The post Biden’s ‘minimum tax on billionaires’ appeared first on American Enterprise Institute – AEI.